Economic Prospects of the CIS: Sources of Long Term Growth

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The Economic Prospects of the CIS

The Economic Prospects of the CIS Sources of Long Term Growth

Edited by

Gur Ofer Emeritus Professor of Economics, Hebrew University, Israel and the New Economic School, Moscow, Russia and

Richard Pomfret Professor of Economics, University of Adelaide, Australia

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Gur Ofer and Richard Pomfret 2004 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data The economic prospects of the CIS: sources of long term growth / edited by Gur Ofer and Richard Pomfret p. cm. Includes bibliographical references and index. 1. Former Soviet republics–Economic conditions–Congresses. I. Ofer, Gur. II. Pomfret, Richard W. T. HC336.27.E26 2004 338.947–dc22 2003064351 ISBN 1 84376 615 9 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents vii x xiii

List of abbreviations List of contributors Preface and acknowledgments 1

Introduction Gur Ofer and Richard Pomfret

1

2

Down and up the stairs: paradoxes of Russian economic growth 32 Ksenia Yudaeva, Maria Gorban, Vladimir Popov and Natalya Volchkova

3

Transition and growth in Belarus Marina Bakanova, Lúcio Vinhas de Souza, Irina Kolesnikova and Ivan Abramov

57

4

Ukraine: the lost decade . . . and the coming boom? Olexander Babanin, Vladimir Dubrovskiy and Oleksiy Ivaschenko

76

5

Barriers to growth in Moldova Artur Radziwill and Oleg Petrushin

6

Explaining growth in Armenia: the pivotal role of human capital Heghine Manasyan and Tigran Jrbashyan

101

128

7

Turkmenistan: economic autocracy and recent growth performance Alexandre Repkine

154

8

The Uzbek paradox: progress without neo-liberal reform Martin Spechler, Kuatbay Bektemirov, Sergei Chepel’ and Farrukh Suvankulov

177

9

Tajikistan’s growth performance: the first decade of transition Khojamahmad Umarov and Alexandre Repkine

198

Economic growth in Kyrgyzstan Roman Mogilevsky and Rafkat Hasanov

224

10

v

vi

The economic prospects of the CIS

11

Natural resources and economic growth in Kazakhstan 249 Yelena Kalyuzhnova, James Pemberton and Bulat Mukhamediyev

12

Conclusions Gur Ofer and Richard Pomfret

268

References Index

276 289

Abbreviations ADB AGR AM AMD ARA bcm BET BRB BSSR CEE CEECs CGE CIA CIS CISR COMEX CPI CPSU CST DD DW EBRD ECE EERC EIA EU FDI FERF FIAS FOB FPA FSU Gazprom GDN

Asian Development Bank Agriculture Armenia Armenian dram (National currency) Agency for Restructuring Agriculture billion cubic metres ‘Belarus Economic Trends’ Belarusian rouble Belarusian Socialist Soviet Republic Central and Eastern Europe Central and Eastern European countries computable general equilibrium Central Intelligence Agency Commonwealth of Independent States Center for Strategic Studies and Reforms, Chisinau, Moldova Turkmen Commodity Exchange consumer price index Communist Party of the Soviet Union construction Dutch disease Durbin-Watson Coefficient European Bank for Reconstruction and Development Economic Commission for Europe Economics Education and Research Consortium Energy Information Administration European Union foreign direct investment Foreign Exchange Reserve Fund Foreign Investment Advisory Service free on board fixed production assets former Soviet Union Russian (also Soviet) Gas Producing Corporation Global Development Network vii

viii


GDP gross domestic product GKO government short-term bonds GKS GosKomStat, Russian Statistical Bureau GNI gross national income GNP gross national product Goskomstat, GosKomStat, Russian Statistical Agency GRP gross regional product GVA gross value added HBC Hard Budget Constraints HDR Human Development Report HIPC heavily indebted poor country ICOR incremental capital–output ratio IFC International Finance Corporation IFI International Financial Institution IFO international financial organization IMF International Monetary Fund IND Industry IO input–output IT Information Technology ITERA Russian Gas Marketing Company JVs joint ventures LESC legal environment stability coefficient LSMS Living Standard Measurement Study NAR National Academy of Russia NATO North Atlantic Treaty Organization NBER National Bureau of Economic Research NIE newly industrializing economies NMP net material product NSC National Statistical Committee NSS National Statistical Service OAB Oxford Analytica Brief OECD Organization for Economic Cooperation and Development OLS Ordinary Least Square PhD Doctor of Philosophy PIP Public Investment Programme PPI producer price index PPP purchasing power parity PRGF Poverty Reduction and Growth Facility PSAs production-sharing agreements R rouble R&D Research and Development

Abbreviations

RCA ROP RSFSR SBC SD SER SISI ‘Opinia’

revealed comparative advantage resource-oriented policy Russian Soviet Federation Socialist Republic Soft Budget Constraints Standard Derivation Services de Serviciul Independent de Sociologie si Informatii (SISI) ‘Opinia’ SNA System of National Accounts SOEs state-owned enterprises SU Soviet Union TA technical assistance T-bills Treasury Bills TCO Transport and Communications TE transition economy TFP total factor productivity TRD trade and catering Turkmenstatprognos Turkmenistan Statistical Agency UGSS United Gas Supply System ULIE Ukrainian League of Industrialists and Entrepreneurs UNDP United Nations Development Programme US United States US$ US dollar USSR Union of the Soviet Socialist Republics VA Value added VAT Value Added Tax WB World Bank WP Working Paper WTO World Trade Organization YOY year on year

ix

Contributors Ivan Abramov, Head of Department, Institute of Economics, National Academy of Sciences of Belarus, Minsk Olexander Babanin, Associate Professor, European University, Kyiv Marina Bakanova, Country Economist, The World Bank, Belarus Country Office, Minsk Kuatbay Bektemirov, Head, Department in the Aral Sea Region Institute for Socio-Economic Research, Uzbekistan Academy of Sciences, Karakalpakstan Branch, Nukus Sergei Chepel’, Researcher, Institute of Macroeconomic and Social Studies of the Ministry of Macroeconomic Statistics, Tashkent Lúcio Vinhas de Souza, Economist, Kiel Institute for World Economics, Kiel Vladimir Dubrovskiy, Director, Center for Social and Economic Research, CASE-Ukraine, Kyiv Maria Gorban, Economist, Center for Economic and Financial Research, Moscow and Economist, European Business Club, Moscow Rafkat Hasanov, Head, Secretariat of the Special Representative of the President of the Kyrgyz Republic on Investment Attraction, Bishkek Oleksiy Ivaschenko, Researcher, Cornell University, Ithaca Tigran Jrbashyan, Managing Director CO, ‘Sed Marsed Investment Consulting’, Yerevan Yelena Kalyuzhnova, Director, The Centre for Euro-Asian Studies, The University of Reading

x

Contributors

xi

Irina Kolesnikova, Senior Researcher, Institute of Economics, National Academy of Sciences of Belarus, Minsk Heghine Manasyan, Director, Caucasus Research Resource Centers – Yerevan Roman Mogilevsky, Executive Director, Center for Social and Economic Research, CASE-Kyrgyzstan, Bishkek Bulat Mukhamediyev, Professor, al-Farabi Kazakh State National University, Almaty Gur Ofer, Emeritus Professor of Economics, Hebrew University, Israel and the New Economic School, Moscow, Russia James Pemberton, Head, School of Business, member of The Centre for Euro-Asian Studies, University of Reading Oleg Petrushin, Senior Economist, KPMG Consulting/Barents Group, and Sectoral Consultant, Center for Strategic Studies and Reforms, both in Chisinau Richard Pomfret, Professor of Economics, University of Adelaide, Australia Vladimir Popov, New Economic School, Moscow and Carleton University, Institute of Central/East European and Russian-Area Studies, Ottawa Artur Radziwill, Economist, Center for Social and Economic Research – CASE-Poland, Warsaw Alexandre Repkine, Visiting Professor, Techno-Economics and Policy Program, College of Engineering, Seoul National University, Seoul Martin Spechler, Department of Economics, Indiana University-Purdue University Indianapolis, Indianapolis, IN Farrukh Suvankulov, Research Scientist, Ministry of Finance of the Republic of Uzbekistan, Tashkent Khojamahmad Umarov, Head, Department of Microeconomic Research, Institute for Economic Research in the Ministry of Economy and Trade of Tajik Republic, Dushanbe

xii


Natalya Volchkova, Economist, Center for Economic and Financial Research, Moscow Ksenia Yudaeva, Policy Director, Center for Economic and Financial Research, Moscow and Scholar-in-Residence, Carnegie Moscow Center, Moscow

Preface and acknowledgments This volume’s ten country studies, which are mostly based on collaborative work by in-country and external researchers, were prepared within the context of a comparative project on ‘Understanding Growth’ organized by the Global Development Network (GDN).1 A major goal of the project was to bring out domestic research capabilities, as well as tapping into their access to country-specific information. Lyn Squire, Director of the GDN, and Gary McMahon, Principal Economist for the GDN, played an important role in promoting and managing the overall project. The Economics Education and Research Consortium (EERC) in Moscow – GDN’s regional network hub in the Commonwealth of Independent States (CIS) – designed the analytical framework and implemented the country study stage of this project. At the EERC in Moscow, Eric Livny was responsible for the terms of reference and research process design. In the many tasks of coordinating the project, he was ably assisted by Alexis Belyanin (recruitment of country study authors), Olga Lavrentieva (general project coordination), and Ludmila Semenova (preparing the book for publication). Four thematic papers prepared in the summer of 2000 provided a background against which proposals were assessed and competitively selected at a meeting in Moscow in February 2001.2 Unfortunately, teams on Azerbaijan and Georgia could not be assembled, and the Turkmenistan incountry participant subsequently withdrew from the project. First drafts of the papers were discussed at a workshop in Kyiv in July 2001, and the full papers were presented at the GDN Conference in Rio de Janeiro in December 2001. During 2002 the authors revised their papers to focus more succinctly on the CIS countries’ post-independence growth experience rather than on the 30 to 50 years growth experience, which was the time-frame of the GDN project. The full-length papers are available on the EERC website at http://www.eerc.ru and shorter versions, focusing on more specific topics, are collected in this volume. At the Moscow meeting, the proposals were refereed by Micael Castanheira, Gary Fields, Erich Gundlach, Sergey Guriev, Dennis Mueller, Gur Ofer and Richard Pomfret, and Stanislav Kolenikov acted as data advisor. At the Kyiv workshop, Micael Castanheira, Michael Kaser, Gur Ofer and Richard Pomfret commented on the drafts. In Rio the CIS papers xiii

xiv


were presented in sessions which also included papers from other regions, and the discussants included Bill Easterly, Noha El-Mikawy, Hadi Esfahany, Thorvaldur Gylfasson, Gary McMahon and Lant Pritchett, as well as ourselves. We thank all of these people for their comments. Finally, thanks to Cathrin Vaughan, Jackie Mcdermott, Alison Stone and also to Alexandra Minton at Edward Elgar, who was an excellent editor. Gur Ofer and Richard Pomfret April 2003

NOTES 1. The GDN was launched in 1998 by a number of national and international development institutions, and operates through a series of regional networks. The first global research project aims to explain the growth experience of the seven regions, and in collaboration with the OECD which is undertaking a similar project for its member countries, will yield a global account of economic growth. 2. The four background papers were: 1) Nauro Campos and Fabrizio Coricelli, ‘Growth in Transition: What we Know, What we Don’t, and What we Should’, 2) Micael Castanheira and Vladimir Popov, ‘Framework Paper on the Political Economics of Growth in Transition Countries’, 3) Randall Filer, Thorvaldur Gylfason, Sˇtepán Jurajda and Janet Mitchell, ‘Markets and Growth in the Post-Communist World’, and 4) Sergei Guriev and Barry Ickes, ‘Microeconomic Aspects of Economic Growth in Eastern Europe and the Former Soviet Union, 1950–2000’.

1. Introduction Gur Ofer and Richard Pomfret This book brings together ten studies on the transition and growth experience and the foundations for long-term growth of the new independent states created with the dissolution of the Soviet Union in December 1991. The 15 republics of the Soviet Union and their successor nation states exhibit a huge range in size and in income levels (Table 1.1), as well as in historical and cultural backgrounds and in resource endowments. Despite the variety of initial conditions, the number of countries and their shared Soviet experience provide us with a unique natural experiment of the effects of different approaches to establishing and organizing a market-based economy. The country studies of ten members of the Commonwealth of Independent States (CIS) are mostly based on collaborative work by incountry and external researchers. In this introduction, we provide an overview of the common pre-1992 background and comparative information about the post-1992 performance of the CIS countries. In the concluding chapter we will revisit the comparative aspects, bringing out the common and country-specific features of their growth experience since independence. The first section reviews the Soviet background and the second section the post-independence experience, emphasizing the uniformity and diversity of the 12 CIS countries’ recent history. The third section focuses on the problems of explaining economic growth in transition economies and outlines the individual country studies.

1.

THE SOVIET BACKGROUND1

Most of the literature, even more so the economic literature on the Union of the Soviet Socialist Republics (the USSR, hereafter the Soviet Union or SU), at least the Western literature, was related to the country as one political unit with a uniform economic system, planned and ruled from Moscow and tied together in a tight web of production, supply and trade network that ignored republican borders or distance.2 With few exceptions and only 1

2

2870 2600 1570 1130 1690 1340 2380 1640 2120 3110 2390 3430 2500 4170 3590 3110 69 66 69 66 69 72 71 73 71 69 69 70 70 69 71

464 417 343 363 386 623 455 643 627 476 589 569 643 607 623

0.289 0.289 0.287 0.308 0.307 0.304 0.259 0.328 0.292 0.238 0.258 0.278 0.235 0.299 0.274 0.278

11.1 15.5 32.9 51.2 35.0 43.6 14.3 33.6 14.3 3.3 11.8 5.0 6.0 1.9 2.4 2.3 37 44 41 34 39 71 47 46 54 43 55 51 61 59 47

19 11 17 50 13 24 17 21 20 38 79 18 32 24 31

24.4 20.9 22.2 10.3 12.1 24.0 14.5 18.6 18.0 33.4 18.0 12.8 33.2 18.4 41.5

Sources: Columns 1 and 2: World Bank (1992); columns 3, 4, 7, 9: Bosworth and Ofer (1995); columns 5 and 6: Atkinson and Micklewright (1992, Table U13), which is based on Goskomstat household budget survey data; column 8: Tarr (1994).

Notes: a GNP per capita in US dollars, computed by the World Bank’s synthetic Atlas method. b Poverty is defined as individuals in households with gross per capita income less than 75 roubles. c Impact on the terms of trade of moving to world prices, calculated at a 105-sector level of aggregation using 1990 weights. d The annual increase in the consumer price index, end of year.

289.3 16.8 4.4 5.3 3.7 20.5 3.3 7.2 5.5 10.3 4.4 148.3 51.9 1.6 2.7 3.7

Population Per cap Life High educated Gini Poverty GDP in Terms Inter-republic (million) GNPa expectancy specialists coefficient (% of pop)b Manufacturing of tradec Trade Balance; mid-1990 (1990) at birth (per 10000) (1989) (1989) % of NMP

Republic

USSR Kazakh Kyrgyz Tajik Turkmen Uzbek Armenia Azerbaijan Georgia Belarus Moldova Russia Ukraine Estonia Latvia Lithuania

Republics of the USSR: initial conditions (1989–90)

Table 1.1

Introduction

3

occasionally, were particular problems of individual republics or regions seriously discussed. The main exceptions were the republics of Central Asia with a mostly Muslim population and a significantly lower income level, different demography and different industrial structure. Indeed, the level of uniformity in the working of the political, social and economic systems was much more similar than in any group of market economies. The 15 republics that made up the Soviet Union were, however, different in a number of important respects (Table 1.1). They differ in size, from Russia with more than half the population and nearly two-thirds of the National Income, through large Ukraine, with more than 50 million population, down to Estonia with 1.6 million. They are located in different parts of the Soviet Union, some to the west of Russia, with relatively open transportation and other lines to the West, but others in the Caucasus and in Central Asia are landlocked with poor access to their neighbours. Around 1990, they varied in per capita income by a factor of just less than four, from Estonia at the top and Tajikistan at the bottom. While a significant range, it is much narrower than that between developed and developing countries over such a cross-continental expanse. The industrial structure of the different republics varied to some extent but less than what may have been expected by the gaps in income levels. The share of manufacturing in gross domestic product (GDP) ranged between 34 and 61 per cent in 14 of the republics, and up to a high of 71 per cent in Armenia. This is a wide range but it is entirely within or above the range of normal industrial shares in developed countries. It reflects the emphasis of the Soviet Union on industrialization as a major growth vehicle. Some republics, Russia, Kazakhstan, Uzbekistan and Turkmenistan, are generously endowed with natural resources, especially energy, a potential advantage if used properly and the symptoms of the Dutch disease are avoided. However, in the Central Asian republics and Moldova agriculture still employed more than a third of the labour force, and produced more than a third of GDP. The entire Soviet Union had smaller shares than developed countries of labour employed in services and of GDP produced in services. Other differences between the republics were narrower. Life expectancy at birth ranged between 66 and 73 years, the number of specialists with higher education ranged just between 343 and 643 per 10000 employees (Table 1.1). The high levels of health and education and of industrialization were partly the outcome of the Soviet growth strategy and partly the result of significant transfers, through the budget and via favourable terms of trade, granted by the central government (actually Russia) to the other republics.3 Russia’s subsidy to the other republics through the terms of trade amounted to about 8 per cent of its National Income, and the direct subsidies were additional. On the receiving end, the trade subsidies ranged

4


from 3 per cent of the respective National Income in Ukraine to as much as 42 per cent in Lithuania (Table 1.1). Much of the trade collapsed together with the Soviet Union, and with it most of the direct and indirect subsidies were also eliminated, a very serious demand and income shock, of varied degrees, to most of the newly independent states. All had to pay much higher energy prices and many witnessed their supply lines and the demand for most of their production collapse. The above is a partial list of some diverging initial conditions faced by the newly independent states. Initial conditions and their diversity were considered by students of transition as one group of factors that, side by side with the policies selected, affected the process itself and its outcome. Indeed the literature is divided over the relative importance of each of these two sets of factors, and some observers also emphasize the possible interaction between the two, that is that favourable (or adverse) initial conditions allow (or preclude) the choice of better (or poorer) policies leading to multiple better (or worse) outcomes. Also, the same policies may produce, with different initial conditions, opposite outcomes. While the great divide in this respect is between the former socialist countries in East and Central Europe (and also the Baltic States) and the CIS countries (Berglof and Bolton, 2002), there have also been significant differences in performance among the latter group. However, before going into the discussion of more differences in the initial conditions it is important to emphasize the common heritage and its major impact on the transition process. The legacy of the old regime can be divided into two main clusters. The first covers the physical economy and its infrastructure, the level of GDP, the industrial structure, the factors of production and their quality, the technological level and capacity, the transport and supply networks, the urban environment, and so on, some of which were mentioned above. They provide the physical base for further development and for long-term growth. Some of them are supportive and others may provide a hindrance to future economic growth. We come back to some of them below. The second aspect of the old regime is the institutional framework, in the most general sense, which coordinated the economic (as well as political and social) activity under communism. These institutions include the system of central planning, the growth and development strategy, and the authoritarian regime. In all these aspects the old regime was an almost complete contrast to the market system, the democratic regime and the institutional framework that the ‘transition to’ is all about. This contrast in institutional regimes, and the task of complete overhaul, is a much higher barrier to successful transition, and much more difficult to overcome, than any of the physical economic characteristics listed above.

Introduction

5

The transition is first of all, and most of all, one of the most radical institutional changes in modern history. In discussing this great transition, we follow the conceptual framework developed by Douglass North (1990, 1994, 1999). According to him the quality of any (market) system depends on the quality of its institutions. They consist of three elements: the formal rules of transactions and the legal infrastructure, the informal behavioural norms of the population and the bureaucracy, and the quality of enforcement. On the level of formal institutions, the centrally planned system is a command economy. All decisions on production and transactions are made at the top and are implemented through a hierarchy of mostly quantitative commands, whose fulfilment is enforced by coercive means and strict discipline. This is a diametrically opposite set-up to that of a market-based system in which most decisions are voluntary, originating from below with individual initiatives responding to, mostly, price signals and other indirect incentives, obeying the laws of conduct rather than specific instructions. The authoritarian nature of the regime was also characterized by the general rule that all is forbidden unless declared permitted, the opposite principle of a democratic regime. While under central planning the rules of the game were universal in principle, and in this respect impersonal, unlike in a market environment every agent was personally identified and accountable to the authorities. In this way the authoritarian regime was open to ample discretion with highly arbitrary decisions and thereby it eliminated a substantial degree of its seemingly impersonal nature, raising significantly the costs of transactions and opening the door to ample corruption, which is also the result of the need to negotiate so many decisions with the bureaucracy. Central planning is a rigid system, working best in routine mode and paying a very high price for any changes. It can enforce relatively more easily quantitative directives rather than qualitative ones. Hence, most of the control and rewards in the system are for doing more of the same, very little is effectively directed to improved quality to enhance efficiency and to the introduction of new technologies. Very taut plans with demanding quantitative targets crowd out qualitative improvements. Therefore creativity and initiatives from below are mostly discouraged, even rejected. Despite the seeming advantage of a central government to internalize the positive external effects of R&D and the dissemination of new technologies, the communist system failed in this area. As the economy developed, central planning became more cumbersome, rigid and inefficient, contributing to declining growth (Ofer, 1987). The reign of quantities under central planning delegated a marginal role to prices, the traffic police of the market. Prices had a very limited allocative

6


role and were used mostly for accounting and control purposes. Prices were determined by the government and were in many cases distorted. The semiautarchy of the Soviet Union, and the full isolation of domestic prices from world market prices, helped preserve the extreme price distortions, another barrier on the way to the market and to openness. The growth strategy under communism, consistent with the above, followed a model of ‘extensive growth’ aspiring to maximize growth through utmost mobilization of all available inputs, labour and capital. All ablebodied were required to work, low wages served as an added incentive for high participation rates, and investment rates were kept high, concentrated mostly on heavy industry and capital goods. This emphasis on heavy industry, connected also with the military effort, gravitated the SU and most of the republics into a state of over-industrialization, imposing additional burdens of restructuring on the transition. While technological innovation and emulation of Western technology were sought, the nature of central planning and the concentration on input mobilization failed the system in this respect. The extensive growth model leads by definition to declining growth rates and eventual stagnation as the untapped reserves of labour (for a given population) and the ability to keep a high rate of capital accumulation are exhausted. Indeed, apart from most of the Central Asian republics, labour reserves were exhausted earlier, which pushed Soviet growth to depend more and more on investments, resulting in a sharp decline in capital productivity. Also contributing to the system’s failure and to declining growth was the decision of the Soviet leaders to engage in an intensive military build-up and arms race, which was especially damaging to civilian technological advance, and the policy of haste, of cutting corners in order to achieve fast growth early, even at the cost of heavier losses of growth later on. Inappropriate technology, run-down infrastructure, overutilized natural resources and a distorted industrial structure (over-industrialization and undeveloped services), and a very low rate of population growth in most republics were part of the heritage of this strategy for the new regimes. All the above notwithstanding, the combination of central planning and the growth strategy did achieve some of the goals of the Soviet regime; faster growth at the beginning, industrialization and urbanization, and modernization, and a significant increase in the standard of living of the population; all with more success during the earlier stages and less during the last two decades of the Soviet Union. The communist regime also invested relatively large amounts of resources in education and in health, bringing the United Nations Development Programme (UNDP)’s ‘Human Development Index’ (United Nations, 1997) of the Soviet Union well above the country’s ranking according to its level of per capita income and creat-

Introduction

7

ing a respectable stock of human capital, which also served the goal of growth. The Soviet Union also maintained a certain level of income equality (even allowing for the special privileges to the elites), partly through wage policy and partly through generous welfare services, which among other things also contributed to weak incentives. In order to finance large investments, defence expenditures and generous social services, the communist regime maintained large public budgets. The budget was financed mostly from the profits of public enterprises and from various turnover (sales) taxes, imposed at the gates of enterprises, with little or no real tax-collecting effort. The big government budget and the lack of any culture of voluntarily paying taxes in a market environment came back to haunt the new states during the transition period. These, together with a corresponding lack of any meaningful macro-monetary system, contributed to the eruption of inflation and to the difficulties in combating it, as well as to the difficulties during the early transition period in preserving the high levels of social services and human capital, needed badly for long-term growth. Formal institutions, à la North, are supported by efficient enforcement and by informal institutions. Enforcement under the communist regime was through intimidation and harsh sanctions. Everybody was scared of the various police forces and of the officials of the Communist Party. The courts of law served as additional government arms to impose its will and the chance of winning a case against the government was near zero. Following the death of Stalin, discipline started very slowly and gradually to erode and with it also the fear. More and more law enforcers directed attention to their self-interest, engaging in illegal activities, corruption and bribery. These phenomena expanded significantly towards the end. Over this period there were no attempts to change the legal system and laws, to adjust them to a somewhat less fear-stricken society. The new independent states inherited an enforcement system that was utterly unfit for a free and democratic society, but also one that had already developed a corrupt culture that, unless radically reformed, could only flourish further under the new little-restricted freedoms of a transition economy. Informal institutions are the collection of behavioural norms, the culture of doing business, negotiating and observing contracts, and following the rule of law with little intervention by the legal or enforcement authorities. They develop over time under the umbrella of formal institutions, and support them. An illustration from the field of contracts in a law-abiding society is that most contracts are not prepared by lawyers, the majority of them are observed, most cases of disagreement are settled by the parties, and only very few reach the courts. During the very early years of the communist regime, ideology played a role of supporting the regime and its goals

8


among parts of the population and among the elites. National patriotism supplemented and then replaced ideology during and in the aftermath of the Second World War. The supporting mentality was supplemented and then largely replaced over time by an alternative body of informal rules and norms of behaviour, antagonistic to the formal institutions. While these informal institutions provided a degree of flexibility absent but badly needed in order for the rigid system to function, they mostly provided an opportunity for people to take advantage of the system for their self-benefit. The informal institutions in the economic sphere consisted of norms of behaviour that helped officials and managers of enterprises and shops to negotiate deals outside the production plan to help them fulfil the plan outside of its instructions, but also to simulate plan fulfilment without really doing so, to negotiate with lower-level authorities reduction of the targets against the permission of those higher up, and to conspire to steal outputs and inputs from the state by shifting deals to the underground economy. In this way the informal institutions undermined the formal ones, unlike in North’s framework where they support each other. The arbitrary and discretionary nature of the regime and its dependency on personal connections and relationships provided perfect support for such activities. The contrast between formal and informal institutions was further widened by the hypocritical behaviour of the leadership, manifested in a growing contrast over time between the declared goals and values of the regime and its hidden agenda of power and self-serving. Increasing segments of the population came to realize the gap and responded through shirking, a growing sense of cynicism and strong distrust, which further encouraged unlawful, ‘informal’ behaviour. While most assets were formally the property of the state, their property rights trickled informally down the bureaucratic ladder, opening opportunities for rent-seeking and taking. In this way the old regime left to the transition states scorched land as far as proper free-society modes of conduct are concerned. It destroyed all the institutions of civil society, decimated any remnants of social capital and positive social networking, and destroyed the basis for solidarity and of observing the law. Transaction costs under this environment skyrocketed.4 The transition economies (TEs) inherited the perception of a deep conflict rather than complementarity between formal and informal institutions, which also made enforcement more difficult. This conflict, or gap, was made still deeper due to the non-familiarity of everybody with the nature of the new laws for a market economy and a free society, many of which were imported from the West and transplanted.5 In this respect the East European countries and the Baltic States enjoyed the advantage over the CIS states, of being able to refresh their own, more familiar pre-Second

Introduction

9

World War codes. In the CIS states, the enhanced freedom under the new regime (and the weak bureaucracies) opened up vast opportunities for the old behavioural norms to flourish. In the framework of Douglass North the two most important roles of the government in supporting the market economy are the protection of property rights and of contracts, and the facilitation of impersonal, universal transactions, in place of the personally based transactions typical of lessdeveloped markets. Given the tasks of privatization and of the creation of markets, not to mention all the other government roles, an effective government is even more important during the transition than under normal conditions. The discontinuous nature of the transition, involving huge redistribution of assets, extreme changes in relative prices, and opening the economy, provided ample opportunities for rent-seeking and other grabbing activities. The meeting of these opportunities with the economic and transactions environment of the pre-transition period imposed an additional heavy responsibility on the government. The sad story is that while TEs suffer from a greater incidence of market failures, warranting more government intervention, their institutions suffer from serious government failures that put in great doubt the merit of such interventions. In many cases, the government becomes a partner of ‘state capture’ rather than one of its combatants. All TEs, but the CIS states in particular, suffer from weakness and inefficiency of the government; the most obvious reason for this is the lack of knowledge and experience of how to run a market democracy. The CIS countries suffered from an even deeper governance problem, since none of them had real government under Soviet rule, and all were subject to the Soviet highly centralist rule. The case of Russia is less clear: while the republic of Russia per se shared the same experience as all the others, in 1992 it inherited the ministerial structure of the Soviet Federation, its Central Bank and so on. The new CIS states, except for Russia very long ago (and the Baltic states) had no national legacy as independent states, nor any experience with capitalism and democracy that could have been revived and relied on. Even a common national identity was and is still absent in many of them. In the Caucasus and Central Asia there is a pseudo-national history in some states, which is more tribal than national, but in Belarus and Moldova national feelings are only remotely defined. National identity is also in dispute in Ukraine, Moldova and Kazakhstan (and the Baltic states) where history and the deliberate Russification efforts of the Soviet government increased the proportion of Russians among their populations. While some of the population in a number of CIS states were elated by gaining independence and freedom from Soviet domination, these feelings were not as strong as in East Europe

10


and the Baltics, and a degree of attachment to and continuing dependence on Russia did remain. None of the CIS countries could rely on expectations of joining the European Union or the North Atlantic Treaty Organization (NATO), giving them hope and motivation for sacrifices, and guidance (Roland and Verdier, 1999; Roland, 2000). None of the CIS countries under the Soviet rule developed any significant opposition to the regime, not to speak of one with some democratic and market experience. True, in many cases pseudo opposition leaders or groups took over the government from the ruling Communist Party secretariats, but all of them came from the ranks of the Communist Party and could hardly contribute the needed experience and knowledge. Furthermore, they faced an uphill conflict with the government structures that more or less remained in place. In cases where the old communist regime stayed in power (Kazakhstan, Turkmenistan, Uzbekistan) there may have been a chance for a more effective government, but then the pace of the reforms was put in doubt.6

2. ECONOMIC REFORM IN THE COMMONWEALTH OF INDEPENDENT STATES After the dissolution of the Soviet Union in December 1991, the 15 republics became internationally recognized independent nations. Twelve of them formed a loose successor organization, the Commonwealth of Independent States – the three Baltic countries did not join the CIS.7 Despite many agreements to maintain the common economic space within the CIS and the continued economic importance of Russia to most CIS countries, the organization has had little economic content. The CIS members do, however, have sufficient common background that they form an obvious group for comparative economic analysis. Since 1992, however, they have pursued diverging paths in economic strategy and policies All of the CIS countries have been involved in the transition from a centrally planned economy to a market-based economy.8 The transition had begun under Gorbachev’s leadership in the late 1980s, but the dissolution of the Soviet Union added negative economic shocks to the already apparent transformational recession and inflation, and allowed national variation and experimentation in transition strategies. Although the general principle following the dissolution of the Soviet Union was for the republics to become independent countries with the preexisting borders and political leadership, an immediate effect was to intensify inter-republic conflicts, stimulate secession movements, or provoke civil war for national control. The Armenia–Azerbaijan conflict over NagornoKarabakh was the bloodiest inter-state conflict until a 1994 ceasefire, and

Introduction

11

remains unresolved. Georgia and Moldova have secessionist regions that operate largely outside the central government’s control. Tajikistan’s civil war ended with a 1997 peace agreement, but the government’s authority over some areas remains incomplete. Russia has ongoing difficulties in Chechnya. Elsewhere nation building was less bloody but still difficult. Apart from Russia the CIS countries had no previous experience of nationhood and to varying degrees the leadership was preoccupied in the early years with building a national identity as well as with the practical problems of building national institutions. Large minorities, especially the Russian minorities in Kazakhstan and Ukraine, required political balancing acts. The political disruption added to the economic disruption of the breakup of intra-Soviet ties. Production chains had already begun to dissolve in 1990 and 1991, but formal independence was an added blow. The extent of inter-republic transfers within the Soviet Union is controversial; it was very significant to some republics, but apart from some continuing subsidization of energy trade, the transfers ended more or less definitively in 1992. The shift from controlled to world prices for international transactions benefited some countries more than others (see the final column of Table 1.1), but everywhere the process of adjusting to major price changes and breaks in demand and supply chains added to the transformational recession which had begun in the final years of the Soviet Union. The cumulative decline in output was far more severe than in Eastern Europe (apart from war-torn Yugoslavia) and for most of the Soviet successor states was concentrated in the period 1992–94 (Tables 1.2 and 1.3, and Figure 1.1).9 The years 1992 and 1993 were a period of monetary chaos. In an attempt to alleviate the economic impact of the collapse of the Soviet Union, the CIS countries retained the common currency. The institutional design of the rouble zone was, however, unstable as each national government could create rouble credits, retaining the seigneurial benefits for itself but distributing the inflation costs across the whole rouble zone. The currency arrangement added to the hyperinflation of 1992–93. The countries issuing national currencies and then adopting price stability as a priority (that is, the Baltic countries and the Kyrgyz Republic) were the first to bring inflation down below 50 per cent. By the mid-1990s, however, almost all CIS governments recognized the high costs of hyperinflation and the monetary causes of inflation, so that controlling inflation through monetary policy became a priority (Table 1.4). Against this backdrop, CIS governments were either actively or by default creating market economies. Administered resource allocation by central planners has been replaced by allocation of resources in response to market signals, although governments continue to play a role in influenc-

12

12 1 1 21 13 5 18 5 7 5 12 1 10

8 12 3 12 0 3 2 4 2 2 3 2 7

42 23 10 45 3 19 29 15 29 5 14 11 2

1992 9 23 8 25 9 16 1 9 11 10 14 2 0

1993 5 20 13 11 13 20 31 13 19 17 23 4 4

1994 7 12 10 2 8 5 1 4 13 7 12 1 5

1995 6 1 3 11 1 7 8 4 4 7 10 2 5

1996 3 6 11 11 2 10 1 1 2 11 3 3 5

1997 7 10 8 3 2 2 7 5 5 5 2 4 4

1998

2001preliminary actual figures from official government sources; 2002EBRD estimates.

1991

1990 3 7 3 3 2 4 4 4 4 16 0 4 3

1999 6 11 6 2 10 5 2 8 8 18 6 4 4

2000 10 11 4 5 13 5 6 5 10 12 9 5 3

2001 8 9 3 4 8 2 4 4 7 14 5 3 2

2002

74 62 91 37 84 71 37 64 56 96 46 105 113

2001; 1989100

Sources: 1989: European Bank for Reconstruction and Development (EBRD), Transition Update (April 2001), p. 15; all other years: Transition Report (2002), p. 58.

Notes:

14 4 8 5 0 8 9 0 3 7 4 4 1

1989

Growth in real GDP 1989–2000 (%)

Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyz Rep Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan CEE & Baltics

Table 1.2

13

249.7 2.7 5.5 9.2 4.9 13.8 3.2 3.2 3.7 132.7 3.2 2.4 48.3 13.1 1.4 2.4 3.2

USSR Armenia Azerbaijan Belarus Georgia Kazakh Kyrgyz Lithuania Moldova Russia Tajik Turkmen Ukraine Uzbek Estonia Latvia Lithuania

1513 17 24 48 29 105 12 25 20 872 13 11 238 67 12 19 25

GDP 6058 6189 4458 5234 5894 7593 3702 7589 5379 6577 4105 4795 4933 5118 8656 7780 7589

GDP p.c. 289.4 3.3 7.1 10.3 5.5 16.7 4.4 3.7 4.4 148.3 5.3 3.7 51.9 20.5 1.6 2.7 3.7

Pop. 1988 20 33 73 41 122 16 32 27 1151 16 13 311 87 17 26 32

GDP

1990

6871 6142 4681 7153 7569 7305 3592 8591 6211 7762 2995 3626 5995 4264 10733 9841 8591

GDP p.c. 290.9 3.8 7.7 10.2 5.4 15.6 4.7 3.7 3.6 146.9 6.1 4.8 50.3 24.1 1.5 2.4 3.7

Pop. 1132 13 16 59 15 75 10 22 9 664 5 8 127 79 15 15 22

GDP

1998

3893 3341 2135 5743 2737 4809 2042 5918 2497 4523 830 1723 2528 3296 10118 6216 5918

GDP p.c.

Source:

Maddison (2001), pp. 183–5.

Notes: Popmid-year population in millions; GDPgross domestic product in billion 1990 international dollars; GDP p.c.gross domestic product per capita in 1990 international dollars.

Pop.

1973

Maddison’s estimates of per capita GDP at PPP

Republic

Table 1.3

14

177 412 709 163 176 41 30 198 609 1005 377 305 20

1995 19 20 53 39 39 31 24 48 418 992 80 54 15

1996 14 4 64 7 17 26 12 15 88 84 16 59 10

1997 9 1 73 4 8 36 39 86 28 24 23 29 8

1998

European Bank for Reconstruction and Development (EBRD) (2002), Transition Report, p. 60.

5273 1664 2221 15607 1892 229 330 311 350 1748 891 1568 39

1994

Source:

3 732 1 129 1 190 3 125 1662 772 789 875 2195 3102 4 735 534 251

1993

2002estimate.

1 346 912 971 887 1381 855 1 276 1526 1157 493 1 210 645 445

1992

Notes:

274 107 94 79 79 85 98 93 112 103 91 82 119

1991

Inflation (change in consumer price index)

Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyz Rep Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan CEE & Baltics

Table 1.4

1 9 294 19 7 12 8 28 43 17 11 18 5

1999

2001 3 2 61 5 8 7 10 22 39 12 12 26 6

2000 1 2 169 4 13 19 31 21 34 8 28 50 7

1 3 41 5 6 3 9 16 13 10 2 23 3

2002

15

Introduction

115

Central Europe

105 Uzbekistan

95

Belarus Estonia

85

Turkmenistan Kazakhstan Kyrgyzstan Latvia Lithuania Russia

75 65

Azerbaijan

55

Tajikstan Armenia Ukraine (forecast) Georgia Moldova

45 35

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

25

Source: Popov (2001), p. 6.

Figure 1.1

GDP change in FSU economies, 1989 100

ing both prices and the framework within which people respond to price signals. A fuller menu of necessary reforms would include, besides price liberalization and privatization, emphasis on the interconnection between inflation and budget deficits, the benefits of bringing domestic prices (including interest rates) in line with world prices, financial and banking reform to remove constraints on enterprise formation and expansion and to ensure efficient allocation of capital, property rights essential for a market (and enterprises) to function effectively, enterprise reform (not just privatization, but removing soft budget constraints and facilitating formation of new enterprises), and welfare reform to provide a safety net for those unable to provide for themselves in the market economy. Some of these reforms are, of course, easier to implement quickly than others and almost everywhere the first stage of transition concerned the trinity of liberalization, stabilization and privatization. Early transition debates within the CIS, as in Eastern Europe, concerned the relative merits of rapid and gradual reform. Big Bang (or Washington

16


Consensus or ‘shock therapy’) strategies emphasized the interactions and necessity of proceeding quickly and in synchronization; without meaningful relative prices and a stable absolute price level, enterprise reform would not produce good resource allocation, but without enterprise reform there would be no necessary response to relative prices. Gradualists feared the adjustment costs, welfare losses and social disruption of Big Bang policies. In practice, the Big Bang versus gradualism debate subsided because all agreed on the general nature of the list of needed reforms and nobody advocated major delay. The first transition stage was easier, while the second stage of institutional reforms was slower. Prices were substantially liberalized in January 1992, when Russia undertook a general price reform and the other countries followed, albeit with exceptions for a varying list of key goods and services. Despite initial scepticism in some countries about free trade and the need for price stability, these two goals were accepted very quickly as prime targets. Policy-makers came to appreciate that openness has important benefits – not just in gains from trade, but also the introduction of appropriate relative prices, access to best-quality inputs, and dynamic benefits from the transfer of ideas and techniques.10 A liberal trade regime is reflected in the almost universal acceptance of the principles incorporated in the World Trade Organization (WTO); by 2002 Turkmenistan was the only transition country not to have applied for WTO membership (Table 1.5). Fiscal balance was difficult to achieve, because government revenues fell, while demands for expenditures continued or even increased; in general, they declined for support of the economy, investment and defence (apart from in war situations), but increased for social services and for providing an economic safety net. Moreover, policy-makers unacquainted with macroeconomics at first failed to appreciate the tight connection between budget deficits and accelerating inflation. Nevertheless, after initial hyperinflationary episodes, price stability was generally recognized as a priority.11 In the long run, stabilization requires fiscal balance especially if the domestic capital market is thin; although foreign aid can help in the short run, in practice it seemed to delay necessary fiscal reforms (as in Moldova, Ukraine, the Kyrgyz Republic or Mongolia). Privatization was embarked upon rapidly, and in all countries small-scale privatization and housing privatization proceeded quickly. Large-scale privatization was slower and the procedure varied across countries. In some cases voucher privatization led to fairly rapid distribution of many state assets, but raised concerns about equity and insider control. In other countries, a case-by-case approach to selling large enterprises led to much slower privatization as assets were overvalued or unacceptable conditions were imposed. A theme of several of the country studies in this volume is that

Introduction

Table 1.5

17

WTO status of Soviet successor states WTO status

Kyrgyz Republic Latvia Estonia Georgia Lithuania Moldova Russian Federation Belarus Armenia Ukraine Uzbekistan Kazakhstan Azerbaijan Tajikistan Turkmenistan

Joined WTO 1998 Joined WTO 1999 Joined WTO 1999 Joined WTO 2000 Joined WTO 2001 Joined WTO 2001 Negotiating (1993) Negotiating (1993) Negotiating (1993) Negotiating (1993) Negotiating (1994) Negotiating (1996) Negotiating (1997) Negotiating (2001) Not applied

Note and Source: date in brackets is when the Working Party was established. Up-to-date membership information is provided on the WTO website www.wto.org.

the variations in privatization methods affected the nature of the market economy being established and the growth performance of individual countries. By the end of the 1990s all of the CIS countries, with the possible exception of Belarus, had more or less completed the first stage of transition; prices had been liberalized, the macroeconomy stabilized and most small enterprises privatized. The painful progress of large-scale privatization, however, highlighted the need for structural reform. Enterprise reform needed to go beyond a simple change of ownership. For market incentives to elicit desirable responses, enterprises must face hard budget constraints, have access to finance at competitive interest rates, be prevented from engaging in anti-competitive behaviour, enjoy protection of physical property and of other property rights, be able to rely on efficient infrastructure provision, and so forth. Already during the first stage of transition substantial variations in the form of market economies had emerged in the CIS, but these differences are widening during the more complex second stage. There are diverse paths to establishing a market-based economy, just as there are many variants of market-based economies. Growth has come primarily from new enterprises, although they can take diverse forms (new private enterprises in Poland, township and village enterprises in China). For such enterprises to succeed, the government must not be too heavy

18


handed; the grabbing hand of the state can prevent the working of the invisible hand of the market. The extent to which governments can provide a helping hand is disputed; governments must provide law and order and other public goods, and address market imperfections, but whether they should go further in promoting new enterprises by providing training, subsidizing credit, creating special zones and giving other tax benefits (after choosing losers and winners), is doubtful. A corollary to the role of new enterprises in generating growth is that not much economic growth has come from the pre-existing state enterprises, whether privatized or restructured in some other way. The only effective solution appears to be to establish a hard budget constraint and take the consequences. The World Bank’s study Transition: The First Ten Years (2002) concludes that the success formula has been ‘encouragementdiscipline’ – the former applied to potential new enterprises and the latter to pre-existing old enterprises. Inequality and poverty increased dramatically in Eastern Europe and the former Soviet Union (Table 1.6).12 The trend was perhaps not unexpected, Table 1.6 Poverty measures for Eastern Europe and CIS 1987–99 and 1993–95 Country

Belarus Estonia Kazakhstan Kyrgyz Rep Latvia Lithuania Moldova Russia Turkmenistan Ukraine Uzbekistan

1987–99

1993–95

Number, millions

Share of population, %

Number, millions

Share of population, %

0.10 0.02 0.80 0.50 0.03 0.04 0.20 2.20 0.40 1.00 4.80

1 1 5 12 1 1 4 2 12 2 24

2.3 0.6 11.0 4.0 0.6 1.1 2.9 74.2 2.4 32.7 13.3

22 37 65 88 22 30 66 50 61 63 63

Notes: The numbers indicate how many people in each country were living below a poverty line of 120 international dollars per month; ‘international dollars’ means that values are estimated at purchasing power parity using 1985 US dollars as the base. The 1990s data are for 1993, except that Lithuania is for 1994, and Belarus, Estonia, Latvia and Ukraine are for 1995. Lithuanian data for 1993/94 do not include consumption in kind. Source: Milanovic (1998), Table 5.1.

Introduction

19

as a market economy rewards people through income differentials, but the extent of the increase in inequality did come as a surprise. The high incidence of poverty was particularly shocking to people who had lived in a superpower where poverty was never officially recognized – even if large numbers of people, especially in Central Asia and the Caucasus, were living in under-provisioned households with per capita income of less than 75 roubles in 1989 (Table 1.1). By the early 2000s provision of a safety net for those who were having difficulty coping in the market economy had become a priority, with governments that failed to provide such a safety net facing difficulties in maintaining public support for further structural reforms. Tables 1.7 and 1.8, as well as the recent year columns in Tables 1.2–1.4, give selected information on the distance travelled by the CIS states so far, and on how ready they are to embark on long-term economic growth. By 2000–2002 most of the countries have stabilized, both fiscally and monetarily, and already experienced a few years of economic growth, though most are still struggling to regain the 1990 level of per capita GDP. Most of the countries transformed their economies from predominantly public, through a variety of privatization processes, to predominantly private, with Belarus, Turkmenistan, Uzbekistan and Moldova lagging behind. All countries went through a significant structural change with a decline in the share of industry and a rise in services. By 2002 most of the countries managed to avoid extremely large external deficits, Azerbaijan, Armenia, Moldova excepted, but most CIS countries, even those with rich natural resources, accumulated significant external and internal debt in the process. Only a few succeeded in using borrowing for successful stabilization, restructuring and growth. All of them except for Russia started the transition with no debt and this provided an opportunity to borrow additional resources for growth and restructuring. The high debts accumulated by the turn of the century will constrain further use of borrowing and impose a fiscal and trade burden on future growth prospects. Foreign direct investment (FDI) is a most desired substitute to foreign borrowing, but so far most CIS states have failed to attract significant FDI flows, the exception being the few energy-rich countries. Outsiders investing in a country expect a level playing field, full protection of their property, and no advantage to the domestic competitor. Therefore the extent of FDI flows to a country is one of the best indicators of the solidity and maturity of the institutional environment. This is why the extent of FDI flows, the abundance of natural resources and military conflicts kept aside, are consistent with the achieved transition levels (Table 1.7). This is also why both European Bank for Reconstruction and Development (EBRD) transition indexes and FDI flows are so much higher in the Central and Eastern Europe (CEE) and Baltics group. While the CIS countries most advanced in the transition had

20

Source:

Note:

54.3 49.9 54.6 74.5 59.0 65.4 31.8 66.6 68.2 61.5 67.3 59.2 40.0 49.3 52.0

3 2 2 4 3 3 3 3 3 3 3 2 1 2 2

23.8 19.9 31.3 37.8 18.2 22.4 28.0 37.6 31.6 27.4 35.8 16.3 24.4 36.6 32.5

3.8 1.4 0.4 0.4 2.0 1.1 6.0 1.9 1.9 0.5 2.9 0.1 0.8 1.6 0.5

9.5 0.9 0.8 6.2 6.8 7.8 3.4 9.7 4.8 9.1 11.3 6.9 2.5 3.7 0.5

29.4 4.8 19.9 113.0 15.0 29.2 103.3 114.7 38.5 71.1 42.8 24.5 7.6 59.6 53.8 63.1 127.7 73.5 43.9 91.6 * 53.6* 97.6 81.1 31.5 75.2

European Bank for Reconstruction and Development (EBRD) (2002), Transition Report, various tables.

*Public debt only.

70 60 20 80 65 65 60 70 75 50 70 50 25 65 45

9.7 5.7 2.5 7.1 7.4 11.9 24.4 19.6 27.3 30.4 14.1 19.2 30.9 8.1 30.4

3.3 4.0 0.7 6.2 0.7 12.4 1.5 2.2 3.7 1.5 0.0 0.9 4.5 2.0 1.2

% GDP Share of Average General Fiscal Current General External Debt FDI inflows, private services in transition gov’t deficit, % account gov’t debt, debt, % Service, % of GDP GDP, % score expenditures, of GDP balance, % of GDP of GDP % of 2001 % of GDP % of GDP exports of G&S

FSU states: various transition scores (2001 or 2002)

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyz R. Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan

State

Table 1.7

21

Source:

Note:

50.0 59.3 33.3 52.5 13.0 14.8 17.9 40.1 39.5 26.5 22.2 3.1 22.1 12.9 71.1 8.2

7.6

Political stability; no violence

17.2 24.1 38.5 6.3 13.2 50.0 44.8 59.8 31.6 41.4 27.0 27.6 36.9 14.9 79.1

Voice and accountability

World Bank Institute, New Governance Indicators database.

*Not including the Balkan states.

Belarus Kazakhstan Russia Turkmenistan Uzbekistan Georgia Armenia Moldova Kyrgyz republic Ukraine Azerbaijan Tajikistan Average CIS SD Average CEE & Baltics* SD

Country

9.2

16.9 31.9 33.1 9.4 21.3 28.1 15.3 12.5 31.9 26.9 18.1 7.5 20.2 8.4 67.0

Government effectiveness

14.6

2.4 23.7 6.5 3.3 11.2 17.8 23.1 12.4 20.7 13.6 39.1 5.9 18.0 10.2 71.9

Regulatory quality

5.9

20.3 31.8 17.1 12.9 27.6 39.4 45.3 40.3 26.5 31.2 21.8 4.7 29.6 12.8 71.2

Rule of law

7.6

54.7 23.3 12.4 6.2 29.2 28.6 24.2 23.3 20.5 19.3 10.6 9.3 20.6 7.4 69.1

Control of corruption

Table 1.8 Six components of governance, 2000/2001, individual CIS (grades between 0 and 100, developed countries 100)

22


by the end of one decade reached a level of 3 for overall transition achievements, even the weakest among their East European neighbours had attained 3and most reached 4 (EBRD, 2002, p. 20). While the EBRD transition indexes include a heavy dose of institutional variables, the data in Table 1.8 focus on specific measures of quality of government, based on the work of Kaufmann et al. (2001, 2002) and the World Bank Institute database. Hundreds of variables for more than 150 countries were aggregated into six main clusters: 1) Voice and accountability: focuses on the quality of the (democratic) political process and civil and private liberties; 2) Political instability and violence: measures the threat and realization of destabilizing the government or regime by any form of unlawful means; 3) Government effectiveness: measures the quality of inputs, mostly of the bureaucracy, and of the processes by which policy is being formed, including its independence of political interference; 4) Regulatory burden: looks at the quality of the policies and especially the degree to which they interfere negatively with the proper operation of the market economy; 5) The rule of law: estimates respect for the law and the quality of the judiciary and enforcement arms; and finally, 6) Control of corruption: measures the inclination of people and officials to offer and accept bribes and the various forms of grand corruption including ‘state capture’ (Kaufmann et al., 2002, pp. 4–6 and Appendixes). The figures in Table 1.8 represent grades between 1 and 100, where 100 represents the top level in the best-governed developed countries. As can be seen from the table most quality measures are very low, and much lower than the corresponding ones for the East European group. In a few cases – Armenia, Georgia, Moldova – a high level of democratization is correlated with bad measures across the board, indicating too much freedom leading to anarchy. With the exception of ‘voice’, most governance criteria, especially the fighting of corruption, are also below the corresponding level in groups of developing countries of a similar level of economic development. Similar comparatively dismal observations are found with respect to banking and financial institutions (Ofer, 2003). Ten to 12 years after independence, CIS countries still have a very long institutional way to go and one wonders how much of this can be traced to their communist sources. What have been the general lessons from transition? The economic performance in the former Soviet Union has been disappointing. Initial conditions were unfavourable as many enterprises were uncompetitive, but mass closure was unthinkable, so subsidies led to budget deficits whose monetization caused high inflation. Sustained growth requires controlling the budget deficit and hence inflation, so that relative price changes can be observed and financial markets can develop. Trade taxes, although relatively easy to collect, are an undesirable revenue source because an open

Introduction

23

trade policy is the best way to introduce appropriate relative prices (that is, world prices). Financial reform, and more general institutional reform – the second stage of transition – is necessary for private sector development, as well as improving macroeconomic policy options. So much is well known, but often forgotten, in established market economies. One of the most novel lessons is the significance of hard budget constraints; distinctions of ownership structure are subsidiary. Finally, economic reform has a political dimension: if the population is kept onside by compensating losers as well as fairly rewarding gainers then the process is more likely to be sustainable, and the economy likely to meet people’s needs and expectations.

3. EXPLAINING ECONOMIC GROWTH: TEN TRANSITION STORIES The growth record is hard to interpret because initial conditions, as well as policy choices, matter. Despite many attempts to identify patterns, no robust econometric relationship between pace and depth of reform and economic performance has been established. The best Eastern European performer was rapidly liberalizing Poland, while the best performer among former Soviet republics was gradual-reforming tightly controlled Uzbekistan (and not the more liberal Baltic countries). Eastern European countries generally did better than the Soviet successor states (in crosscountry regressions, distance from Düsseldorf is the strongest explanatory variable), although China and the South-East Asian countries did much better than any others.13 Much attention has been paid to explaining the East Asian edge. The Chinese reforms, which began in the late 1970s, focused first on reforming agriculture, and then gradually adopting an open door policy, while smallscale local businesses (the township and village enterprises) were treated in a hands-off fashion by authorities in the more dynamic coastal regions. Initial conditions meant that China, and Vietnam, could follow comparative advantage (in labour-intensive manufactures) rather than having to transform an economy dominated by an inefficient manufacturing sector. Putting agriculture first worked because agriculture was important (80 per cent of China’s labour force in the late 1970s) and because small-scale rice farming could be stimulated by changing ownership structure and price incentives (unlike wheat or cotton farming where key inputs like machinery or irrigation were indivisible and their availability was disrupted by the break-up of collective farms). Although China never adopted a Big Bang liberalization and stabilization strategy, monetary policy was sufficiently controlled to never permit inflation to stay above 20 per cent for long.

24


In explaining the disappointing economic record of the CIS countries as a group, the institutional disadvantages discussed in section 1 of this Introduction are critical, but they have worked out in different ways in individual CIS countries. The richness of the case studies in this book lies in their focus on country-specific explanations of the growth record. Although a common framework was initially imposed on the authors (and is still reflected in the longer versions of the studies),14 the various chapters highlight specific features which were important to their country’s economic history since 1991. Chapter 2 on Russia, by Ksenia Yudaeva, Maria Gorban, Vladimir Popov and Natalya Volchkova is more than just a chapter on Russia. It uses Russia as a case study to investigate the factors that contribute to the shaping of the degree of success of the transition process. Russia, according to the authors, experienced an early collapse of government that caused most of Russia’s difficulties and rendered it unable to overcome inhibiting negative initial conditions. Russia failed because it developed a weak illiberal democracy without the rule of law, before the economic reforms, because it did not produce well-trained politicians and economists for the new regime, and because it failed to bring the government and the Parliament to work in tandem. It also failed because it had to import from the West and adapt and transplant an alien legal and institutional structure, a framework that neither the government nor the people could internalize and identify with in a short while. It also failed since there was nobody to blame for the failure of communism except itself, and there were no promising expectations to join a guiding and supporting alliance, like the European Union (EU) or NATO. The disorganization caused by the (wellintentioned) mistakes of Gorbachev and of the mass liberalization under Yeltsin in 1992, as well as the inherited distorted industrial structure, could not be controlled by the weak government – hence the long-term decline in output. Other policy mistakes over the years were the overvaluation of the rouble, partly due to its use as a macroeconomic stabilizer and partly caused by large energy exports, that inhibited restructuring, and the tight money policy that created money substitutes, barter, arrears and nonpaments. It was the crisis of 1998 that changed it all. The sharp devaluation opened opportunities for restructuring, import substitution and becoming competitive, and the rise of Putin brought a more effective government, stability and trust, a clear action plan and better prospects. Both, with the help of high energy prices, produced positive growth at last. The authors are of a strong view that it is the right policies, at least during later years, and not initial conditions that determine the economic prospects. They prove it through a cross-sectional analysis of Russia’s regions that shows high liberalization scores bring about (especially during the

Introduction

25

second half of the 1990s) higher investments, including FDI, in every sector, GDP and industrial growth. In 1990 Belarus had the second-highest level of GDP per capita after Russia among the members of the CIS group, and by 2001 moved to first place among them. The high initial income level is explained by the industrial structure of Belarus as a big factory for processing and assembling high value-added and complex manufacturing goods. This same structure was also one of the main initial problems: the very extensive forward and backward internal network threatened chaotic disorganization, and the extensive external supply network, predominantly with the SU, and the lack of energy resources brought decline in trade and extreme deterioration in terms of trade. Despite the above, and the additional negative effects of the Chernobyl catastrophe, Belarus experienced one of the lowest output declines during the early 1990s (more came later) and has so far had one of the best recovery records (Tables 1.1, 1.2). Belarus, as shown in Chapter 3, is also a special case as a late starter of reform and a slow reformer throughout, and of a reform reversal since 1995. The authors of the chapter, Marina Bakanova, Lúcio Vinhas de Souza, Irina Kolesnikova and Ivan Abramov, try to explain this apparent paradox. The three main explanations are the maintenance of a strong, authoritarian government that moderated disorganization and corruption, the use of direct interaction methods of the old regime mostly via non-privatized SOEs, in order to encourage production some of which may be of little value, only part directed to consumption, and also a reflection of possible overestimation of the relevant statistics. The chapter finds that only 40 per cent of the old Belarusian manufacturing was competitive and that the diversion of trade from Russia to the West has a positive effect on growth, even though Belarus continues to maintain close trade relations with Russia (including implicit subsidies). Belarus’s hope of a possible reunion with Russia and the continued talks about it blur the country’s resolve to become an economically viable unit. The chapter also demonstrates that private and privatized enterprises are more efficient, but that the government continues to support SOEs, and trade with the West is more rewarding but the government continues to seek more trade with Russia. The question arises whether the very gradual reform is a better way to proceed, or what is observed is just a postponement of the time of reckoning when the price of transition will have to be paid. Ukraine is the second-largest former republic, with more than 50 million people. It is made up of two main parts: the east, with a large Russian as well as Russified population, the location of the main large heavy energy consuming industries and the west that was annexed to the SU from Poland before the Second World War, with its much more Ukrainian nationalistic,

26


anti-Russian and agrarian population. The tension between these two parts is one of the explanations for the continued failure of the government to unify the country and to introduce effective democracy and a market economy. Given its industrial, natural and agricultural resources and human capital, one could have expected that Ukraine would do better. Yet, like Russia, output continued to decline until after the 1998 crisis and the appointment of a new, more reform-oriented government. The story that is told by the authors of Chapter 4, Olexander Babanin, Vladimir Dubrovskiy and Oleksiy Ivaschenko, is one of a colossal government failure. They mention the divisions within society as one reason for this. A second explanation is the fact that during the Soviet period Moscow and Russia were the centre of government, the economy and academia, and many talented and capable Ukrainians tended to move there, leaving Kiev with second-rate leaders and professional people and no experience in government.15 Others who suffered from the communist regime and were able, left for the West. However, the main reason for the failure of transition in Ukraine is the conspiracy between magnates of the old, energyintensive industry, and all branches of government, in a ‘state capture’ scheme to plunder the rest of the country by collecting and distributing rents among themselves and to protect and preserve their loss-making oldfashioned sectors. Most of the government leaders belonged to the old nomenklatura. At first, rent was obtained from the subsidies to the price of energy imported from Russia and Turkmenistan and from fees for the transmission of oil and gas through its borders. When these resources dried up, they were substituted by government funds and borrowing abroad, at the expense of the rest of the population and of reforms. An elaborate system of barter deals sanctioned by the partners in the Parliament facilitated it. Only the near exhaustion of these funds (the authors criticize lax foreign lending in this connection) that brought Ukraine to the brink of a financial crisis in 1999, produced the shock needed to appoint a more reform-minded prime minister (Yushchenko, December 1999 to Spring 2000) and turn the corner into a more active reform path. Moldova is the worst performer during the first decade of transition. From being one of the more affluent republics of the SU, by 2002 it had recovered to just above a third of its initial per capita GDP, the worst growth performance among all CIS states (Table 1.2). The dismal record is even more surprising given the title of ‘a small wonder’ given to it by The Economist, as late as 1995. Artur Radziwill and Oleg Petrushin paint the picture of this failure in a number of dark colours in Chapter 5. The main economic problems started from an especially severe double blow to the terms of trade and the collapse of trade: in addition to the sharp increase in energy prices, Moldova, a large producer of top of the line agricultural

Introduction

27

products, saw prices (previously heavily subsidized) plummeting and the markets disappear. When, later, prices and trade potential improved, it was the absence of agricultural reform that prevented recovery. The conflict between the Russian and the Romanian parts of the country inflicted on Moldova a second initial blow. Even when the eastern part was separated out, the rest of the country could not find a cohesive national focus and a common destiny and could not agree on a strong effective government. Without clear prospects, the government and the agricultural–industrial production elite engaged in corruption, rent-seeking and ‘state capture’ instead of in reforms. There is some irony in the fact that external borrowing, intended to help with reforms, was used in order to extend the ability of Moldova to avoid reform. In more recent years, when reform started to move ahead and some growth resumed, servicing the external debt has provided an additional burden. No wonder The Economist asked in 2000 ‘Can Moldova get worse?’ Armenia, the smallest CIS state, is landlocked and even further isolated due to the hostilities over Nagorno-Karabakh with Azerbaijan, and Turkish support to the latter. The devastating earthquake of 1988, the armed conflict and the isolation caused output in Armenia to fall sharply, by almost two-thirds up to 1993. Being a major producer of intermediate goods, many for the military sector, the break-up of the Soviet production chain and the isolation from energy supplies also contributed to the sharp decline. An early privatization of agriculture increased its share in the economy and helped with the supply of food. In Chapter 6, Heghine Manasyan and Tigran Jrbashyan go back to the Soviet period and observe a long-term rise in the productivity of the Armenian economy since the early 1970s, which they attribute to the sharp increase in the educational level of the labour force. They argue that the steady economic growth since 1994 is partially a recovery process, including the effects of the ceasefire and the resumption of the operation of the nuclear power station, and partially a result of market and institutional reforms, including macroeconomic stabilization introduced in the early stages of transition. However, during the last few years, the contribution of total factor productivity (TFP) to the country’s growth became positive again, more or less corresponding to previously established (‘normal’) patterns. They therefore believe that further sustainable economic growth for Armenia is possible only through human capital accumulation and concentration on high value-added exportable manufacturing. In discussing economic autocracy and recent growth performance in Turkmenistan, Alexandre Repkine in Chapter 7 emphasizes the role of abundant natural gas and oil in explaining the growth record of the leastreformed CIS economy. Between 1991 and 1997 Turkmenistan experienced

28


a collapse of non-energy output, but the president maintained tight control over the economy and used populist policies and repression to maintain political stability. During the second half of the 1990s economic recovery was led by import-substituting activities in the manufacturing sector (oil refining and textiles) and in agriculture (sowing wheat in place of cotton), but failure to undertake economic reforms stifled any non-state-led activities. The resource rents have underpinned both phases in Turkmenistan’s economic growth, but the strategy does not offer good long-term prospects. Repkine explains the almost total absence of economic reform in terms of the interests of the autocrat, who lacks incentive to consider long-term economic growth above short-term control over the resource rents. In Chapter 8 on the Uzbek paradox, Martin Spechler, Kuatbay Bektemirov, Sergei Chepel’ and Farrukh Suvankulov examine Uzbekistan’s economic progress without neo-liberal reform. Their explanation of the paradox lies in omitted variables from the simple correlations of economic reform and economic growth – specifically, institutional capital. Uzbekistan has pursued gradual reforms, in contrast to Turkmenistan’s non-reform strategy, but the goals of stability, equity and political sustainability were at least as important as economic growth, and therefore a Big Bang transition strategy was ruled out. Initial growth, up to 1996, was helped by earnings from cotton, gold and uranium and the achievement of energy self-sufficiency, but in the longer term growth has been led by public investment and provision of infrastructure, education and a social safety net and other public services. Tajikistan’s growth performance in the first decade of transition is analysed by Khojamahmad Umarov and Alexandre Repkine in Chapter 9. The disastrous decline in incomes has left Tajikistan as the poorest CIS country with income levels comparable to those of the world’s poorest countries. This is largely explained by the civil war, whose negative effects were not simply those of immediate destruction but also included debilitation of institutional development leading to the virtual absence even today of a competitive economic environment or of restructuring of the economy. The share of the non-state sector has increased substantially, but this reflects the collapse, rather than privatization, of the state enterprises (apart from a single complex producing aluminium) and the shift to small-scale subsistence activities and shuttle trade. With declining domestic demand and lack of credit facilities, even the shuttle traders have few growth prospects. The economic decline is exacerbated by geographical isolation and by mass emigration which has eroded the country’s stock of human capital. In explaining economic growth in Kyrgyzstan, Roman Mogilevsky and Rafkat Hasanov in Chapter 10 also emphasize the role of landlockedness and lack of easily tradable natural resources. Like Tajikistan, Kyrgyzstan

Introduction

29

was severely harmed by the collapse of intra-SU trade in the early 1990s. The government adopted radical economic reforms along the lines of the Washington Consensus (the Big Bang model), but the growth outcome was disappointing. Mogilevsky and Hasanov explain this in part by the lack of supporting institutional development, captured by measures of instability in the legal environment. Kyrgyzstan was successful in attracting foreign assistance, mainly from the international financial institutions, but the disappointing growth record meant that repayment even of concessional loans was difficult and by 2001 the country was on the brink of default, which was only averted in 2002 by a Paris Club rescheduling (see Table 1.7). In contrast to the other Central Asian countries, Kazakhstan is rich in natural capital, both energy and minerals resources and farmland, in Chapter 11 Yelena Kalyuzhnova, James Pemberton and Bulat Mukhamediyev focus on the management of natural resources in their study of economic growth in Kazakhstan. The economy experienced a sharp decline in output between 1991 and 1996, accompanied by rising unemployment and structural change as both industrial and agricultural output fell. Since 1996 the economic recovery has been driven by increasing oil and natural gas production. The strength of the energy sector has allowed the country to import essentials while maintaining more or less balanced trade, but it has also prevented new activities from emerging so that the economy has become increasingly dependent on the energy sector. The economy has thus become more exposed to risk, and future growth will depend critically on sound management of the resource rents. Fischer et al. (1998) state that there are ‘two forces: those arising from the transition and transformation process, and the basic neoclassical determinants of growth’. This book is about the first of the two and this bias is evident in most if not all the chapters, each one with a slightly different story emphasis. It is the weakness and failure of the governments and the lagging institutions that held back the resumption of growth. Human capital was there, technology and capital, even the knowledge of how to run a market economy could be obtained from the global economy (or even internally), to be put to work if and when the conditions become supportive. This is why in most of the normal growth regressions based on transition indicators and initial conditions, CIS transition economies position themselves at a distance from the estimated line and have such large residuals (negative or positive). These residuals are explained by the missing, or badly defined and measured, institutional determinants. For example, capital flight from Russia alone during the first decade amounted to US$20–30 billion a year, and this is only part of the potential resources, inside and outside the country, that could have been put to work if they could have been secured and protected by a supportive business environment, not to mention the

30


potential of additional domestic resources that could have been mobilized through a properly working market-oriented banking system and the billions that could have come from abroad. Is this colossal institutional failure a result of bad policies or is it a reflection of the enormity of the needed structural changes and cultural and mental transformations that must accompany them? Or is it that the choice of policies was constrained by the institutional heritage, as was also their effectiveness? While this seems to be the proper generalization, the individual stories of the CIS states provide a canopy of variations and colours around it.

NOTES 1. 2.

3. 4. 5. 6. 7. 8.

9.

10.

This section draws on and sometimes quotes from Ofer (2001) and Ofer (2003). The inter-republic trade between the 15 members of the union ranged, for individual republics, from 85 to 97 per cent of their entire trade. The only exception is Russia itself where ‘only’ two-thirds of its trade was directed to other republics. Part of this difference is due to the fact that a substantial proportion of the external trade of the other republics took place via Russia (Bosworth and Ofer, 1995, p. 74). Russia sold the republics’ energy at below world market prices and bought industrial and agricultural products at above world prices. On the contrast between formal and informal activities and institutions, see Gaddy and Ickes (2002, Chapter 4). See the discussion on the ‘transplant effect literature’ in Chapter 2 on Russia in this volume, based on Berkowitz et al. (2000) and Polterovich (2001). A discussion, more literature and a strong view on this issue can be found in Chapter 2 on Russia. The CIS was formed in December 1991, although Azerbaijan did not ratify its membership until after the fall of the Popular Front government and Georgia did not join the organization until the following year. This section draws on material in Constructing a Market Economy: Diverse Paths from Central Planning in Asia and Europe and on a summary article (Pomfret, 2002; 2003). Besides the four GDN background papers, other reviews of the transition experience in Eastern Europe and the former Soviet Union include Wyplosz (2000), Fischer and Sahay (2000), Roland (2000), Havrylyshyn and Nsouli (2001), Åslund (2002) World Bank (2002), and Blejer and Skreb (2002). The GDP estimates must be treated with caution, because of collection biases (in centrally planned economies managers tended to over-report output, but in the new environment producers hide output from the tax collectors’ eyes), index number problems (the bundle of goods in 2002 was far different from that in 1989), and differences between output measures and well-being. All of these considerations cause GDP estimates to understate the benefits of transition, which include greater consumer choice and less queuing. Maddison’s purchasing power parity estimates in Table 1.3 may better capture living standards, and they also highlight some potential implausibilities in the official data, for example for Turkmenistan. Trade taxes were an attractive revenue source for new governments because they are relatively easy to collect, but in the long run they are harmful. If openness is desirable, then so is convertibility of the national currency into foreign exchange for current account transactions; otherwise there are too many distortions hindering international trade. Capital account convertibility is more contentious; many transition countries quickly accepted it as a means of encouraging foreign investors, but it also increases potential

Introduction

11.

12. 13.

14. 15.

31

volatility and several countries, such as the Czech Republic in 1997 and Russia in 1998, experienced serious crises. Higher inflation obscures relative price changes and hence undermines the signalling mechanism of a market economy, and inflation discourages financial market development. Low levels of inflation do not matter in this context, but a threshold seems to exist. The idea of a threshold value beyond which inflation is harmful to growth was popularized by Bruno and Easterly (1998), although their threshold of 40 per cent now appears too high. Focusing only on transition economies, Christoffersen and Doyle (1998) estimated a threshold of 13 per cent. By contrast, the picture in China and Vietnam is mixed. In China, inequality initially declined after 1978, but then increased in the 1990s. The econometric literature is reviewed in Pomfret (2002, pp. 90–93) and in World Bank (2002). Among the studies finding a primary role for reform policies are a series of papers by IMF economists (for example Fischer et al., 1998; Fischer and Sahay, 2000). Initial conditions are the strongest determinants in the econometric work of EBRD economists Falcetti et al. (2000), although they find that some countries defied the odds by performing better, or worse, than initial conditions suggested and that the effect of initial conditions diminishes over time. The full-length papers are available on the EERC website at http://www.eerc.ru. ‘it was easier for an Ukrainian to become a factory manager in Siberia than in Ukraine’.

2. Down and up the stairs: paradoxes of Russian economic growth Ksenia Yudaeva, Maria Gorban, Vladimir Popov and Natalya Volchkova 1.

INTRODUCTION

Russia’s economic performance during the first transition decade was one of the worst among transition economies. Output decline was deeper and lasted longer than in the countries of Eastern and Central Europe and in most of the CIS countries not affected by war. What caused such a bad performance? This chapter, following Popov (2000) and Berglof and Bolton (2002), attributes Russian growth failure to the collapse of the government. Early literature on the subject concentrated on the ‘competition’ between reform policies and initial conditions as the main determinants of growth during the first transition period. While proponents of the first theory claim that faster-reforming countries had stronger growth, their opponents point to the fact that faster-growing countries also had better initial conditions. The emerging consensus of this literature is that initial conditions matter for the depth of initial decline, and depth and speed of the reform progress determines the speed of the recovery (see Berg et al., 1999; Fischer and Sahay, 2000; Campos and Coricelli, 2000 and so on). Some CIS countries, such as Uzbekistan, still do not fit this picture. Zettlemeyer (1998) attributes Uzbekistan success to favourable initial conditions, such as natural resource abundance (cotton, some non-ferrous metals) and self-sufficiency in energy, but Spechler et al. (Chapter 8, this volume) attribute it to better, though non-conventional policies. Russia has oil, and is self-sufficient in energy, so it is not clear, if based on initial conditions why output decline should be larger and longer-lasting in Russia than in Uzbekistan. Recently, a number of researchers pointed to institutional performance as an explanation for differences in growth rates among transition economies. Popov (2000) suggests that one of the main explanations of stronger output decline in Russia was the bad performance of government institutions. He shows that countries which were able to keep the level of budget expenditure close to pre-transition levels performed better during the tran32

Paradoxes of Russian economic growth

33

sition than countries where budget finance collapsed. Berglof and Bolton (2002) show that the ‘great divide’, that is the division of transition countries into those with good growth performance and a good financial system, and those with slow growth and a bad financial system, corresponds to the division according to fiscal performance of countries’ governments. Sonin (1999) arrives at a similar conclusion and argues that bad-quality government manifested itself in rent-seeking behaviour and inability or unwillingness to protect property rights. The question, which remains open, is why government institutions collapsed in Russia and some other CIS countries, while other countries managed to keep or create stronger institutions. Theories explaining this phenomenon can be divided into several groups. Roland and Verdier (1999), and Roland (2000) point to the effect of expectations. This effect could explain quite well the difference between CEE and other transition economies: the desire of the Eastern European and Baltic countries to become part of Europe worked as a coordination mechanism for the formation of market and governmental institutions. It is more difficult to use this theory as an explanation of the failure of Russian growth in comparison to some other CIS countries. Castanheira and Popov (2000) blame improper reform sequencing for government collapse in Russia. They claim that most of the countries in the world first developed the rule of law, and only later on introduced democracy. According to this theory, strong governments are observed under strong democratic regimes of Eastern and Central Europe, which developed the rule of law before the Second World War, an initial condition, and managed to return to it at the beginning of transition; and under strong authoritarian regimes like China and Vietnam, which started developing the rule of law in their countries while keeping the communist party ruling, a policy decision. Illiberal democracies, or weak democratic states like Russia and some Latin American countries, switched to democracy without having developed the rule of law and, therefore, ended up with weak governments. This reasoning leaves several issues unexplained. For example, it is unclear whether the rule of law in the Western sense can be seen in China and Vietnam, which definitely managed to guarantee security of property rights with their bureaucratic systems. Mukand and Rodrik (2002) and Rodrik (2000) address some of these questions. They notice that the economic performance of transition economies follows a U-shape pattern: countries closest to the EU perform well; as distance to the EU increases, countries’ growth performance deteriorates, and then starts improving again. Mukand and Rodrik explain this U-shape pattern using imitation-experimentation paradigm. They model a periphery country’s choice of economic policy. The further away the

34


country is from the leader, the more different its policy should be in order to be successful. So, the best economic policy requires experimentation and choice of the policy best suited for this particular country. However, government can be corrupt, and the honest government can decide to imitate the leader’s policy because this policy appears to be the most transparent for the electorate. In countries located close to the leader, both honest and corrupt governments will choose to imitate, because the benefits of imitation are quite large. In the remote countries, imitation is completely inefficient, and governments will experiment, some of them successfully. The worst-case scenario takes place in the countries in the middle: in order to look transparent, honest governments in such countries choose to imitate, even though imitation policy may not be welfare-improving. According to this theory, Russia and Ukraine became victims of this forced imitation effect: they chose to imitate policies common to Western countries, which jeopardized their growth performance. Yet a different interpretation can be derived from ‘transplant effect literature’, pioneered by Berkowitz et al. (2000) and Polterovich (2001). Berkowitz et al. (2000) claim that the level of legality in a country is very closely related to the transplant effect, that is to the level of adaptation of the law and familiarity of the population with the law. They notice that most of countries in the world have not developed the law internally, but rather transplanted the law from other countries. The level of law enforcement depends on how well citizens of the country understand the law. The level of understanding is higher in those countries where a large share of the population was familiar with the law before it was introduced, because, for example, they were emigrants from the country of origin. Additionally, the understanding of the law depends on the degree to which the law was adapted to local conditions after transplantation. As far as transition countries are concerned, a large number of them (mostly CIS countries) did not have modern commercial law before communism, so they had to transplant the law after the beginning of transition. Transplantation was done very quickly, and the level of adaptation was really minor. Therefore, all these new transplants by definition belong to the unreceptive transplantation group.1 Some Central and Eastern European countries, on the other hand, went through the process of law adaptation in the inter-war period, and therefore can be classified as receptive transplants. As the expectation hypothesis of Roland and Verdier (1999) and Roland (2000), this hypothesis provides a good explanation for the differences between CEE and CIS countries, although the nature of explanation is different: it is history of the law, not expectations, which determines differences in growth performance. In this chapter we empirically test the importance of different factors in explaining the weakening of the government at the beginning of transition.


35

In particular, we test whether it is expectations, or history, which is important for development of good institutions. The dependent variable is the index of quality of the government, constructed by Kaufman et al. (1999), and the list of independent variables includes proxies for the factors, suggested in Shleifer and Vishny (1998) and several other papers. The results are inconclusive: it turned out that expectations and history are highly correlated, so it is impossible to evaluate their relative importance.2 We also discuss the importance of initial conditions, macroeconomic policies and structural reforms for Russian economic development. We demonstrate that during the stage of decline, initial conditions played the most importance role: exporting regions experienced significantly smaller output decline than other regions. During the fixed exchange rate period of 1996–98, and particularly during the recovery after the 1998 crisis, regions that were more active in their economic reforms earlier on started to get benefits in terms of better growth performance. Investment growth, particularly the growth of foreign direct investment, is also faster in the regions with higher reform progress. The chapter is organized as follows. Section 2 discusses the politicaleconomic aspects of Russian transition. In particular, it seeks explanations for the collapse of the government in Russia, and how the poor functioning of the government and natural resource abundance could explain such peculiarities of Russian performance as barter and export of capital. Section 3 shows how macroeconomic policies and structural reforms can explain differences in inter-regional performance. Section 4 concludes.

2. POLITICAL AND LEGAL TRANSITION IN RUSSIA AND THE COLLAPSE OF THE RUSSIAN GOVERNMENT It is a tradition in the transition literature to consider 1992, the year when such reforms as price liberalization, exchange rate unification and privatization started, the beginning of Russian transition. Although we will stick to this tradition, one should bear in mind that this dating is not absolutely correct. The 1992 reforms were preceded by Gorbachev’s six year perestroika period, marked with some market-oriented reforms, and dismantling of the Soviet economic and, particularly, political system. On the economic side, Gorbachev’s reforms were initially yet another attempt to break the tradition of Soviet extensive growth through the modernization of existing industrial capacities. This attempt was rejected by the system it tried to improve. Tons of expensive imported equipment bought out of external loans were either never installed, or of little use due to lack of technical

36


documentation or trained personnel. Perestroika also brought in some elements of economic liberalization. It was aimed at limiting the scope of central planning, and creating incentives for the enterprises to develop themselves. In a failed attempt to mimic Chinese reforms, small cooperatives and self-employment were legalized. Worst of all, macroeconomic policy during the perestroika years was extremely irresponsible and led to the accumulation of monetary overhang. The latter undermined the whole mechanism of economic stimulus exactly at a time when these stimuli were supposed to replace directive planning as the major mechanism of the allocation of resources. As a result, the decline actually started in 1990 and continued in 1991, when the USSR was still in place and the centrally planned economy was still dominant. On the political side, perestroika resulted in the weakening of the role of the Communist Party, and the rise of democratic and, even more importantly, nationalistic movements. The latter process led to the break-down of the Soviet Union, and the formation on its territory of national states, including Russia. Russia started its economic and political transition with a very weak federal government. Yeltsin was very popular among the general public, which allowed him to appoint a reform-oriented government, but he was not supported by the communist-dominated Parliament. The Russian budget was in deep deficit, and the bureaucrats at middle and lower levels often sabotaged the newly appointed top level of the federal government. In order to prevent the breaking down of Russia into smaller states, and to get the political support of the regions, Yeltsin granted generous independence to the regions, which further weakened the position of the federal government. The initial reform plan was quite ambitious; it included price liberalization and mass privatization. The model for the first part of this plan was Poland, where ‘shock therapy’ policy resulted in a quick return to growth. The second part of the reform package was an unprecedented privatization programme, and its goal appears to have been the building of support for the government by the new class of property owners. Both parts of the reform package failed: price liberalization, combined with budget deficit and inconsistent policies of different branches of the government, resulted in high inflation. Mass privatization without a proper system of property rights protection ended up in rent-seeking behaviour on the part of the enterprise managers and numerous wars for control over the most lucrative enterprises. Neither of these measures improved the support for the government, but rather weakened it, since they reduced the popularity of Yeltsin. The desperate attempt to improve the powers of the executive branch was undertaken in 1993, with the adoption of the new Constitution. The


37

Constitution granted to the president excessive powers in comparison with those granted to the Parliament. This attempt, however, did not attain its goal either: since the president received a veto power over the decisions of the Parliament, the latter lost all incentives to perform constructively. In a situation when most of the Parliament members were still opposed to the reforms, the new Constitution provided them with no incentives to seek compromises, and as a result, they turned to populism aimed at increasing their re-election probability. The president, on the other hand, had too much discretion. No mechanisms of checks and balances over the president’s actions were envisaged. Hence, he had little incentive to promote long-term policies including those aimed at growth, and concentrated instead on short-run gains, such as getting re-elected.3 Reforms slowed down and the economy continued its free fall. The regional–federal interbudgetary relationship also contributed to the poor Russian growth performance in the mid-1990s: regional, and particularly local governments lacked incentives to implement pro-growth policies, and instead were involved in rent-seeking behaviour and competition over transfers from the governments at the upper levels (Zhuravskaya, 1998). Thus it seems that government weakness has been instrumental in the failure of Russian reforms and growth throughout the 1990s. Therefore, it is interesting to further examine the causes of this weakness and discuss whether a better strategy was feasible. There are two strands of the literature, which search for the explanation of the weakness of the Russian government. The first compares Russia to the countries of Central and Eastern Europe, and tries to explain why Russia was unprepared for the proper functioning of democratic institutions and for the implementation of market reforms. The second, exemplified mainly by Castanheira and Popov (2000), compares Russia to such fast-growing countries as China and Vietnam, or better-performing Uzbekistan and Belarus, and asks a more fundamental question of whether it was appropriate for Russia to introduce democratic institutions at such an early stage of transition, and whether it would have been better for Russia to limit itself initially only to economic reforms. We will start with a short discussion of the second idea, and then proceed to the first one. The defendants of the idea that economic reforms should precede the political ones claim that proper development requires first building the rule of law under autocratic order, and only then introducing democracy. In illiberal democracies, where the rule of law is not supported, governments are weak, and prone to sacrificing pro-growth policies for policies with short-run gains. Certainly, Russia during the 1990s falls into this category of illiberal democracy. It is unclear, however, whether this was a result of policy mistakes or of constraints that limited the policy options. Taking the

38


lead in the country as the head of the anti-coup coalition, Yeltsin was supported by the democrats, was considered to be a democrat, and was expected to implement democratic policies. A non-democratic regime was therefore politically non-feasible for him. Moreover, even if feasible, Yeltsin lacked the needed tools to support an authoritarian state. In the CIS countries that introduced authoritarian regimes after the breakdown of the Soviet Union, the head of state was often the former head of Communist Party, who relied on strong within-party relationships, supported by strong traditions of family ties. Additionally, in the CIS countries where authoritarian regimes were successful, the leading group also had full control over the main natural resource (cotton in Uzbekistan, oil in Kazakhstan). Yeltsin had none of these: Russia did not have its own Communist Party in the Soviet Union and, in any case, Yeltsin placed himself as a major enemy of the communists, so he could not rely on the party apparatus. Family clans were not as strong in Russia as in Central Asia even before the revolution, and migration during the 1930s–1950s broke them even further. Finally, as an outsider to the production system, Yeltsin could not gain control over the energy resources prior to the transition. The remaining question is whether the mistake was made by Gorbachev, who initiated political reforms too aggressively. Actually, Gorbachev did try initially to follow a proper sequencing of the reforms: he planned to first introduce in the Soviet Union economic reforms of a ‘Chinese type’, combined with the imposition of a strong rule of law (pravovoe gosudarstvo). Whether these partial reforms failed because of the inability of the Communist Party of the Soviet Union (CPSU) to reform itself due to policy mistakes, or because reforms suitable for China did not properly address Russia’s problems (Mukand and Rodrik, 2002), is a question which still remains to be answered. The question of why Russia was less successful then the East European countries is much better understood. The initial weakness of the government can be explained on the basis of differences in the political processes. Shleifer and Vishny (1998) point to the fact that what is really crucial for the success of economic development during the transition is the level and quality of the human capital of politicians. A market economy requires different skills from politicians than those they have acquired under socialism. Many East European countries had elite groups with some of the required skills outside the government and the Communist Party, like Solidarity in Poland, Charter 77 and other groups in Czechoslovakia and similar quite well-organized opposition groups in other countries. Some members of these groups worked in business activities prior to transition and later on entered the government. Russia did not have such an elite or any kind of well-organized opposition or a dissident’s movement (Bunce,


39

1999). It may be argued that the existence of such organized opposition was especially advantageous in cases where reforms have been carried out by opposition parties and were of shock therapy type, as in Eastern Europe. On the contrary, if reforms were carried out by existing communist leaders, as in China, and were more or less gradual, the existence of the old state apparatus and the weakness of the opposition were assets rather than liabilities. Most former Soviet Union (FSU) states, with the possible exception of the Baltics, were in this regard at a disadvantage – they did not have either organized political opposition or an existing powerful state apparatus. State institutions in countries where opposition leaders took power after the collapse of the Soviet Union (the Baltics, Caucasus, Moldova, Ukraine, Belarus, Kyrgyzstan) and that tried to introduce shock therapy-type reforms, suffered from the organizational weakness of the opposition forces. On the other hand, countries like Uzbekistan, Turkmenistan and Kazakhstan, where reforms were carried out by former communist regimes and leaders and their immediate successors, did not have full-fledged governments in Soviet times and had to create many layers of their public service from scratch, which became a source of their institutional weakness. Russia, similarly to the Czech Republic and in contrast to other FSU countries, did not have its own governmental institutions prior to transition. There was no Communist Party of Russia (only the Communist Party of the Soviet Union and communist parties of other Soviet Republics) and the Russian Soviet Federation Socialist Republic (RSFSR) government and ministries were weak. True, being the legal assignee of the Soviet regime, Russia inherited all Soviet ministries and government bodies, including Soviet embassies abroad, which could have been an advantage, had reforms been carried out gradually by Gorbachev or his communist successor. But this Soviet heritage turned out to be of limited value, since reforms were carried out by the Yeltsin-led opposition and were modelled on Polish-style shock therapy. Following this logic, the Czech Republic would probably do well under either scenario – under opposition-led shock therapy reforms (because it had relatively well-organized opposition beforehand) and under communist-led gradual transition (because it inherited the state institutions of Czechoslovakia). While lack of human capital can serve as a good explanation for the weakness of the government during the first years of transition, it is difficult to imagine that this factor persisted beyond the few early years. Some more fundamental difficulties should have undermined the strength of the Russian government. We divide the proposed explanations into two sets of factors: those related to expectations and incentives, and those related to historical legacies.

40


The desire to become a part of the European Union and to escape from the Russian orbit is often considered as an important explanation of the success of institutional reforms in Eastern and Central Europe. These countries had a clear model of the needed institutions that they wanted to build, and their populations were ready to bear the costs that were involved. Being the centre of the disintegrating communist empire, Russia had no one to run away from, and thus no incentives for society to reach an agreement on the speed and costs of reform. Society was much more divided compared to most East European countries. In Russia the communists and the nationalists were stronger and the communists did not show any tendency to turn into ‘social democrats’ as in Eastern Europe; moreover there were additional deep contradictions between major industrial groups (namely, agriculture, defence and machine building, and energy and natural resources) on the issue of how to finance the economic reforms. Clearly, these factors did not help in implementation of the government reform strategy. The preserved mentality of Russia as a superpower and the perceived large military potential contributed to the inclination to shift some costs of the reforms to other countries. The set of historical explanations builds on the fundamental differences in the state of development of the rule of law and democratic traditions in Russia and Eastern European countries. For a number of reasons, even before the 1917 Revolution, the rule of law and elements of democracy were less developed in Russia than in Eastern European countries, including Poland, which at the time were parts of the Russian empire.4 At the beginning of the transition, Russia was characterized by a poor legal culture, and weak and corrupt institutions responsible for enforcement of the law. Another problem was the absence of key market-oriented laws. Many Eastern European countries adopted market economy legislation during the period between the two World Wars and were able to switch back to this legislation at the beginning of the transition. However unfit and old was such legislation in comparison to that functioning in developed countries, it was adapted to current national conditions, and well understood by the population. Russia, in contrast, was lagging behind developed countries in the introductions of such common laws even before the Revolution,5 and for this reason lacked market economy legislation prior to transition. The laws, introduced in the early 1990s, were mostly pure transplantations from foreign countries and languages, and were little adapted to the Russian situation or understood by the population. Even worse, a number of laws, and much of the accompanying regulations, have not been implemented or enforced.6 As Pistor et al. (2000) showed, Russia is not unique in this: enforcement of law is weak in all new or unreceptive transplant countries.


41

We tested empirically the relative importance of some of the explanations of the weakness of the Russian government.7 Regressions are estimated for the group of transition economies. As dependent variables, we use the 1997–98 index of government effectiveness, taken from Kaufman et al. (1999).8 Our main goal was to test the relative power of the expectations (EU accession) versus the historical (adaptation of the law) hypotheses. We use a dummy for EU accession countries as classified by the World Economic Outlook of the IMF as a proxy for the first hypothesis, and the new transplant and unreceptive transplant dummies as in Pistor et al. (2000) as proxies for the second hypothesis. The choice of additional control variables depended on theoretical relevance and data availability. The list is as follows: 1.

2.

3.

4.

5.

The level of economic liberalization prior to the transition. In addition to its direct effect, this factor can have also an indirect one, which is related to the availability of human capital experienced in working in a market economy. We used two proxies of this concept: the 1989 Liberalization Index, developed by De Melo, Denizer and Gelb (IMF World Economic Outlook, October 2000), and the share of private sector in 1990 as reported in Berg et al. (1999). Political independence before the transition. According to most researchers, this factor should strengthen government institutions. An alternative hypothesis is that it is often easier to build new institutions than to reform the old ones. We use the respective dummy to test which of the two effects dominates (political independence for FSU0). Abundance of natural resources can weaken the government by creating more opportunities for rent-seeking behaviour. We test this hypothesis through a dummy for natural resource-rich country, and the share of natural resources capital in total wealth (both are taken from Campos and Coricelli, 2000, dataset). It is often argued that a high share of agriculture at the outset of the transition was associated with poor growth performance. We test whether the share of agriculture in terms of total labour force (from Campos and Coricelli, 2000) had any effect on the quality of the government (for example, via the quality of human capital). Finally, we include distance from Düsseldorf in order to check its effect after controlling for expectation or adaptation of institutions effect.

Unfortunately, we were unable to separate the EU accession and adaptation of institutions from one another, as the correlation coefficient between the proxies for these two effects is higher than 0.9 in our final

42


sample. When both were included in the regression simultaneously, they had the predicted sign, but none of them was significant. Although EU accession and adaptation of institutions explanations cannot be separated, these two hypotheses together explain most of the variance in the differences in quality of governments between CEE and FSU transition economies. The results for the rest of the variables are the following. In countries which had an independent state before the transition, governments are significantly less efficient than in other countries. The 1989 liberalization index is positively correlated with both measures of the quality of the government, suggesting the importance of the pre-transition reforms for the quality of the government. Distance to Düsseldorf is insignificant when the historical factors are controlled for. Other initial conditions, such as the share of agriculture or natural resource abundance, are insignificant. The latter result is particularly important, because it says that natural resources can have a positive or negative effect on growth depending on the quality of the government, but they do not have a direct effect on the government after other factors are controlled for. The residual analysis shows that in almost all specifications the actual data on Russian government effectiveness lies from 1 to 40 per cent above the corresponding fitted values.

3. DO INITIAL CONDITIONS, MACROECONOMIC POLICIES AND REFORMS MATTER? Russia started the transition with deep distortions in its industrial structure (see Figure 2.1). The share of industry in GDP stood at 48 per cent compared to an average 41 per cent in countries with a similar income level.9 At the same time, the average age of the industrial capital stock was quite old: in 1989 it was about ten years old.10 Russian managers, who had been for decades stuck with a single goal of plan fulfilment, were not used to adjusting their production to the tastes of consumers; this problem was deeper in Russia than in CEE countries, which spent fewer years under communism. An enormous share of the military sector (much larger than the 7 per cent of GDP suggested by official Soviet statistics, and probably as high as 15–17 per cent; see Steinberg, 1991; CIA, 1978; Åslund, 1989, p. 15),11 barely-alive agriculture, eating away one-third of all budget spending, and a quarter of all capital investments, and a poorly developed service sector – this is the economy structure of the country in 1989–91. Compared to other countries of the former Socialist camp at the outset of transition, almost no signs of liberalization could be observed: De Melo et al. (1997a) index in 1989 was equal to 0.04 as compared to 0.41 in Slovenia and 0.34 in Hungary; in 1991, it was still only 0.10.

43


In order to test the importance of the initial conditions, macroeconomic policy and the reform progress for economic growth in Russia, we use regional data. Russia consists of 77 regions12 which, while sharing a similar cultural and historical background, differ substantially from one another in terms of growth patterns during the 1990s, the extent of initial structural disproportions, regional policies and the strength of regional governments. Therefore, cross-regional regressions can give a better answer to the question of the effect of different policies on growth than the cross-country ones. 200 China

1996 GDP as % of 1998 GDP

170 Vietnam

140

110 Slovenia

80

Czechoslovakia

Hungary Croatia

50

Macedonia

Estonia Armenia

20 0

10 20 30 40 50 60 70 80 90 Distortions in industrial structure and external trade, % of GDP

Source: Popov (2000).

Figure 2.1 Aggregate distortions in industrial structure and external trade before transition and GDP change during transition Depending on availability, three variables were used as independent ones: the growth of industrial production during 1992–95, the growth rate of nominal gross regional product (GRP) deflated by the product price index (PPI) during 1995–98, and the growth rate of real GRP as computed by the Russian Statistical Agency (Goscomstat) since 1997. As control variables, we used the following indicators:13

44


1. Initial conditions: a) Level of development and the industrial structure: ● Industrial production in 1990 and in the 1992–95 regressions or GRP per capita in 1994 in other regressions; ● Export potential: the first principal component14 of the production of oil in 1995, production of gas in 1995, production of ferrous metals in 1993 and share of export in GRP in 1994; ● Disorganization, computed as a multiple of complexity of the industrial sector, computed by Blanchard and Kremer (1997), and the industrial production structure of the regions. b) Geographical variables that capture the size of demand in the region: ● The proportion of the population living in cities with more than 500000 people in 1996; ● The first principal component of highway density in 1991, railway density in 1991 and distance to Moscow. c) Education: the proportion of population with secondary education among the population above 15 years of age. 2. Initial attitude to reforms: the first principal component of the proportion of votes for Yeltsin and for Ryzhkov, the Communist Party candidate, in the elections of 1991 (‘no reform in 1991’). 3. Economic reform progress in the region: a) Reform progress by the middle of the 1990: the first principal component of employment share in private small business in 1995, production subsidies in budget spending in 1995, budget subsidies per 100 roubles of agricultural production in 1995, privatization of trade in 1995, catering and household services in 1996, proportion of goods and services with regulated prices in the first quarter of 1996, the degree of regulation of food prices in 1996, the share of privatized firms in the total number of firms in 1995, and the share of private sector in construction in 1995. b) Economic liberalization: index of development of regional economic legislation and its enforcement, constructed by Petrov (2001). 4. Measures of the quality of the government: a) Corruption index from Petrov (2001). b) Index of democratization of the region: the first principal component index of regional political arrangements (balance of power between different branches of the regional government, elected or appointed authorities, independence of judges, civil rights), openness of political life, democratic elections, political pluralism, independence of the press, development of civil society, the quality, variety and rate of change of local elites, local self-governance (all from Petrov, 2001). c) Tax collection ability of the government: the first principal component


45

of tax collected in the region to GRP ratio in 1996, share of taxes collected in cash, and the ratio of planned to actual regional budget expenditures (with the minus sign) in 1997. d) Other measures: share of the shadow economy in GRP, the share of the economy controlled by organized crime groups (Argumenty i Facty, 1996). The average growth rate of industrial production or GRP during the corresponding period is used as a depended variable. We divide the entire period into three segments: the high inflation period (1992–95), the period with a stable rouble and an overvalued exchange rate (1996–98), and the period of economic recovery (1999). We estimate all the equations by OLS. In those cases where the heteroscedasticity test failed, we report t-statistics based on robust standard errors. The results are presented in Tables 2.1, and 2.2. Initial economic distortions serve as one of the explanations for the decline of output in transition economies. The Russian specificity in this regard was that in the initial transition period the decline of output was the smallest in the exporting firms, operating mainly in natural resource extracting industries, and thus the corresponding regions.15 However, it was shown by Popov (2000), that the effect of initial conditions becomes much less important in explaining Russia’s output pattern when the strength of the government is controlled for. The advantage of the government collapse over that of the initial conditions in explaining the Russian output decline is also demonstrated, indirectly, by the small amount of FDI coming in and the large flow of capital flight (Fischer and Sahay, 2000; Garibaldi et al., 2002). Countries with extreme structural disproportions should be able to attract much FDI to finance economic restructuring. The Czech Republic or Slovakia, whose level of industrial distortions were almost as large as Russia’s, were among the most successful in attracting FDI. This failure of Russia can only be explained by the inability of the government to guarantee protection of property rights to foreign investors.16 Clearly, the inability of Russia to attract foreign capital, and to diminish capital flight, cost Russia dearly in terms of growth. Many economists claim that macroeconomic policies such as the elimination of inflation were the key to reaching stable economic growth in transition economies as well as elsewhere (Fischer et al., 1998; Åslund et al., 1996; Berg et al., 1999; Fischer and Sahay, 2000 and so on). Political scientists emphasize that macroeconomic policy is endogenous, the outcome of political bargaining of different groups with conflicting vested interests (Shleifer and Triesman, 1999). This kind of political reasoning may explain why Russia chose the development of a debt system, instead of the reduction of government spending, as its macroeconomic stabilization policy.

46


Table 2.1 Regression results for industrial production, 1992–95 and 1996–98 Dependent variable

Industrial production in 1990 Industrial production in 1995 Export potential

Annual average growth rate of industrial production, 1992–95 0.01 [0.95]

0.002 [0.27]

0.018 [2.92]***

0.019 [3.41]***

0.003 [0.50]

0.003 [0.45]

Democratization No reform support in 1991 Reforms 1996 Disorganization index Secondary education Transportation

0.109 [1.12] 0.14 [1.34] 0.007 [1.57]

0.1 [0.99] 0.006 [1.30]

Tax capacity in 1997 Big city dummy

0.013 [0.34]

Corruption index Liberalization index Shadow economy in 1995 Organized criminal control index 1996 Observations R-squared

0.001 [0.10] 63 0.32

Annual average growth rate of industrial production, 1996–98

0.133 [1.73]* 0.002 [0.30] 64 0.35

0.003 [0.49] 0.005 0.006 [1.85]* [2.16]** 0.005 0.003 [0.79] [0.52] 0.009 [3.01]*** 0.004 [0.73] 0.005 0.006 [1.48] [1.94]* 0.128 [2.34]** 0.141 0.102 [1.66] [1.22] 0.01 0.007 [2.53]** [2.07]** 0.01 [1.36] 0.014 [0.53] 0.003 [0.47] 0.034 [3.85]*** 0.132 [2.14]** 0.008 0.005 [1.72]* [1.18] 61 62 0.5 0.24

Notes: Robust t-statistics are in brackets. *Significant at 10%; ** significant at 5%; *** significant at 1%. All variables are scaled by capital at the beginning of 1998.

0.005 [1.15]

0.006 [2.00]*

0.138 [1.64] 0.005 [1.35]

0.063 [0.98] 0.006 [1.32] 62 0.2

47 0.005 [0.77] 0.012 [0.48]

0.005 [0.21]

Big city dummy

0.008 [1.98]*

0.002 [0.24]

0.012 [2.69]***

Transportation

0.111 [1.35]

0.008 [2.56]**

0 [0.09]

0 [0.68]

Tax capacity in 1997

0.08 [0.97]

0.001 [0.29]

Reforms 1996

Secondary education

0.012 [2.49]**

No reform support in 1991

0.089 [1.74]*

0.01 [3.14]***

Democratization

Disorganization index

0.005 [1.07]

0 [1.37]

0.009 [2.59]**

0.09 [1.25]

0.007 [2.60]**

0.002 [0.40]

0 [0.96]

Average GRP index 1997–98 (GKS)

Export potential

GRP per capita, 1998

GRP per capita, 1994

Dependent variable

Table 2.2 Regression results for gross regional product, 1997–98 and 1999

0.017 [0.13] 0.004 [0.67]

0.003 [0.61]

0.005 [1.21]

0.01 [1.61]

0 [1.63]

0.053 [0.46]

0.003 [0.80]

0.011 [1.67]

0 [1.36]

0.003 [0.62]

0.006 [0.05]

0.005 [1.31]

0.011 [1.75]*

0 [1.61]

GRP index 1999 (GKS)

48 61 0.43

Observations R-squared


0.006 [1.53]

0.02 [2.55]**

0.001 [0.19]

64 0.29

0.007 [1.67]

0.016 [2.00]*

0.002 [0.31]

64 0.24

0.015 [2.11]**

Average GRP index 1997–98 (GKS)

Organized criminal control index 1996

Liberalization index

Corruption index

Dependent variable

Table 2.2 (continued)

64 0.11

0.019 [1.68]*

64 0.12

0.003 [0.48]

0.021 [1.81]*

64 0.12

0.022 [1.93]*

GRP index 1999 (GKS)


49

To the extent that macroeconomic policy was driven by political factors, one would have to turn to these original forces in order to explain the overall (GDP) growth trends in Russia. However, it may well help to explain the relative performance of individual sectors. At the beginning of the transition, when the exchange rate was undervalued, exporting sectors took the lead. During the period of fixed exchange rate, when the real exchange rate quickly appreciated, Russian export started to lose its competitiveness and those industries oriented on domestic demand and enterprises close to large domestic markets got a better chance to develop, as indeed the cross-regional regressions, reported in Table 2.1, show. During this period regions with small transportation costs or a small distance to Moscow grew faster than others. At the same time, sectors enjoying high local demand, such as food processing, declined relatively less than others and attracted some foreign and domestic investment. Yet even they suffered from an overvalued exchange rate (as can be learned from their very strong recovery following the crisis of 1998). The combination of weak government and tight monetary policy produced such puzzling economic phenomena, specific to Russia and a few other CIS countries, as barter.17 Prior to the 1998 depreciation, the share of barter in total sales in Russia was above 50 per cent. While barter was known in other transition economies, the nature of Russian barter seems to be uniquely different. As is shown in Table 2.3, the share of barter in Russia was higher than in most of other transition economies, with the exception of Ukraine, Moldova and Kazakhstan.18 Its structure was also different from that in Ukraine and Central and East European countries: in Russia barter concentrated mainly in rural areas and around large monopolies, especially in energy and other natural resources (Carlin et al., 2000). Dalia Marin in a number of co-authored papers argues that barter is a way of solving the disorganization problems in firms. Given the absence of contract enforcement, there is a hold-up problem on the part of buyers in trade credit deals, and barter is a way of collateralizing such deals using the output of the buyer. Marin et al. (2000) tests this hypothesis on Ukrainian data, and show that it is the best explanation for barter in Ukraine. Since disorganization is a problem in Russia as well as in Ukraine, similar logic can be applied to the Russian firms. Gaddy and Ickes (1999) proposed a ‘virtual economy’ theory of barter, which states that barter is a way of state support for value-destructing firms. Marin et al. (2000) questioned the theory by claiming that they do not find confirmation of it in the Ukrainian data. It is possible, though, that for a virtual economy to exist, a large non-virtual economy is needed, supposedly in the natural resource extraction industry, which provides enough rents to support the virtual economy. Therefore, virtual economy theory may not be supported by data from resource-poor Ukraine but may be well

50


Table 2.3 Share of firms with different levels of non-monetary transactions by country, % 25% of total firm’s transactions

50% of total firm’s transactions

Russia Ukraine

35.7 34

20.4 22.4

Other CIS Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan Moldova Uzbekistan

2.4 1.6 15.2 4.7 24.4 23.2 44 13.6

1.6 0.8 6.4 0.8 16.5 12 23.2 6.4

Non-CIS Bulgaria Croatia Czech Rep. Estonia Hungary Lithuania Poland Romania Slovakia Slovenia

3.2 49.1 3 2.3 0 2.7 4.5 8 22.5 19.2

1.6 26.1 0 0 0 0 0.9 4 18.6 4

Dependent variable

Source: EBRD Enterprise Survey (1999).

founded in Russia. The ‘curse of oil’, which we discuss in more detail later, can be one of the causes of barter, according to the virtual economy theory. The list of explanations of barter in Russia also includes liquidity crunch due to tight monetary policy and high yields of government short-term bonds (GKO), price discrimination by natural monopolies, tax evasion and artificial attempts by the government to show lower fiscal deficit through wage arrears to its employees. Notice that all existing explanations of barter imply weakness of the government. Inability of the government to provide a contract enforcement mechanism is needed for both the disorganization and the virtual economy explanations to be true. Institutional collapse is needed for inflation and liquidity crunch to result in barter (Woodruff, 1999; Guriev and Popov, 2001; Popov, 2002).

51


What effect can this massive use of barter have on the future development of the Russian economy? First of all, as shown in a number of papers (Guriev and Ickes, 2000; Carlin et al., 2000 and others), barter delays restructuring of firms. Firms involved in barter have little incentive to improve the quality of their products, and to increase productivity. Instead, they can get involved in counter-productive restructuring, needed to make barter deals as efficient as possible. Additionally, as argued by Haizhou et al. (2001), barter could have slowed down the development of the Russian banking sector. The financial crises and devaluation of the rouble in August 1998 had a remarkable effect on the Russian economy, which suddenly began to grow. (Figure 2.2) The usual consensus is that this growth was the result of the devaluation: both domestic and external demand for Russian output increased as a result of the changes in relative prices, and the Russian economy, which had ample unused capacities, was able to get out of stagnation. Evidence from cross-regional regressions suggests that this is not the entire story (see Table 2.2). After controlling for other factors, regions with higher reform performance had higher growth rates during this period. Thus, the reaction of the Russian economy to the devaluation was in a sense the result of structural transformations and reforms, accumulated from the beginning of transition. At the same time the export potential in the regions was not found to be a significant explaining factor of growth in 1999 (see Table 2.2). If true, it also follows from the regressions that the direct effect of 120 110

Industrial production, SA Real exchange rate

100 90 80

Source: Tacis Russian Economic Trends (Moscow).

Figure 2.2

Output and real exchange rate

05

05 09 01-02

05 09 01-01

05 09 01-00

05 09 01-99

05 09 01-98

60

01-96 05 09 01-97

70

140 130 120 110 100 90 80 70 60 50 40

52


natural resource potential was observed only in the beginning of transition. However, over time we did not find that export potential is a significant explanatory variable for the growth of the Russian regions. Nevertheless it is still possible that the export potential had an indrect effect (positive or negative) on growth through a number of channels that were mentioned above. Studying investment behaviour across the regions of Russia produces similar results. Although the general source of investments in Russia in the late 1990s was mainly revenues from oil and natural resources sales (see Figure 2.3), the recipients of investments were firms in better-reformed regions. We estimated a traditional accelerator model of investment, using the following specification:

Ij 98 Yj98 Yj 97 1 2 d *Democracyj Kj 98 Kj 98 Kj 98 l*Liberalizationj j (**) where I stands for investment, Y is output, K is capital, Democracy stands for the index of democratization, Liberalization stands for the economic liberalization index (the latter two variables are from Petrov, 2001, and they are explained in greater detail above), j is the index of the region. The model was estimated separately for investment in industry, agriculture and services. The results, presented in Table 2.4, show that the level of economic 250 Fixed capital formation index, SA

150 100

Figure 2.3

Investment level and oil price

05

50 05 09 01-02

05 09 01-99

05 09 01-98

01-96 05 09 01-97

Source: Tacis, RET (Moscow).

05 09 01-01

Average oil price, US$/t, right scale

700 600

200

05 09 01-00

1500 1400 1300 1200 1100 1000 900 800

0

53

0 [0.89] 0.001 [1.71]* 0.007 [3.13]*** 75 0.22

0.106 [2.25]** 0.181 [4.09]***

0.001 [0.30] 0.015 [1.94]* 0.022 [1.07] 77 0.13

0.002 [0.09] 0.003 [0.14]


Observations R-squared

Constant

Changes in output in service sector, 1998 Changes in output in service sector, 1997 Changes in output in construction, 1998 Changes in output in construction, 1997 Changes in output in agriculture, 1998 Changes in output in agriculture, 1997 Changes in output in industry, 1998 Changes in output in industry, 1997 Democratization index Liberalization index 0 [1.56] 0 [0.29] 0.007 [2.92]*** 75 0.1

0.005 [0.26] 0.042 [1.12]

Fixed investment in Fixed investment in Fixed investment in service sector, 1998 construction, 1998 agriculture, 1998

Investment equation estimations

Dependent variable

Table 2.4

0.17 [2.00]** 0.145 [0.91] 0.002 [1.68]* 0.011 [2.00]** 0 [0.02] 77 0.13

Fixed investment in industry, 1998

0.001 [1.61] 0.01 [2.05]** 0.003 [0.26] 77 0.12

0.195 [1.95]*

Fixed investment in industry, 1998

54


liberalization is the major factor explaining regional variations in investments. In addition, Manaenkov (2000) demonstrated that progress in reforms is also one of the most important factors affecting the decision of foreign direct investors to come to Russia. Political factors, such as a stronger and more cohesive leadership, and brighter expectations for the continuation of reforms, may also have had their effect on the revival of growth following the 1998 crisis. The election of Putin in 2000 and his reform of the government structure consolidated and strengthened the government. One of the signs for this is the improvement in the government’s abilities of tax collection (see Figure 2.4). Additionally, the announcement of Putin’s economic programme with its strong reform orientation, and the confirmation by Putin that the privatization results will not be reversed, should have strengthened reform expectations among the population. Russia-Goskomstat Expenditure Revenues

Deficit

Expenditure Deficit Revenues

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

Surplus

Figure 2.4

4.

Russia-RECEP

USSR

1986

1985

55 50 45 40 35 30 25 20 15 10

Consolidated budget revenues and expenditure, % of GDP

CONCLUSIONS

This chapter suggests that it was the collapse and weakness of government institutions which led to Russian growth failure during most of the 1990s. Strengthening of the government in the late 1990s coincided with the period of return to economic growth. Weakness of the government is explained firstly by historical factors and secondly by lack of coordination of expectations regarding economic policies. During the 1990s Russia tried to copy Western governmental and economic institutions and legislation,


55

and this attempt failed because of the non-familiarity of the population with legal conditions. Such familiarity is badly needed for the proper functioning of such institutions. In addition, lack of consensus inside the government and among the people over the direction and sequencing, the speed, and the costs of the reforms and their distribution also undermined the ability of the government to function efficiently. Both processes, that is the adaptation of institutions and the alignment of expectations, are not yet finished in Russia. Russian future growth depends crucially on the speed of these processes.

NOTES 1.

2.

3. 4.

5.

6. 7.

8.

9. 10.

The lack of adaptation of the law to domestic conditions in such countries leads to malperformance of the legal system. The bankruptcy law in Russia provides an important example of the non-functioning of an otherwise good law, that was not properly adapted to the local environment (see Lambert-Mogiliansky et al., 2000). This chapter does not give the full list of factors, which may affect Russian development in the future. For example, Russia may face substantial costs of geographical reallocation of production, because under the current structure some increasing-returns industries are located in areas with low demand. Understanding the effect of this and other factors on Russian development deserves a separate study (see Gaddy and Ickes, 2001a, b). See Berglof et al. (2002) on the accountability of the government under the presidency of Yeltsin, and its effect on economic growth. As an explanation for this phenomenon, Sachs et al. (2000) refer to the fact that development of the rule of law in Europe was a result of a compromise between the state and the church during the Reformation period. Since in Russia there was no true competition between the two, no rule of law was developed internally. Owen (1991; 1997), for example, shows that despite 80 years of attempts, Russia failed to introduce the law on incorporation by registration, and kept the concession principle of incorporation until the Revolution. As a result, the pace of development of corporations was much slower in Russia than in developed countries: in 1914, in Russia there were only 2167 corporations, in comparison to almost 61 000 in the UK, about 15 000 in France and 5487 in Germany (Owen, 1995). This resulted in improper usage of many laws, especially in combination with the lack of independence of the judiciary from local governments. For example, bankruptcy law became the main instrument of property contests (Lambert-Mogiliansky et al., 2000). This section of the chapter is close in spirit to the study by Fischer (1998), who evaluated the importance of different factors for the speed of reform during the early transition years. His results show that the outcome of first elections was the most important factor, which also determined the later progress of the reforms. We repeated all the estimations for a composite index of institutional quality, calculated as a simple average of indexes of voice and accountability, political instability and violence, government effectiveness, regulatory burden, rule of law, and graft, and received similar results. It is worth noting that some Eastern European countries were still more over-industrialized: for example, in the Czech Republic the level was 39 per cent. The task of renovating physical capital contradicts the short-run goal of fulfilling plan targets and, therefore, Soviet planners preferred to invest in new capacities instead of upgrading the old ones. As a result the average age of capital stock had a tendency to increase during the Soviet era.

56 11. 12. 13. 14.

15.

16. 17. 18.

The economic prospects of the CIS Interestingly, military spending of the Russian empire was also the highest among developed countries, constituting about 7 per cent of the net national product. Not including ten autonomous republics and ‘regions’. More details on the construction of variables are available upon request. We carried out a principal component analysis of the following four variables: production of oil in 1995, production of gas in 1995, production of ferrous metals in 1993 and share of export in GRP in 1994. The first principal component, which we call export potential, explains 38 per cent of variation in the variables. All four variables are included in the first component with positive signs. Export and ferrous metal production has higher weight than oil and gas production. The details about construction of the principal component are available in the full version of the paper at http://www.eerc.ru/activ/projects/GRP/papers/Russia_final.pdf. Manufacturing firms suffered not only from their initial non-competitiveness, but also from the underdevelopment of the financial sector. Such firms were unable to get credits to finance investment as well as to offer trade credits and leasing schemes to their consumers, which made them even more non-competitive. Another factor responsible for capital flight from Russia is the abundance of (exported) natural resources. Another important characteristic of the Russian economic situation during the period of tight monetary policy was wage arrears, which were also observed in Argentina before the 2001 crisis. The large share of barter sales in Croatia should be viewed as a problem due to the inconsistency of the definition of non-monetary transactions in different countries (Carlin et al., 2000).

3. Transition and growth in Belarus Marina Bakanova, Lúcio Vinhas de Souza, Irina Kolesnikova and Ivan Abramov The stylized pattern of post-reform growth of a transition economy is characterized by a sharp initial fall of output followed by recovery and growth.1 Although the trajectory of Belarusian growth has the expected U-shape, there are some peculiarities about both the declining and increasing parts.2 The cumulative output fall from 1990 in Belarus was less than in almost all the CIS countries but higher than in most Central and Eastern European transition economies. Belarus’s output recovered relatively early (compared to other CIS countries), and the observed high rates of the officially recorded economic growth in 1997–98 were in contrast to the negative or very low growth rates in most CIS countries. The only exception was Uzbekistan, and since in both Belarus and Uzbekistan this had by no means been due to the progress in transition reforms, these cases somewhat challenged the standard transition paradigm in the late 1990s and were even called ‘puzzles’ by a few.3 Here we attempt to help solve this puzzle through a closer look at the particular transition path chosen by Belarus, to understand the reasons for the relatively shallow contraction, the early recovery, the exceptionally high growth rates in 1997–98 and their slowdown afterwards, and thus to question whether there was or is such a thing as the ‘Belarusian miracle’. This chapter starts with the analysis of Belarus’s initial conditions in order to get a deeper understanding of the scope and depth of the problems faced by the country at the beginning of the transition, and to understand the peculiarities of its growth and transition path. This is followed by the introduction of the ‘Belarus Policy Matrix’, to assess the underlying factors behind its growth performance and to study recent developments, with a view towards the sustainability of this growth. Finally, the chapter provides results of empirical investigations into the sources of economic growth in Belarus on macro and micro levels.

57

58

1.


INITIAL CONDITIONS

It is generally agreed that initial conditions are important for growth performance: by using proxies for differences in starting points it is possible to explain a substantial part of the differences in the depth and length of the transformation recession. The disagreement is about the strength of the impact of those initial conditions on growth performance and how quickly (if so) it vanishes over time.4 Study of initial conditions also may shed light on a country’s choice of transition path. According to its initial conditions, Belarus, at a relatively high level of development, suffered from significant macroeconomic and structural distortions. In spite of substantial differences in estimates for income levels during the pre-transition periods (at purchasing power parity or in current US dollars), it is safe to conclude that Belarus had a GDP per capita in purchasing power parity (PPP) terms well above almost all CIS countries (only the Russian level was somewhat higher), and broadly comparable with those in the Baltic states and the Central and Eastern European Countries (CEECs). On average, the population in the BSSR (Belarusian Socialist Soviet Republic) enjoyed higher living standards than those in most other regions of the FSU, and this was partially due to a higher rate of growth during 1985–89, above the USSR average. Under the system of central planning, Belarus – which was previously a predominantly agricultural area – developed a diversified and extensive industrial base, with many assembly industries. The share of Belarus in the USSR output of many complex industrial products was far in excess of its population share (Odling-Smee, 1992, Table A2, p. 52). The share of urban population more than tripled during 1950–90, from 22.2 per cent at the end of 1950 to 67 per cent at the end of 1990. The share of industry in GDP reached 49 per cent in 1990: among the FSU states only the Armenian figures were correspondingly higher. The share of agriculture in Belarus in 1990 was relatively high (at 22 per cent of GDP) whilst the share of services was one of the lowest among all transition economies – 29 per cent of GDP.5 The degree of over-industrialization measured by the difference between actual and predicted share of industry in GDP among the FSU was again the highest for Armenia, followed by Belarus (De Melo et al., 1997b). As a consequence of its industrial development, Belarus was highly dependent on trade in general, and on trade with other republics of the USSR in particular. Thus, total and intra-regional (inter-republican) trade accounted for 47.3 per cent and 41.0 per cent respectively of Belarus’s GNP – the highest figures not only for the CIS but also for the Baltics and CEECs (Michalopoulos and Tarr, 1995, p. 15). Taking into account the price-

Transition and growth in Belarus

59

setting mechanisms of the FSU – overpriced ‘soft goods’ (manufactured products) and underpriced ‘hard goods’ (mostly energy and other raw materials) making, therefore, inter-republican trade a channel of indirect income transfers, in addition to direct budgetary ones – Belarus was classified as a ‘double recipient’ of transfers, by both importing underpriced energy resources and by exporting overpriced industrial goods (Orlowski, 1993; 1995). The potential costs to Belarus from the disruption of trade links with the rest of the FSU were estimated as 52.9 per cent of its NMP (net material product), the highest amongst the 15 republics (Nuti and Pisani-Ferry, 1992, Table 4). Belarus’s terms-of-trade losses due to the shift to world prices in the inter-republican trade were estimated to a fall in a range of 29–31 per cent of GDP (Tarr, 1994). Bakanova et al. (2002) had analysed the competitiveness of the Belarusian industrial sector prior to independence. According to the authors’ calculations, about 40 per cent of the industrial value added was produced in competitive industries, 45 per cent in non-competitive industries and 15 per cent in industries that generated negative value added at world prices. This implies that 60 per cent of Belarusian industry was not only non-competitive, but also that the elimination of some industries would by itself contribute to GDP growth. Calculations using a shadow (equilibrium) exchange rate instead of the official one reveal that about 26 per cent of the industrial value added was produced either in industries that generated negative value added or in industries that were not competitive even if the foreign exchange market were liberalized. That work also showed that the actual trade pattern had no correlation with the expected one, based on the measure of international competitiveness, for Belarus trade both with other USSR republics and with the rest of the world. All these indicate that the structural reforms needed in Belarus were much more complicated than just the redirection of Belarusian trade. Belarusian industry was both very concentrated and complex, with 60 per cent of industrial value added produced by a few key industries (Bakanova et al., 2002). The implication of this interdependence and concentration is a very high probability that, even if a sector was competitive, its output could be used in a sector that was either non-competitive or generating negative value added (in the case of forward linkages), or that the competitiveness of sectors with strong backward linkages could be severely hit by inputs from non-competitive sectors. This, in turn, means that with the start of transition such sectors as the former would have to look for new – other than domestic – markets, whilst for the latter it means the need to switch to another source of supply of inputs. In both cases this implies high search costs (Roland and Verdier, 1999) and much disorganization (Blanchard and Kremer, 1997) and, therefore, output contraction and stockpiling.

60


As a result, at the beginning of the transition Belarus was faced with more complicated and severe restructuring problems than not only most of the CEECs, but also than some of the FSU countries. In addition to heavy dependence upon energy and raw materials supplied from other republics of the USSR (first of all, from Russia), and its role as a producer of mostly complex, finished industrial goods, there were also the lack of national and institutional traditions, as well as the need to cope with the consequences of the Chernobyl nuclear accident. All these placed Belarus in an extremely unfavourable initial position. The experience of other advanced transition economies shows that appropriate policies that are implemented resolutely can overcome initial obstacles and adverse conditions.

2. THE GROWTH PATTERN IN BELARUS SINCE INDEPENDENCE The dynamics of the major economic indicators of Belarus since independence is presented in Table 3.1. With the collapse of the command system, the demand by the FSU was substantially reduced, and import prices for inputs (first of all, for oil and gas) increased sharply, leading to a decline in industrial production and to a sharp contraction in trade. The output fall in Belarus was, however, a mere 3 per cent in 1990 and 1.2 per cent in 1991, the lowest among the CIS countries. During 1992–95 the rate of output decline had accelerated and the cumulative output decline for the period 1990–95 had reached about 40 per cent – the second-best record among all CIS states (the smallest contraction was recorded in Uzbekistan). By mid-1995 most prices had been liberalized, and significant progress had been achieved in the privatization of small-scale enterprises and some progress in that of large-scale ones. During 1992–95, in spite of serious drawbacks, the creation of the new market institutions started and, although macro stabilization was far from being reached, inflation was reduced by 1995 from a four-digit to a three-digit level. A large nominal depreciation of the Belarusian rouble (BRB) between September 1993 and March 1994 allowed for the recovery of exports, albeit with a time lag. Thus, the recession in Belarus appeared to be less profound than should have been expected, given the adverse initial conditions. A deeper contraction was avoided due to some progress attained in liberalization and privatization that facilitated some export recovery. However, especially from the end of 1995, the progress in transition policies in Belarus became rather slow and inconsistent, as indeed is reflected in the reduction in the average EBRD transition indicators, from 2.1 in mid-1995 to 1.5 in mid-2000. A

61

Source:

National Statistics.

1993 7.6 9.4 3.7 1190.2 6.5 1.4 5.5 10.24

1992

9.6 9.2 9.5 970.8 12.4 0.5

1.9 10.24

3.5 10.21

12.6 14.6 14.5 2221.0 30.9 2.1

1994

2.7 10.18

10.4 11.7 4.7 709.3 5.0 2.9

1995

1.9 10.1

2.8 3.5 2.4 52.7 5.1 4

1996

2.2 10.1

11.4 18.8 4.9 63.8 14.3 2.8

1997

1.4 10.1

8.4 12.4 0.7 73.0 18.0 2.3

1998

2.9 10.0

3.4 10.3 8.3 93.7 7.3 2.1

1999

Years (Percentage over the previous year)

Selected economic indicators for Belarus, 1992–2002

GDP Industrial output Agricultural output Consumer prices Real wages Unemployment rate, % General government balance, % GDP Population, m

Table 3.1

0.6 9.99

5.8 7.8 9.3 168.6 12.0 2.1

2000

1.6 9.95

4.7 5.9 1.8 61.1 29.6 2.3

2001

9.90

4.7 4.3 1.5 42.6 7.7 3.0

2002

62


move towards a ‘socially-oriented market economy’ became an officially adopted target, implying a specific transition path, which in many respects undermined the previous reform efforts and led away from rather than towards a market economy. The ‘Belarus Policy Matrix’ representing the alternative strategy includes a brief listing and analysis of the major policies during 1996–2000 in the context of their impact on growth, as presented in Table 3.2. Although there have been some positive developments starting from the end of 2000, the major problems of this strategy are still in place. Thus, in spite of the tightening of monetary policy and the reduction in a number of quasi-fiscal activities, inflation in Belarus remained the highest in the CIS, and credits by the Central Bank remained the major source of budget deficit financing (including that for housing construction). The exchange rate was unified in September 2000, and from 2001 a crawling band regime was adopted, with the Belarusian rouble pegged to the Russian one, but hard currency surrender requirements were not abolished, and a continuous real appreciation of the Belarusian rouble vis-à-vis other currencies created expectations of devaluation and instability in currency markets. Concerning fiscal policy, the fiscal burden remained high. The relatively low fiscal deficit figures did not reflect adequately the fiscal stance, given the persistence of off-budget funds and the high volume of the government contingent liabilities. Administrative wage increases were introduced, aiming initially to reach US$100 at the end of 2001, one of the promises of the presidential election campaign that year. Since these increases had no relation to productivity growth, this step undermined macroeconomic stability, led to an increase in budget arrears, to decline and losses of profitability and competitiveness, and to a fall in investments. There has been very little progress in terms of structural reforms and privatization. The share of the private sector in GDP in 2001 reached only about 20 per cent – the lowest among all the 26 transition economies (EBRD, 2002).6 Business regulations are opaque and unpredictable, thus discouraging private initiative. The state is still heavily involved in all economic activities. Not surprisingly, the cumulative FDI inflow to Belarus during the period 1992–2001 is about US$130 per capita, one of the lowest figures among all European transition economies. The reliance on Russia as a major economic partner remains very strong, despite the facts that Belarusian products grow less and less competitive in the Russian markets, and the divergence of economic interests of the two countries become more evident. An analysis of economic policy in Belarus led us to the conclusion that whatever economic growth there was, it was due to a direct and artificial stimulating of industrial production at state-owned enterprises (SOEs), and to trade and quasi-fiscal transfers from Russia (privileged access to the

63

Short-run impact on growth

Direct effect: increase in aggregate demand Secondary effect: increase in demand from expanding sectors (construction, housing)

Increase in importsubstituting activities Providing for a certain level of ‘strategic imports’ (energy, foodstuffs, medicine)

Monetary policy: subsidized credit to sectors of the economy (agriculture, housing, industry)

Exchange rate policy: multiple exchange rate system with overvalued (or undervalued?) official exchange rate; foreign exchange rationing; surrender requirements

Development of parallel currency markets Depleting of hard currency reserves Worsening conditions for exports Growth in barter trade Unproductive Profit (DUP) and Rent-seeking activities

Inflation Negative real interest rates Increase in domestic consumption, decline in savings Agriculture performs poorly in spite of the policy

Short-run negative effects

Belarus policy matrix: impacts on growth

Major features

Table 3.2

Holding back of productivity growth (export-oriented activities are usually the most productive; problems in financing technological imports) Capital flight and isolation from international markets reduce possibilities of attracting investments Sharp contraction in trade in case of refusal to accept barter deals by trade partners Output contraction in case of sharp devaluation, unless supported by structural reforms

Volatility of growth Costs of disinflation Depleting domestic sources for investments Costs of delayed restructuring

Medium- and long-run potential impacts on growth

64

Disincentives for business, incentives for tax avoidance and evasion Financing of budget deficit through GKOs – government bonds – is increasingly difficult due to the lack of liquidity in commercial banks and low returns of these operations Reliance on money financing of the budget deficit; high inflation tax and seigniorage Non-transparency of public finances due to the presence of quasi-fiscal operations and extrabudgetary funds (first of all, the ‘Presidential Fund’)

Short-run negative effects

Soft budget constraints for Build-up of inventories SOEs, while directives for Falling profitability of SOEs (also production and sales due to cross-subsidization of

Basis for the Government involvement in economic activities (re-organisation) Subsidies for several sectors (first of all, communal services and utilities)

Fiscal policy: high tax burden; relatively low budget deficit

Structural reforms: yet to be started; Business environment: extremely

Short-run impact on growth

Major features

Table 3.2 (continued)

Growth through excess capacity utilization of SOEs has limits, and it is in wrong production lines.

Increasing difficulties with revenue collection when inflation subsides. This might lead to pressure for rising taxes, generating even more disincentives for business (first of all, privately owned ones); Increased pressure on the budget, in case of the transformation of the quasi-fiscal into fiscal operations, aggravating the budget deficit financing problems given a limited ability to borrow abroad; Delay in restructuring of subsidized sectors, waste of scarce fiscal resources that could be directed to the support of activities with long run returns, or to a ‘social safety net’ to soften the burden of reforms for the most vulnerable part of the population

Medium- and long-run potential impacts on growth

65

Reliance on Russia as major economic partner

unfavourable, widespread controls and regulations

utilities: companies pay for utilities well above the price paid by the population) Increase in inter-enterprise arrears Very limited growth of private sector Extremely low level of FDI

Obstacles to private sector development prevent sustainable increase in output and productivity Lack of spillover effects of FDI to productivity growth in the host economy; especially important due to the lack of domestic investment Administered prices and wages send wrong signals to the economy, pulling resources to value-destructing, noncompetitive activities. Subsidies in the form of Low incentives to technology The commercialization of the gas supply at below-market change Russian energy sector imposes limits prices Fears of cuts in supply of gas and on subsidizing Belarus through Barter trade and barter oil due to the arrears lower gas prices and through barter payments for energy Barter deals not always in terms trade; this will reduce the demand resources favourable for Belarus for some Belarusian goods, increase Privileged access to the High sensitivity to Russian production costs and reduce the Russian market for economic cycles competitiveness of Belarusian Belarusian goods (due to Unification of tariffs with Russia led goods, given the lack of the Customs Union) to the increase in tariffs for some restructuring categories, which affected Belarus’ The post-1998 Russian recovery was interests partially based on a real devaluation with expenditure switching effects, leading Belarus to loose market share to domestic Russian products Trade diversion effects from economic integration with Russia might be significant for Belarus

limited disorganization and output contraction due to the restructuring and stimulated the excess capacity utilisation

66


Russian market due to Customs Union; gas supply at below market prices; barter trade and barter payments for energy resources). After an exceptionally high rate of growth in 1997–98, the GDP growth became more moderate. This was due to the exhaustion of these major sources, manifested during 2001–2002 in the sluggishness of industrial output and export growth, in stockpiling, in the worsening financial position of enterprises, and in the acceleration in wage, tax and inter-enterprise arrears. Although the rate of inflation gradually declined, the level of inflation in Belarus remains the highest among all CIS members. A return to a sustainable growth path, based on enhanced competitiveness and increased private (domestic and foreign) investment is impossible without structural reforms. While such reforms are likely to be accompanied by a (temporary) drop in output or in the rate of growth, they will pay off in the long run. Belarus managed to escape the deeper initial output collapse conventionally explained by disorganization. There are two main aspects to the ‘disorganization’ concept: the disruption of production and trade links, and the decline in investments. Belarus, through the use of strong administrative controls over the economy, inherited from the old regime, managed to reorganize the former production and trade links, thus providing for the continuation of production and exports (mostly to Russia), along the patterns during the Soviet period. On the investment front, however, there has been a failure as the old SOEs had no incentives or opportunities to invest, and since the private sector was too weak and vulnerable to undertake new investments on a large enough scale to change the profile of the economy. Finally, it is necessary to stress again that even the past Belarusian performance appears relatively successful only when compared to some transition countries: not only the majority of EU accession countries, including the Baltic states, fare better, but also among the CIS countries, Kazakhstan and Turkmenistan, let alone Uzbekistan, did as well or better than Belarus (EBRD, 2002). In addition, Åslund (2001), using his own revised GDP estimates, showed that Belarus is actually one of the worst performers: only Romania had a smaller GDP increase and only Moldova had a lower 1995–89 GDP ratio. In order to verify whether our conclusions based on the construction and analysis of the ‘Belarus Policy Matrix’ in Table 3.2 are correct, we proceed in the next section to formally analyse the factors behind the economic growth record of Belarus, based on direct macro- and micro-level empirical estimations.


3.

67

COUNTRY-SPECIFIC GROWTH ESTIMATIONS

The following estimations of growth regression for Belarus are based on a series of monthly statistics covering the period December 1993 to December 2000.7 The dependant variable is GDP. The data include the best obtainable data of factors of production macroeconomic stabilization and level of reform.8 Monthly data is used in order to increase the number of observation points covering such a short period of time. The data include: 1.

2.

3.

Factors of production: a) real wages, seasonally adjusted, used as an imperfect proxy for the labour input, L(w);9 no similar alternatives are available for the capital input, K.10 Stabilization: a) inflation:11 the monthly variation of the consumer prices index, lagged by three months; b) government deficit: as percentage of GDP. Structural reforms: a) the number of state-owned enterprises: used as an indication of the reform efforts by the government;12 b) losses or profits of SOEs: as a share of GDP, represent the extent of distortions of the ‘command economy’;13 c) industrial production index: represents the degree of ‘over-industrialization’.14

Additionally, we also use measures of external trade (exports plus imports) in GDP separately for the shares for trade with the Russian Federation and the European Union (EU).15 Table 3.3 summarizes the main findings. Detailed regression results can be found in Bakanova et al. (2002). The main findings are as follows. First, inflation as well as the size of the government deficit are significant and have the expected negative sign. Jointly, they would indicate that a reduction of inflation by 1 per cent together with a similar reduction of the public deficit would increase GDP by over 5 per cent (over 80 per cent of this gain would come from the fiscal side). Second, the number of stateowned firms is significantly positive, but with a small coefficient, which means that the positive effects of the ‘unbundling’ of large concerns predominated; however, the other measure of reform, the net profits of the publicly-owned productive sector, is both significant and has the expected negative sign. Third, the production index is significant and positive, which may be seen as an indication of some productive restructuring. Fourth, the effects of trade with Russia are negative for both imports and exports

68

Table 3.3


A growth regression for Belarus Coefficients

Wages Inflation Deficit Number of SOEs Net profits of SOEs Industrial production Exports to Russia Imports from Russia Exports to EU Imports from EU R2

, s* , s* , s* , s* , s* , s* , s* , s* 0.85

Note: * ‘s’ here stands for statistical significance.

(although only statistically significant for exports), while exports to the EU are positive and significant. Imports from the EU, though, are significant and negative, but with a coefficient far smaller than the one for exports.16 For the two trade flows, exports from Belarus are found to be more important than imports. This may signify the stronger effect of internal restructuring of production. Finally, wages are non-significant. Added dummies for the Customs Union, and the union treaty of Belarus with Russia and for the August 1990 financial crisis, were all found to have no significant impact. These results support some of the preliminary hypotheses that economic growth in Belarus has been mainly achieved through the increase in industrial production of SOEs, which apparently did go through some degree of restructuring,17 and through trade relations with the EU. Macroeconomic stabilization is important and will most likely play a role in the future, when Belarus will embark on ‘real’ reforms. As for the period in question, 1996–98, growth was resumed and reached high rates, and both inflation and the fiscal deficit were indeed lower. One may, however, question the results, as the official CPI inflation rates most likely underestimated the real inflation rates, since many prices, especially of consumer goods, were controlled.18 The same can be said in relation to the government balance: the results should be treated with caution, since the data on quasi-fiscal operations are not available on a monthly basis. The most interesting, but not surprising result is the negative effect of exports to Russia on economic growth in Belarus. Whilst at a specific moment in time an upturn in exports to Russia could be seen as a driving


69

force for reviving economic growth (especially of SOEs, previously oriented towards this market), in the long run the preservation of the existing structure of trade will have negative growth and welfare effects. A preliminary conclusion would be that more intense trade relations with larger, more dynamic and diversified economies, like the EU, would have substantial beneficial effects for Belarus, surpassing those it could reasonably expect to gain from its current ‘special relationship’ with Russia. Countries with similar structures and experiences to Belarus – namely, the Baltic republics – graphically illustrate that such gains are attainable. An attempt to quantify the potential effects of trade in the ‘right’ direction was done through a counter-factual ‘free trade experiment’ as an alternative to the current ‘special relations’ with the Russian Federation. This was done through an estimation of a small computable general equilibrium (CGE) model for Belarus by Bakanova and de Souza (2002). The results of those estimations seem to support the conclusion that the current, almost exclusive trade relationship with Russia is not optimal from the point of view of Belarusian welfare, suggesting an alternative more balanced policy, one leading toward an ‘Association Agreement’ with the European Union (a good proxy for the developed countries) which, after the current enlargement wave, will be the largest neighbour of Belarus and its natural market. This could bring very substantial benefits to the country,19 especially if coupled with the resumption of the domestic reform and liberalization process.

4. MICROECONOMIC ASPECTS OF ECONOMIC GROWTH IN BELARUS Here we study the comparative performance of enterprises with different types of ownership, and how this effects economic growth in Belarus over the period from 1993, the start of mass privatization, until 2000. This period has been subdivided into two: 1993–95, a period of output decline, and 1996–2000, a period of output recovery but stalled privatization. All enterprises in the sample were grouped into the following four categories: 1) SOEs: as of 2001, SOEs employed 57 per cent of the total labour force; 2) Privatized enterprises: 19 per cent of those employed in the economy; 3) Newly formed enterprises with no legacy of the socialist regime – ‘start-ups’ – which are mainly small and medium-sized: 17 per cent of total employment;

70


4) Enterprises with foreign participation – joint ventures (JVs):20 1.3 per cent of total employment. Three measures of economic performance are used in the following analysis: changes in labour productivity, the actual capacity utilization rate – as a measure of capital productivity – and the share of exports to the ‘rest of the world’ (Bakanova et al., 2002; Kolesnikova, 2001). The first measure could be an indicator of either ‘defensive’ or ‘survival-oriented’ restructuring, mostly through eliminating excess employment, or ‘active’, ‘growthoriented’ restructuring, through increase in sales (Guriev and Ickes, 2000). Therefore this measure may be misleading as far as proactive restructuring is concerned. Hence, we use simultaneously the two other measures of restructuring. The export variable fits the situation in Belarus very well since the majority of Belarusian enterprises are export-oriented and the indicator could be a good proxy for production competitiveness (Djankov and Hoekman, 1997). The estimated regressions also included, in addition to the performance variables, controls for industry and size and age of firms. As to industry we estimated performance both within and between industries (see Table 3.4). The sample of includes panel data for 388 enterprises, mainly in manufacturing, from different regions of Belarus over the 1993–2000 period. As most enterprises were privatized during this time interval, this also enables us to compare the performance of the same enterprises before and following privatization. The results of the regression analysis, shown in Table 3.421 suggest that fully state-owned enterprises underperformed on average, as estimated by each of the three performance variables – the log labour productivity growth rate, the log actual capacity utilization rate, and the log share of exports to the rest of the world. Those results are generally robust and significant across all time samples.22 On the other hand, light industry enterprises created after 1990 outperformed according to all performance variables: small ones in the labour and capacity equations, and large ones in the export equations, but only during the later period. As mentioned above, restructuring may be either growth-oriented or survival-oriented, depending on the specific situation and the strategy selected. The latter means that the enterprises have to decrease costs and, hence, reduce the level of activity. The operational indicators of the privatized enterprises after 1996 (that is, labour productivity growth rate, actual capacity utilization, share of export in output and share of export to nonCIS markets) show that all of them were restructured to some extent. The growth-oriented restructuring, however, is characteristic of the enterprises with a state ownership stake of no more than 25 per cent. On the other

71


Table 3.4

Regression results (enterprise restructuring) 93/00

C SOE 80PE S 50PE S 25PE S 20PE S JV 90A FU MA CH WO CON S LI FI SS MS ML S BS

93/95

96/00

L Prod.

Cap. Uti.

X to ROW

L Prod.

Cap. Uti.

X to ROW

L Prod.

Cap. Uti.

X to ROW

, s , s , s

, s , s , s , s , s

, s , s , s , s , s , s , s , s , s , s , s , s

, s , s , s , s , s , s , s

, s , s , s , s , s , s , s , s , s , s , s , s , s , s

, s , s , s , s , s , s , s , s , s

, s , s , s , s , s , s , s , s , s , s , s , s , s , s , s

, s , s , s , s , s , s , s , s , s , s , s , s , s , s dropped , s , s , s

hand, the restructuring indicators of enterprises with a high state ownership (over 80 per cent) are actually identical to full SOEs, and are survivaloriented. The indicators for enterprises with state ownership of between 25–90 per cent are much better, but several factors contributed to worsening in their performance during 1996–2000.23 First of all, the process of reducing the state ownership shares of the previously privatized enterprises stopped following the issue of the Presidential Decree establishing a ‘golden share’ for the state, granting it unlimited rights to veto any managerial decision. Such a right was used even in enterprises with minor state shares. In addition, cases increasing the share of the state in previously privatized enterprises were also observed. This was done by re-estimation of the fixed assets of the enterprise and was applied mostly to highly profitable companies. Other newly created obstacles involved restrictions on concentration of ownership. One can hardly expect to see private investment in enterprise restructuring in such cases. As a result the share of securities of privatized corporations in the stock market declined over the 1996–2000 period from 25 per cent to 10 per cent.

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To sum up, state ownership was always associated with less restructuring. This means that the economic growth that took place in the state sector during 1996–2000 has been achieved through the accumulation of unused and outdated physical assets and of labour, with the help of soft budget constraints for SOEs and without restructuring. Whatever economic growth there was in the SOE sector, it was of the extensive type. The economic policy pursued during 1996–2000 impeded the restructuring of privatized enterprises and thus prevented economic growth on an intensive and sustainable basis. We also find that start-ups and joint ventures (JVs) are the most efficient firms. The potential contribution of these firms to economic growth in Belarus can be crucial, but in order for this to happen, many more of them have to be (allowed to be) established and an appropriate institutional and microeconomic environment for them must be created.

5.

CONCLUSIONS

At the beginning of the transition Belarus was faced with more complicated and severe problems than most of the CEECs, and even some of the FSU countries. Heavy dependence upon energy and raw materials supplied from other republics of the USSR (first of all, from Russia), its role as a producer of mostly complex, finished industrial goods, the lack of an institutional tradition, as well as the need to cope with the consequences of the Chernobyl nuclear catastrophe, all made the Belarusian position extremely unfavourable. These specific initial conditions could be seen as a partial justification for the choice of a more gradual pace of reforms.24 However, they cannot justify inconsistencies and reform reversals, as happened in Belarus. An analysis of the peculiarities of the Belarusian development after gaining independence and, specifically, after 1995, led us to the conclusion that the resumption of economic growth in 1996, particularly the high rates of growth during 1997–98, were achieved through the rolling back of the transition reforms, the increase in the authoritarian coercive power of the state, the reintroduction of administrative controls over all economic activities and the artificial stimulation of production by SOEs by soft credits and other privileges. This conclusion is confirmed by the empirical investigation of both the macro and the micro levels. This analysis revealed the potential contribution in terms of sustainable growth that restructuring and structural changes in the composition of GDP, liberalization and privatization can bring to Belarus. The expansionary monetary policy may have stimulated domestic con-


73

sumption, and the Russian market may have helped to absorb additional output, but both actions had only short-term effects and at the cost of longer-term harm. Although there had been some initial restructuring in SOEs, most of the increased production came from the utilization of excess capacity, and the economic expansion in the state sector was of an extensive character and composed of ‘old’ products. The economic policy in Belarus failed to stimulate domestic savings and private fixed investments, as well as to attract FDI, thus imposing severe constraints on the future rate of growth and its sustainability. Although the reliance on Russia as a main economic partner may have brought some short-run gains, it has not been optimal from the point of view of long-run growth prospects. An alternative to such an ‘Eastward orentation’ could be a more even-handed policy, including an association agreement with the European Union which, following the completion of current EU enlargement in May 2004, will become the largest neighbour of Belarus, and also its natural market. The orientation towards the West will also redirect the economy of Belarus toward a more competitive composition. The main conclusion of this chapter is that the gradual nature of some of the reforms in Belarus did ameliorate to some extent the pains of the transition during its first decade. However, some of these pains were merely postponed to the future and will have to be endured. While this is mostly true for the early years of the transition, some of the political and economic actions taken during the second half of the decade seem to be counterproductive with little offset in terms of reduced pain, then or in the future. Long-term growth of Belarus depends on a shift of strategy from depending on the artificial comparative advantages of the past and on state control, to reorientation of the production structure accompanied by the continuation of the stalled domestic reforms and liberalization process.

NOTES 1. 2. 3. 4. 5. 6. 7. 8.

For a stylized description of the general post-transition ‘U-shaped’ growth trajectory, see Havrylyshyn et al. (1998), Wyplosz (2000) and Fischer and Sahay (2000). In fact, it looks more S-shaped. See, for example, Havrylyshyn and Wolf (1999), Fischer and Sahay (2000). See, for example, De Melo et al. (1997b), Berg et al. (1999), Falcetti, et al., (2000). The estimations of predicted as opposed to actual shares of services in GDP for the FSU republics are done by Easterly et al. (1994). The share of a genuine private sector is probably even lower – about 10 per cent GDP. The source of the data is a database of the EU TACIS project ‘Belarus Economic Trends’ (BET). Variables that represent initial conditions can only be used in a cross-country setting and therefore they are not included here.

74 9. 10.

11.

12.

13. 14.

15.

16. 17. 18. 19. 20. 21.

22.

The economic prospects of the CIS A possible alternative proxy could be the unemployment series: unfortunately, according to the available series, unemployment in Belarus fluctuated from an initial value of 1.4 per cent to a final 2.1 per cent, with some fluctuations in between, clearly unrealistic. A possible series for K, the monthly series of net profits of government-owned enterprises, will be used by us as a proxy for the level of economic reform. It serves as a proxy of the investment flow that when aggregated over time, discounted and netted from depreciation, it approximates the series of the capital stock. A tested alternative to the inflation series, real M0 (currency in circulation plus currency in checking accounts) is non-significant. The degree of monetization could also be seen as an indicator of financial development, but this is counter-factual for Belarus and its limited financial system, especially in an environment of persistent high inflation. The number of SOEs rose throughout the period, from 7709 to 11 410, but their average size declined, both as part of the process of ‘unbundling’ of the economic groups. Therefore the expected sign of this coefficient is unknown: a large state sector should be detrimental for growth, but the ‘unbundling’ may indicate a certain degree of economic reform, which would be supportive for growth. The aggregate value of this variable falls from over 40 per cent to 20 per cent of GDP. This is far from being a perfect measure, since the aggregate index may hide substantial sub-sector changes that might reflect an adjustment process that can support growth. For Belarus, the level of the index itself changes little from the beginning to the end of the series, from 100 to 95.4, with considerable variation in between. An analysis of input–output tables for the period 1993–98 reveals considerable intra-sector industry changes, with light sectors, like ‘Food Production’ growing from 5 per cent of the total to 23 per cent by the end of this period, overtaking ‘Machinery’ which, during the same period, falls from 30 per cent to 22 per cent of total industrial GDP. The source of these data was the IMF/DOTS. Belarus is a ‘small open economy’, imports plus exports averaged 117 per cent of GDP during the covered period, but with a highly distorted external trade: trade with Russia during this period amounted to around 65 per cent of all imports and 51 per cent of exports while imports from the EU totalled only 17.61 per cent in 1999, a considerable improvement from the 7.9 per cent registered in 1992. The corresponding export shares are the already low 12.5 per cent in 1992 and 10.6 per cent in 1999. One result of this situation is that Belarus’s trade with Russia causes a 10 per cent loss to the GDP of Belarus across the covered period, and close to 20 per cent in 2000, not counting the implied trade subsides of quasi-fiscal transfers. Those results for trade with Russia and with the EU are consistent with the results – not reported here – of cross-country ‘growth equations’, using all CIS and CEEC transition economies. It is also worth mentioning here that the positive effect of ‘unbundling’ includes also ‘alienation’ – that is, the closing of some inefficient units. Indeed the IPPI, a price index of goods at the factory gate, existing since 1997, rose much faster than the CPI. The one-shot welfare gains from trade liberalization could amount to up to 6 per cent. Initially some of them were included in the second group. The variables are: a) Ownership dummies – soe: traditional state enterprises; pes: privatized enterprises with state-hold stake; 80 pes: over 80 per cent; 50 pes: 50–79 per cent; 25 pes: 25–49 per cent; 20 pes: less than 25 per cent; jv: joint venture; b) Age dummy – 90a: created after 1990 (new entrants); c) industry dummies – en: power; fu: fuel; ma: machinery; ch: chemicals; wo: wood/forestry/pulp/paper; cons: construction materials; li: light industry; fi: food industry; d) Size dummy – ss: less than 200 employees; ms: 201–500 employees; mls: 501–1000 employees; bs: more than 1000 employees. A full description of the sample and more detailed results can be found in Bakanova et al. (2002). An interesting exception is that fully state-owned enterprises have a slightly highercapacity utilization ratio on average than firms with a non-state share of capital during 1993–95.

Transition and growth in Belarus 23. 24.

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It should be noted that the composition of enterprises within state ownership groups changed from year to year as the privatization process proceeded. At the same time, a highly educated labour force, favourable geographical position and homogeneous population are all factors that could be considered as valuable assets at the beginning of transformation.

4. Ukraine: the lost decade . . . and the coming boom? Olexander Babanin, Vladimir Dubrovskiy and Oleksiy Ivaschenko 1.

INTRODUCTION

At the beginning of transition many experts forecasted a rosy prosperity for Ukraine’s economy. As soon as Ukraine had broken the records for hyperinflation and for economic decline for a country not involved in a military conflict, the very same experts started to blame everyone for the collapse of the economy. Among the culprits the following were named: ● ● ● ●

Russia, for the increase of energy prices and the policy of discrimination against Ukrainian goods; the reformers for poorly designed reforms; the communist nomenklatura for opposition to the reforms; and finally, the West for the imposition of economic and social models allegedly alien to Ukraine, and for insufficient financial aid.

While the authorities were sluggish in implementing market reforms, the bureaucracy was pretty active in imposing discretional regulations that strengthened its own ‘grabbing hand’. As a result, the reforms were extremely slow and inconsistent. A number of structural and institutional factors made the initial position of Ukraine less favourable than that of other transition countries. Firstly, Ukraine is an extreme case of over-industrialization in large-scale enterprises, energy-intensive and military production sectors, and heavy dependence on energy imports. Secondly, Ukraine did not have a proper government for many years, the best people immigrated to the SU and to Russia, and the domestic ex-Soviet elite of government officials, academics and enterprise managers was mediocre and unprepared to deal with the changes. At the start of the transition Ukraine had the highest share of large-scale industrial enterprises and was the second-largest (after Russia) industrial 76

Ukraine: the lost decade . . . and the coming boom?

77

producer in per capita terms among the CIS countries.1 With 3 per cent of the USSR territory and 18 per cent of its population Ukraine produced 16.7 per cent of the USSR industrial output. About one-third of Ukraine’s industry was devoted to military production, the demand for which declined very sharply. However, the major problem was caused not just by the fact that deindustrialization and the changing industrial structure entailed high costs in terms of output contraction and shedding of the labour force. As we argue further in this chapter, the key consequence of over-industrialization in Ukraine was the creation of the powerful industrial lobby doing its best to retard any effort of market-oriented reforms in order to preserve the existing sources of rents. The creation of Ukraine’s industrial sector, non-competitive worldwide, may be compared with the experience of Latin America during the 1960s–1970s and the policy of import substitution. It was described as follows: ‘political considerations interfered with economic management, budgets were overspent, and the market was not available to discipline behaviour. The results were often disappointing, with many inefficient state-owned enterprises (SOEs) draining public finance’ (InterAmerican Development Bank Economic and Social Progress in Latin America, 1996) – a pattern typical of transition economies. An additional initial difficulty was that most of the large industrial enterprises belonged to energy-intensive sectors, a heavy burden on Ukraine that has to import three-quarters of its energy needs at much higher prices. The resulting development in Ukraine was, however, very peculiar: instead of engaging in energy-saving restructuring, energy importation (and transfer to Europe) became a focus of continued subsidization and rent-seeking and a barrier to further reforms. Here is a case when difficult past legacies can encourage both constructive and counter-productive policies, when some legacies could have been turned into advantages under a thoughtful government policy, and where the choice of policy depends on the institutional environment. The fact that in several transition economies the success in curbing inflation was not followed by growth recovery suggests that monetary stabilization alone may not be conducive to growth. Ukraine is a case in point. While it managed to depress inflation from 10.155 per cent in 1993 to 10 per cent in 1997, and keep it below the CIS average since then, output continued to decline until 2000. This clearly indicates that economic recovery is not possible if monetary discipline is not accompanied by profound changes in the institutional environment. In Ukraine, the restoration of relative macroeconomic stability was of little help as structural reforms were stalled. In this chapter we analyse the reasons for Ukraine’s embarrassing economic performance over most of the last decade, provide explanations for a long-awaited economic recovery, and contemplate its future economic prospects.

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2. A SUMMARY OF UKRAINE’S RECORD OF REFORMS Structural Reforms A summary of the reform record of Ukraine, as compared with a number of its neighbours can be found in Table 4.1. In 1999 Ukraine was behind most of its neighbours in almost every index; only Russia managed to stay behind in financial reform. Most critical is the lag in Ukraine in large-scale privatization, enterprise reform, competition policy and legal reform. In the same way Ukraine was also, in 1999, behind most of the transition economies in the various indices of economic freedom (Table 4.2). Although some progress of structural reforms has been made, overall Ukraine’s advancement in reforms was behind that of all CEE and most of the FSU countries. The Ukrainian privatization process was dominated by insiders who often viewed it solely as a mechanism of gaining ownership, Table 4.1

Progress with structural reforms, 1999

Index/Country Price liberalization Foreign exchange and trade liberalization Private sector share in GDP (%) Small-scale privatization Large-scale privatization Enterprise reform Competition policy Infrastructure reform Banking sector reform Reform of non-banking financial institutions Legal extensiveness (company law) Legal effectiveness (company law)

Ukraine

Russia

Latvia

Poland

Czech Republic

3.0

2.7

3.0

3.3

3.0

3.0 55.0

2.3 70.0

4.3 65.0

4.3 65.0

4.3 80.0

3.3 2.3 2.0 2.3 2.0 2.0

4.0 3.3 1.7 2.3 2.4 1.7

4.0 3.0 2.7 2.3 3.1 3.0

4.3 3.3 3.0 3.0 3.2 3.3

4.3 4.0 3.0 3.0 2.8 3.3

2.0 2.0

1.7 3.7

2.3 3.7

3.3 4.0

3.0 3.3

2.0

2.3

3.0

3.0

2.7

Note: Higher index means more progress. Source: EBRD, Transition Report (2000).

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3.80 4.00 4.00 3.00 5.00 3.00 4.00 3.00 4.00 4.00 4.00

3.29 2.61 3.40 2.90 4.83 2.62 3.05 3.04 3.19 3.33 3.93

FSU 3.92 3.89 3.80 3.13 5.00 3.57 3.77 3.75 3.72 3.98 4.53

CIS 3.69 3.75 3.88 3.00 5.00 3.25 3.25 3.25 3.50 3.75 4.25

WCIS 2.67 1.33 3.00 2.67 4.67 1.67 2.33 2.33 2.67 2.67 3.33

Baltics 2.74 2.50 3.88 2.75 3.25 2.25 2.25 2.50 2.25 2.75 3.00

CEE

3.53 3.33 4.00 3.67 5.00 2.00 3.33 2.67 3.67 3.67 4.00

SEE

3.85 4.00 4.17 4.00 5.00 3.00 3.33 3.67 3.67 4.00 3.67

FYR

Source:

Authors’ calculations based on the Heritage Foundation’s Index of Economic Freedom for 1999.

Note: The lower the ranking, the higher the quality of institutional climate. The FSU includes the CIS and the Baltic States. WCIS stands for the ‘Western CIS’ (Belarus, Moldova, Russia and Ukraine). CEE stands for Central and Eastern Europe (Czech Republic, Slovakia, Hungary and Poland). SEE stands for South Eastern Europe (Albania, Bulgaria, Romania), and FYR for independent states of the former Yugoslavia.

Average score Trade (protectionism) Taxation (tax rates) Government intervention Monetary policy (inflation) Foreign investment (barriers) Banking (restrictions) Wage and price controls Property rights (protection) Regulation Black market (extent)

Ukraine

Index of economic freedom, 1999

Factor/Country

Table 4.2

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but who were not interested in real restructuring. There had been many cases of ‘latent’ or ‘virtual’ privatization, where state property was ‘sold’ for nothing in order to honour creditor claims. The lack of effective ownership and restructuring is perhaps most evident in the poor performance of agriculture. Ukraine has the most fertile land in Europe.2 Potentially, with 0.4 per cent of the world’s territory, Ukraine can feed up to 1 billion people. Paradoxically, the 1999 harvest was the worst since 1945 and Ukraine had to import 1 million tons of wheat.3 The declining performance of the sector is due to deep-rooted structural problems. In 1999 only 15 per cent of the farmland was cultivated by private farmers in the form of subsidiary household plots inside collective or state farms, or of family farms. A significant change happened only recently when during 2000–2002 the area of arable land in private hands grew by 2.5 times. Turning next to the coal industry, despite the urgent need for restructuring there was no progress whatsoever. Seventy-five coal mines, out of a total of 252, produce only 5 per cent of the entire output. The average cost of production of Ukrainian coal is 150 per cent of the selling price. The difference is financed by state subsidies that exceeds by 1.5 times the budget expenditures for R&D. The share of barter in coal-related transactions reaches 70 per cent, and a large number of intermediaries open ample opportunities for fraudulent practices and rent collection. A third case is related to the transportation sector. Until recently Ukrainian railroads lost money and accumulated large debts, and much of their transactions were based on barter and handled by more than 600 intermediaries. In 2000 a new management was appointed, a hard budget constraint introduced, barter eliminated and the number of intermediaries reduced to 12. As a result, for the first time since 1991 the annual turnover went up by 9 per cent. Finally, Ukraine’s administrative reform that started only in December 1999 was stopped just four months later. Prime Minister V. Yushchenko failed to subordinate such vital bodies as the Customs and the State Tax Administration to the Finance Ministry, and a number of old ministries previously closed under him have been restored immediately following his quick dismissal. The downgrading of the status of the Ministry for Industrial Policy, the ministry that effectively blocked enterprise restructuring, was also reversed. The only positive result of this reform was in changes of the procedures of the Cabinet decision-making process. The above are only a few major examples out of many. Thus, despite some achievements, the process of restructuring was unsatisfactory. In what follows we argue that the major explanation for the slow pace of structural reforms in Ukraine has to be found in weak and slow institutional changes.


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The Institutional Environment The progress of structural reforms depends crucially on the extent of support to the reforms by the institutional environment. The lack of institutions that make and enforce economic rules significantly hinders the process of development. In Ukraine these were manifested in poor enforcement of contracts, poor tax collection, in prevalent corruption and state capture (Hellman and Schankerman, 2000), in a large unofficial sector (Hellman, et al., 2000) and in vague property rights (Shleifer and Frye, 1997). Per contra, there seems to have been an implicit ‘social contract’ between the various interest groups to support a soft budget constraint (Kornai, 1992) and collect rents. In a nutshell, all these culminated in the lack of imposed ‘discipline’ on the old sector, and of ‘encouragement’ to a new one (World Bank, 2002). The poor quality of the institutional environment and the resistance to economic reforms by the strong, rent-seeking forces are increasingly recognized as the main impediments to better economic performance of Ukraine. The perception by foreign investors of Ukraine’s institutional climate is best demonstrated by the fact that the cumulative FDI inflows over 1989–2002 (on a per capita basis) were among the lowest in the region.

3. IDENTIFICATION OF THE MAIN PROBLEMS HINDERING UKRAINE’S ECONOMIC PERFORMANCE Ukraine has inherited from the Soviet era a bouquet of adverse initial conditions. However, a decade of transition suggests that they are not the main culprits of poor economic performance per se. The institutional theory of Douglass North (1990) suggests that the explanation has to be found in understanding what kind of institutional environment the inherited distortions create and support. Economic and political actors are a product of specific historical paths. Due to the heritage of a thin division line between branches of power, politics in transition is inseparable from business. Market incentives and competition thrive in an evolutionary environment when the best managers of enterprises and entrepreneurs, brought up in the appropriate business culture, are selected (Nelson and Winter, 1982). If, however, such a group is absent and per contra some powerful actors are rent-seekers, in line with past traditions, they can impede the needed institutional changes for a market economy, changes that would endanger their monopoly power. Such ‘intermediate winners’ of the initial changes (Hellman, 1998) prevent legislation and regulations designed to protect

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property rights, contract enforcement and so on. In what follows we show how the initial industrial and institutional conditions, including the nature and interests of the elites, helped to shape policies that blocked key aspects of the needed reforms. The resistance to reform in Ukraine is a combination of four interlocking elements inherited from the socialist period: extreme over-industrialization in heavy energy-intensive and resource-extensive industry, depending on energy imports from the FSU, and managed by elites accustomed to rent-seeking, paternal dependency on Russia and the government, unqualified, indeed adversely selected, for the required changes. We take them one by one. Over-industrialization An excessive share of industry in GDP is considered as an unfavourable initial condition for transition. It reflects industrial development that is divorced from competitive considerations under market conditions and thus includes loss-making sectors, even producers of negative value added. In the past they were sustained by subsidies and low energy prices. The sharp rise in the price of energy following the disintegration of the Soviet Union turned many more industrial enterprises in Ukraine into lossmaking. Upon gaining independence Ukraine had the highest share of large-scale industrial enterprises and was the second-largest (after Russia) industrial producer in per capita terms among the FSU states. With 3 per cent of the USSR territory and 18 per cent of its population Ukraine produced 16.7 per cent of the USSR industrial output but only 0.9 per cent of its oil production. The needed changes in the industrial structure entailed high costs in terms of output contraction and the shedding of many workers in existing sectors. Over-industrialization was also reflected in a large military sector. In 1990, one-third of Ukraine’s GDP was originated in military production. Declining defence orders led to a sharp decline in military production, and in its labour force from 2.7 million in 1990 to 1 million in 2000. The world’s largest missile plant, Pivdenmash in Dnipropetrovsk, reduced its employment from 50000 in 1991 to 10000 in 2002. However, the need to reduce the number of workers in industry was not the main obstacle. The main obstacle was the need to shift from a command principle of resource allocation to a market selection process determined by competitiveness. The key consequence of over-industrialization in Ukraine was the creation of a powerful industrial rent-seeking lobby struggling to preserve the old structure on the basis of continuous government support and to resist any efforts of market-oriented reforms.


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One positive aspect of the predominance of industry in the economy was its association with high scientific knowledge and a highly skilled labour force. Indeed, in 1992 Ukraine had the world’s highest percentage of researchers – 6761 per million people (World Bank Development Report, 1997). Such a high level of human capital could have been used in order to reduce distortions and restructure industry, through ‘creative destruction’ and the reallocation of resources to a competitive composition. Unfortunately this did not happen. Resource-oriented Policy Resource oriented policy (ROP) includes two aspects: first, an emphasis on extensive growth, that is growth through the mobilization of labour and capital inputs; and second, the management of the economy through direct orders and administrative intervention, and through subsidies and soft budget support. These are in contrast to intensive growth, growth based mostly on increase in total factor productivity, and to the directing of the economic agents through incentives and indirect, arm’s-length guidance, both as in a market economy. In Ukraine, institutional traditions and memory prevailed, resourceoriented policy persisted into the 1990s, and manifested itself in a nonmarket selection system with long-term negative effects. A resource-oriented paternalistic authority discretionally supports the individual firm or sector with regulation or protection and in this way helps create potential rent incomes for both the firm and the respective officials. The more vulnerable the firm and the weaker its managers, the more potential rents can the patron squeeze out of it. This inevitably leads to a deterioration in efficiency. In the energy-scarce Ukraine such a policy is unsustainable in the long run. Dependency on Energy and Institutional Memory Rent-seeking was strengthened by the high dependence of Ukrainian manufacturing on imported energy. About 60 per cent of Ukraine’s fuel requirements were satisfied through imports, primarily from Russia and Turkmenistan. Thus, upon independence Ukraine suffered from an extreme terms-of-trade shock. In 1991 energy efficiency in Poland and Hungary was 26 and 55 per cent, respectively, higher than in Ukraine. One could have expected that the lack of energy resources would result in a faster restructuring of energy-intensive enterprises, the introduction of energy-saving technologies and thus the elimination of opportunities for energy-related rents. The Ukrainian experience is indeed unique since none of these things have happened. The policy of energy subsidies to industrial

84


producers continued internally under the pressures of the rent-seeking lobby, providing little incentive for enterprises to adopt energy-saving technologies and at the same time wasting a large amount of state resources needed elsewhere. Moreover, the subsidies to imported energy from the FSU encouraged the re-export of energy at world market prices for additional windfall gains. Such a scheme could not be implemented without the support of top government officials. The state subsidies were financed through pension and wage arrears, and a growing internal and external debt at exorbitant interest rates. The natural resource abundance, the main traditional source of rents, is characterized as a ‘mixed blessing’ (Sachs and Warner, 1995; Gylfason, 2001). While providing a country with additional income, it also embodies the risk known as the ‘Dutch disease’, which has three main symptoms: the crowding out of high value-added activities, the promotion of rent-seeking and corruption, and the creation of economic over-confidence leading to irresponsible economic policy and soft budget constraint. The above risks tend to appear in countries with weak inexperienced government and be avoided where the government institutions are strong, like in Norway. If government institutions are strong enough, as in Norway, the DD is not observed. Indeed, a syndrome similar to the Dutch disease may be observed in a country with poor institutions based only on the redistributional rent, a ‘pseudo’ Dutch disease. Ukraine provides a glaring example of a country that is trying to preserve Dutch disease behaviour. This was done through the replacement of real macro rents with mostly ‘virtual’ and distributional ones. We define two sources of rents: the redistribution of value created by others, and those embodied in the utilization of natural resources. We also distinguish between macro rents, for the country as a whole, and micro rents for individual economic agents within the country. Both can be either of the first or the second sort. While the macro rents can improve welfare, and can be even a source of growth, the micro rents are barriers to growth due to their negative effects on productive incentives (Shleifer et al., 1993). Micro rents and soft budget constraints were integral parts of the way the old system was run. In this sense they are path-dependent. Under the transition this leads to continuous support to loss-making enterprises and the creation of a web of informal networks tied by corruption links of businesses and the bureaucracy. Competitive firms are crowded out, indeed prevented from being established; resources are diverted away from growthpromoting activities; bad managers are rewarded and good ones rejected. Government officials and the old managers managed to prolong the irresponsible soft budget economic policy as well as the corruptive rentsharing behaviour of the old central planned system in a ‘virtual’ and artificial Dutch disease.


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Adverse Selection of the Elite and Paternalism The reform-oriented efforts clearly depend on the quality of the country’s elite. During the 1990s the Ukrainian ruling circles were dominated by incompetent ex-Soviet nomenklatura members, who found themselves all of a sudden, in a completely different economic reality of major distortions.4 The economy required drastic and comprehensive reforms, for which the Soviet-type elite was not prepared nor motivated. There are a number of factors, some specific to Ukraine, that caused its government to be weak, unprepared for the reforms and therefore possibly open to corruption and to state capture. Kiev was never an important government or a scientific centre; for most Ukrainians this was Moscow. The Soviet government, the Soviet Communist Party and the main Moscow universities and research institutes constantly attracted the most talented Ukrainians, leaving Kiev with second-rate people in all these areas. Until 1945 no ethnic Ukrainian was appointed to the position of first secretary of a local branch of the Communist Party. Following the death of Stalin, times have changed. However, it was still easier for Ukrainians to be promoted to managerial positions in Siberia or in Kyrgyzstan, than in Ukraine. Many young Ukrainians moved to higher-paid jobs in the north of Russia and Siberia. The local nomenklatura, dreaming about higher positions in Moscow, had no incentives to improve the situation in Ukraine. The motto of one of the last communist rulers in Ukraine, V. Shcherbytsky (1972–89), was to follow the orders from Moscow and suppress any attempts at local initiative. Not surprisingly, in the early 1990s the number of ethnic Ukrainians holding doctorate degrees in economics or history residing in Moscow, exceeded those living in Kyiv. In 1994 the chairman of the National Bank of Ukraine admitted that if he only had in his staff half of the Ukrainians working at the Central Bank of Russia, he could work wonders. After the defeat of the Ukrainian Republic in 1917–21 thousands of the most energetic, capable and dynamic elite members emigrated to the West. After a short period of Ukrainization efforts Stalin reversed his policy and introduced a regime of terror. More than 7 million Ukrainians died during the artificial famine of 1933–34. Fearing prosecution of the Ukrainian ‘bourgeois nationalism’, many thousands of educated economists, lawyers and managers decided to leave the country. Then Ukraine suffered huge losses totalling more than 6 million people during the Second World War. The war was followed by a second wave of emigration of more than 300 000 young Ukrainians. Emigration out of the Ukraine, either to other Soviet republics or to the West, mostly of young people, as well as immigration of older people to Ukraine’s ‘sunbelt’ (the ‘Florida effect’), in addition to low

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birth rates typical of the European parts of the SU, made the population of Ukraine very old, with more than 30 per cent retired people. In addition to the conservative and paternalistic mentality, and a stronger institutional memory brought by such an old structure, it also imposed on Ukraine a heavy social burden. The weakness of the new independent government of Ukraine and its passivity is also due to its paternalistic relationship with Russia. The government of Ukraine accepted a paternalistic dependency on Russia, it stayed loyal to Russia and even gave up some of its sovereignty, to some extent in exchange for continued subsidized energy supply. A high percentage of Ukrainians in top positions in Russia5 can also partly explain why in 1992–93 the Ukrainian authorities relied so heavily on their links with their counterparts from the Russian Federation. The paternalistic dependence on Russia may have contributed also to the preservation of the paternalistic, soft-budget policy of the ruling elite towards domestic firms. This similarity between the macro (external) and micro paternalism is not just a coincidence, particularly because the ‘external’ soft-budget treatment was the source of funding of the ‘internal’ soft-budget constraints, thus postponing the urgent reforms. No wonder that later, when the Russian subsidies stopped, Ukraine readily replaced its older patron with the international financial organizations (IFOs). Figure 4.1 show the rate of state paternalism of different types of Ukrainian enterprises. It all sums up to a situation in which upon independence a weak and incapable elite ruled Ukraine. President L. Kravchuk (1991–94), as well as two Prime Ministers, V. Fokin and V. Masol were all former leaders of the Communist Party. In 1998, an ex-Minister of Agriculture with leftist views was elected as the Parliament speaker. Like all other republics, Ukraine inherited an undeveloped decision making system. No consistent programmes of reform were prepared during 1987–92 and the quality of the first programmes was low. Trying to pacify immediate losers – former communist officials, retired military and special service officers and others – the government was hesitant to start radical reforms. It also follows that a critical task facing Ukraine in order to promote growth is to develop a new class of entrepreneurs and retrain its human capital. Rents and Distortions Rent-seeking was embedded into the Soviet system based on soft-budget constraint and the economy of favours. It failed to shrink at the same rate as the sources of rent of the country dwindled. During the exhausting hyperinflation during 1992–94 no social force effectively opposed the rentseeking policy. The industrial lobby, together with the de novo rent-seekers,


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100% 80%

Rely on themselves

60%

Expect state support but rely on themselves

40%

Expect state support

More than 250 employees

51–250 employees

Up to 50 employees

Start-ups

Privatized

State-owned

0%

Average

20%

Source: International Finance Corporation Survey conducted in 2000.

Figure 4.1

The degree of paternalism

were granted large privileges in the form of an open subsidy account to the extent of 60 per cent of all budget expenditures in 1992, one of the main sources of hyperinflation. During 1992–94, Russia still charged low prices for energy, but instead of using this benefit to support restructuring the cheap energy became a source of rent income for both the officials and their privileged firms. Later on, explicit subsidies were replaced by hidden ones, which however still amounted to 20 per cent of GDP (Lunina and Vincetz, 1999). From 1994 Russia started to charge higher energy prices, but the Ukrainian government continued to protect the energy-intensive industries at the expense of the more capable ones through soft credits, followed by barter deals and mutual offsets. While energy prices were higher, Ukraine also collected revenues from the transportation of gas to Western Europe through its borders. These revenues, totalling US$2 billion annually, were transacted in barter terms and thus remained a source, to this day, of macro rent for the country, distributed to the same rent-seekers. While planned tax revenues from this source in 1999 totalled US$391 million (the potential

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volume of revenues should be four times higher), just 8.5 per cent of this was received. In 2000 the respective tax revenues tripled, but still remained ridiculously low. The rest of the funds seem to have ended up in private pockets. During 1996–98 the government developed alternative ways to keep short-term rents going. These included the financing of continued soft credits and the resulting budget deficits with domestic borrowing in the form of T-bills, (Treasury Bills) through arbitrage of import and export prices mentioned above and of currency devaluation channels. The use of internal and then external borrowing for soft budget credits and rents to the old industries is especially frustrating. Independent Ukraine started as a debt-free country and could have used this exceptional potential resource of foreign and internal borrowing capacity for restructuring purposes, attracting FDI and new technologies, and lending to new firms. This, of course, was conditioned on the building of trust with the lenders. Instead, domestic T-bills served as a source of rents to vested interests, and then when Eurobonds were issued, the money received was needed to cover wage and pension arrears and to serve previous debts. Without reforms the borrowing capability was exhausted very quickly, leading Ukraine, in the footsteps of Russia, to the financial crisis of 1998. The consistent preference treatment of the old capital- and energyintensive industries precluded the Ukrainian government from supporting new, real value-creating and potentially competitive industries through implementing market reforms. In fact it helped to crowd them out of business. No wonder that output continued to decline. Ukraine had the thirdworst record among transition countries, and its share of the old industries in GNP continued to grow. Micro-level Rents and Deadweight Loss The dissolution of the SU had created unfavourable terms of trade for Ukrainian producers of energy-intensive commodities. Why, then, despite the sharp price shocks of 1992–94 did energy intensity not fall but instead continue to rise up to 2000? Paradoxically, the heavily subsidized energyintensive bulk commodities played the same role as the exportable raw materials do in the traditional Dutch disease case: ● ●

Energy-intensive products totalled two-thirds of all merchandise exports in 2001. During 1992–98 there was a sharp increase in the share of raw materials in both GDP and exports, while the share of high value-added manufacturing goods declined. While GDP fell by 60 per cent after 1991, the consumption of natural gas went down by just 35 per cent.


●

89

So, the share of energy consumption in GDP increased during the 1990s by several times. Since the time when inflation came down, there was a continuous appreciation of the real exchange rate.

The survival of the energy-intensive enterprises and the continuation of the resource-oriented policy in Ukraine was clearly related to the opportunity to generate micro rents, at the expense of macro rents. The practice of buying cheap metals, chemicals, oil and natural gas from state enterprises and from imports and selling them abroad at world prices played a key role in the creation of large fortunes for well-connected people. As import contracts were backed by government guarantees, this mechanism provided an opportunity to create enormous private wealth at the expense of the budget deficit. In 1992–99 some US$25–40 billion flew outside of Ukraine through the use of fake companies and contracts (OAB, 2001, 9 May). Seventy nine per cent of all payments for energy imports are still (in 2002) made through offshore zones. The large sums involved made it desirable and possible to create a lobby to support, protect and prolong the status quo of priorities of economic policy, which totally ignored the true terms of trade and the comparative advantages of Ukraine. In Ukraine the state was captured by these vested interests from the very beginning. It supported the energy-based ‘rent pumps’ by all means. An analysis of Ukrainian legislation (1992–2000) found that out of 10000 legislative documents connected with business activities in the area of commodity production, 2232 were related to energy consumption (Figure 4.2). This indicates that energy-related issues were of primary focus for the authorities: on average, the Ukrainian Parliament issued a legislative document devoted to this problem every working day. Moreover, more than 1000 legislative documents concerning energy issues had been of a soft budget constraint nature. At the same time, just 230 of them focused on hardening the discipline in this area, of which 94 were adopted during 1999–2000. Thus, there is clear evidence of a deliberate and strong resource-oriented policy until 1998. This policy provided strong incentives to waste energy rather than save it, and that is what happened. It is characteristic that during this period more than 50 per cent of metering instruments and systems were obsolete. While the European rate of losses of electricity varies from 6 to 8 per cent, in Ukraine it averages 22 per cent.6 The annual losses of wasted energy average US$1.2 billion a year, an amount comparable with the annual combined volume of technical assistance and foreign loans. While support to the energy-intensive industries did manage to survive, this cannot last forever.

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300 Hardening of budget constraint Energy saving

250

ROP

200

150

100

Figure 4.2

2000

1999

1998

1997

1996

1995

1994

1993

0

1992

50

Energy-related legislation. Composition

There are limits to how long forced redistribution to these industries from other branches of the economy and deficits can last, and at the same time the depreciation of their own fixed assets is reaching the bottom. The chances of foreign investments coming in to Ukraine, let alone to the noncompetitive resource-intensive industries, are still slim, due to the generally weak protection of property rights and the institutional infrastructure. Rent-seeking is spread also among other sectors of the economy, such as agriculture, the financial sector, military production and others. It obscures competitive selection in two ways. A lack of discipline in the ‘old’ sector not only inhibits the market exit of the less efficient, but also brings discouragement of market entry.

4.

THE PATTERNS OF UKRAINE’S TRANSITION

Although macroeconomic stability matters for the business environment, the key impediments to business development in Ukraine – instability of


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legislation, state interference, non-level playing field for small firms, corruption and so on – have to be found at the institutional level.7 Institutional measures such as regulatory reforms are of key priority for improving the business environment and boosting economic growth. The opposite seems to have happened until recent years. Unstable Legislation Instability of the legislation is a powerful tool allowing the bureaucracy to gain from information asymmetry. Below is just a short list of the most striking examples. During 1996–97 the government introduced 1500 amendments to the excise tax rates on alcohol and tobacco products. The law on VAT, adopted in 1997, has been amended since then more than 200 times. The number of legislative acts regarding non-monetary means of payment grew from 10 to 101 between 1995 and 1999. This reflects an avalanche of discretionary regulations, providing rights of non-monetary payments to specific business units. The law on licensing of new enterprises was amended 14 times in 19 months following its adoption in 2000. The Anti-Monopoly Committee, the government body created by the constitution, does not have enough power to cope with the activities of 378 monopolistic structures in 562 national markets. Now the practice of extracting monopolistic rents may spill over to new sectors such as the Internet and cryptography. State Interference Due to specific institutional peculiarities in Ukraine, the role of the government as an instrument of rent-seeking is very high. As mentioned above, the major economic actors during 1992–99, and again after May 2001, were interested in strengthening their grabbing capacity. The government acted not as a referee that pays attention to the fair rules of the game, but as a major player in this field. It has strong links with directors of state-owned enterprises (which call themselves ‘industrialists’, in comparison to the managers and owners of new and small businesses who are called ‘entrepreneurs’). President Kuchma, the ex-director of the Pivdenmash Missile Plant in Dniepropetrovsk, won the elections for president in 1994 with the support of the Ukranian League of Industrialists and Entrepreneurs (ULIE), under the slogan, ‘If Kuchma wins, your plant will be working’. His successor at ULIE, A. Kinakh, served as the Prime Minister from May 2001 – November 2002. These sinister ties determined the rent-seeking behaviour of the government, in contrast to the economic logic. Therefore,

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the rate of ‘creative destruction’ is very low in comparison with the restructuring challenges the Ukrainian economy faces. Poor Contract and Law Enforcement President Kuchma admitted that 40 per cent of his instructions in 1999 were not implemented, and thereby confirmed the reality of poor enforcement. The most important aspect is the government failure and/or unwillingness to maintain fair contract enforcement. Arrears in VAT refunds by the government to exporters grew from US$200 million at the end of 1997 to US$1100 million in August 2002. At the same time, enterprises owed the budget nearly the same amount of VAT payments. Since arrears at the enterprise level did not balance, both sides found themselves in bad equilibria. Of course, exporters close to top officials got their VAT refunds on time. Similarly, financial delinquency does not create a threat of bankruptcy when there is a close alliance between the enterprises and the right government officials. Soft Budget Constraints and Non-monetary Means of Payments The lack of effective bankruptcy procedures led to a situation where half of all enterprises were loss-making. Among the main debtors are the ‘favourites’ from the basic sectors, who exerted effective pressure for their debts to be written off. Officials decide discretionally which companies will be allowed to survive. Tax privileges are an important source of rents. For example, the gas trading company United Energy Systems had a turnover of several billion dollars in 1996, but it paid in taxes less than US$6000.8 The specific feature is that the authorities themselves are actively involved in the promotion of non-monetary means of payments. The world’s biggest barter deal is the Ukrainian-Russian agreement on the annual supply of 32 billion m3 of natural gas to Ukraine as a payment in kind for its transit through Ukrainian territory. When in 2000 the Ukrainian negotiators of the Ukrainian–Turkmen gas agreement demanded payments in money, President Kuchma intervened personally and the signed contract included a provision on a 50 per cent payment in goods and services. Another example connected with the legalization of non-monetary means was one of the first acts of the newly appointed Prime Minister Yushchenko. In 2000 he disolved Ukrspetsfin, a state company, established two years earlier in order to help sustain the web of mutual nonmonetary arrears through mutual cancellation of debts. This company served as a tool to sustain loss-making enterprises with full government support and in the name of avoiding unemployment in enterprises that had

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60% 50% Russia

40% Ukraine

30% 20%

2001 prelim.

2000

1999

1998

1997

1996

1995

1994

1993

0%

1992

10%

Source: State statistics of Ukraine, Russian economic barometer.

Figure 4.3 Percentage of barter in industrial output of Ukraine and Russia (1992–2001) overemployment and that could not contribute to economic growth and to the process of ‘creative destruction’. The development of non-payments in Ukraine is presented in Figure 4.3. Labour Market: Job Creation and Job Destruction While the authorities failed to formulate and implement a clear strategy of development, the labour market experienced profound adjustments. Employment dropped from 24.5 million people in 1990 to 21.8 million in 2000.9 Ukraine’s official unemployment rate reached 3.9 per cent in 2002, but according to estimates originated in Parliament the actual figure is much higher, 26.2 per cent. Despite this, workers seem to be more concerned with finding higher-paying jobs than jobs per se. In 2002 the average monthly wage was close to US$75, while dynamic people were seeking jobs with wages starting from US$300. More than 6 million Ukrainians voted

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with their feet and found higher wages and better living standards abroad. Employment-stimulating policies may have important mutual spillover effects on job creation and economic growth. However, such policies will be fruitful only if accompanied by changes in the rent-seeking behaviour of the ruling circles and by improvements in the business environment.

5. THE 1998 CRISIS AS A TURNING POINT FOR GROWTH (1998–2002) Depletion of the Sources of Rents As time passed the sources of rents were gradually exhausted, though, as mentioned above, the traditional energy sources were gradually replaced by increasing arrears and by borrowing domestically, using all instruments including T-bills, and internationally from private foreign financial institutions at high interest rates. All these helped to postpone the day of inevitable breakdown. The Ukrainian authorities were lucky to escape an even deeper financial collapse, because Russia had fallen first in August 1998. The only hope for future growth lay in seizing the moment when these rents would cease. A year later, the threat of default became immanent, since after the 1998 currency devaluation the government froze prices for electricity and wheat, and prevented the closure of the large firms that did not pay their energy bills. Energy arrears reached US$3 billion and an energy shortage developed. In addition, rent-seekers agreed to lower the rates for transit of Russian energy supplies, thus further reducing the budget revenues. By December 1999, the government arrived at a triple emergency situation: ● ● ●

it lacked funds for servicing the external debt; the energy system was on the brink of collapse; the threat of renewed high inflation in 2000 became very real.

Under the pressure of external creditors the leaders agreed to appoint a limited number of people with pro-market reputations to top positions in the government. Pro-reform Policy The Cabinet of V. Yushchenko, appointed in December 1999, made a number of crucial steps in order to de-virtualize the economy. It strengthened the base of reforms through new financing from proceeds of renewed


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acceleration of the privatization process. The support to the loss-making enterprises declined, since the reformers had no direct connections with their managers. A balanced budget was adopted, among others through stricter financial discipline on non-monetary means of payments and arrears. The quality of the legislative work of the Cabinet also improved drastically. The difference between the period of 1992–98 and the year of 2000 is striking. In 1992–93, only few legislative documents devoted to the hardening of payments were adopted; in 1996, the main flow of documents was devoted to barter schemes of payments and in 1998 to mutual offsets and arrears. In 2000, however, the main effort was directed at the hardening of the budget constraints, and while still controversial, to the cancellation of previously granted privileges. Other achievements of the government of Yushchenko are as follows. First, the government succeeded in restructuring the external debt, which allowed it more room to manoeuvre. Second, price and exchange rate liberalization were implemented. This resulted in the increased competitiveness of high value-added goods, produced by enterprises that were privatized earlier and went through postprivatization restructuring during 1995–99. For example, by 2001 Ukrainian companies controlled 94 per cent of the domestic food market, up from just 40 per cent in 1995. The composition of exports improved and the trade balance became positive. Third, barter in the energy sector and mutual budget offsets were officially forbidden. Although later the government violated this commitment, initially it significantly suppressed the ‘offset expectations’. Fourth, in order to provide for the increased volume of money transactions the new government increased the money supply by a dramatic 45 per cent. Due to the above-listed factors the expansion resulted in just 25 per cent inflation, mostly caused by the liberalization of grain prices. This modest monetary emission, combined with an increase in budget revenues, allowed the repayment of some wage arrears and full redemption of pension arrears, improving the purchasing power of households. Fifth, in 1999 a new simplified tax system for small businesses was introduced. It provided a considerable reduction in the tax burden in the hope of higher tax payment discipline. As a result, revenues from small businesses have increased sixfold in two years. Finally, barter transactions fell from 40 per cent of all transactions in 1998 to a mere 8.3 per cent in 2001 (see Figure 4.3). The maintaining of low prices for electricity threatened to crash the energy system, and thus forced the government to harden the budget constraints. The Ukrainian industrial firms changed their behaviour quite significantly because their sources of rents came to an end in 1998–99. The same patterns are observed in other sectors too. When the state stopped subsidizing the supply of oil products

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to agriculture, its consumption of those products fell by half (Sabluk, 2001). There was a steady decline in the annual consumption of gas, which totalled 75 billion m3 in 1999 and 72 billion m3 in 2000. Other developments also contributed to the resumption of growth after 1998. The devaluation increased domestic demand, which turned out to be one of the significant components of growth during 2000, a factor that was missing in previous years. Also, and due to the same reason, there was an increase in the demand for the traditional Ukrainian exports, metals and chemicals. In both cases there was also a contribution to growth on the supply side due to improved management of privatized enterprises. In 2000, for the first time, a positive correlation was observed between growth and deepness of privatization in a cross-section of two dozen economic sectors (Shygayeva, 2001). Even voucher privatization succeeded partially in producing a number of more active economic actors. At the same time that market-oriented sectors were encouraged, the policy of paternalism of the traditional industries was curtailed in a number of ways: financial discipline, especially in the energy sector, was improved; the practices of granting tax privileges and the creation of new free economic zones were discontinued; government borrowing, both domestically and abroad, was reduced;10 the nine-month external borrowing ‘holidays’ were eliminated; and finally the collective farms were dissolved, which laid the ground for a 9.9 per cent growth in agriculture in 2001. So, while the market-oriented sectors demonstrated sharp growth in 2000, there were also positive developments in the traditional industries.11 The policies of the new government were disliked by the traditional rentseekers who, according to the ex-First Vice-Premier Y. Tymoshenko, lost in foregone rents up to 9 billion hryvna (US$1.8 billion). She was dismissed in January 2000, while the fate of Prime Minister Yushchenko was decided three months later. Recent Developments Following the dismissal of the reform-minded Yushchenko, the economy continued its upward trend although the rate of growth began to slow down. The rate of growth of GDP declined from 9.1 per cent in 2001 down to 4.1 per cent in 2002. The new government, led by the head of ULIE, Mr. A. Kinakh, failed to clearly formulate the objectives of its economic policy. This was caused and reflected by the returning to top positions of ministers who were previously dismissed for inefficient work; a return to the policy of discretionary and selective support for certain regions, sectors and enterprises; failure of the government to advance Ukraine’s accession to the WTO; a halt to the policy


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of selling bankrupt, loss-making firms; and the restitution of government controls over strategic companies. It is quite strange that the IFOs found such policies quite satisfactory and came up with new loans. Having received enough funds, the ruling circles concentrated on the parliamentary elections of March 2002 and slowed down work on privatization, the improvement of financial discipline in the energy sector, and the carrying out of administrative reform. These developments suggest that the recent trend of economic growth is again under threat.

6. ASSESSMENT OF THE POTENTIAL FOR THE CREATION OF A NEW INSTITUTIONAL ENVIRONMENT AND MEDIUM-TERM GROWTH The existing political and economic institutions are the major barriers for growth in Ukraine which otherwise seems to have promising potential as a medium-sized catching-up economy, bordering on the first-wave EU accession candidates, with good transportation infrastructure, and a highly educated and creative labour force. This section tries to evaluate the growth potential of these inputs and the comparative advantages of Ukraine, under different assumptions regarding the rate of removing the political and institutional impediments for growth. Three scenarios are developed. A Pessimistic Scenario: Old-minded Elite, Resource-oriented Policy The pessimistic scenario is based on the continuation of the resourceoriented policy, including: ● ●

● ●

widespread rents, anti-market incentives; soft political and budget constraints, privileged privatization, and continued dependence on Russian energy supplies in exchange for political concessions; possible default on external debt; potential crash of the energy system; continued deterioration of fixed capital.

Piecemeal reforms will be conducted only under external pressure, and by the minimal possible extent necessary to avoid an immediate crash. The share of non-monetary payments will increase again, although it can hardly reach its incredible levels of 1997–98. The discretionary preferences of certain groups of taxpayers will discourage other companies from demonstrating profitability. Budget revenues

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will go down, and the authorities will rely on the ‘traditional’ methods of covering budget deficits through wage arrears, expensive external borrowing and/or at the expense of concessions to the gas transportation system, the information space and so on. Though this kind of policy will come to an end sooner or later, it will cause long-term and irreversible damage to the human capital of the country. In 2000 alone more than 800 holders of PhD degrees left the country. More than 6000 qualified software programmers find jobs abroad every year. The high rates of AIDS and of tuberculosis, and their fast dissemination, exacerbate the situation. All in all, the economy will return back to a slow, albeit steady, decline. Baseline Scenario: a Dual Economy In the baseline (middle) scenario the following conditions are expected to dominate: ● ● ● ●

slow replacement of the old elite by competent professionals; slowly shrinking rents, concentrated in a few sectors with restricted access; shrinking external soft budget constraints; growth of the (qualified) labour-intensive rent-free sectors and stagnation in the energy-intensive rent-oriented ones.

This scenario is based on the assumption of somewhat stricter monetary and fiscal policies. The resource-oriented policy will continue, although at a lesser intensity. The market-oriented sectors will strengthen somewhat due to better management and attraction of Western-trained specialists. However, protection of domestic producers will remain a high priority and will be conducted on a case-by-case basis. The government will rely on external borrowing and sales of attractive enterprises to Russian investors. The government will slide into a moderate budget deficit stance, of 3–5 per cent of GDP. All these will allow slow economic growth of 2–3 per cent per year. An Optimistic Scenario: Revealing Competitive Advantages In the optimistic scenario the following conditions are expected to prevail: ● ●

quick shift of the elite in favour of market-oriented professionals; restrictions on and the elimination of sources of rents;

Ukraine: the lost decade . . . and the coming boom? ● ●

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emphasis on market-oriented policies and incentives combined with solid development of a social safety net; development of the sophisticated labour-intensive sectors.

According to this scenario, the pro-market forces will win the presidential elections in 2004. They will initiate and expand the policy of structural change by, first of all, attacking the non-monetary means of payments. This scenario will manifest itself in further monetization of the economy, which will send signals for structural transformations and restrict rentseeking. The dismissal of corrupt officials and the strengthening of property rights will improve the playing field for economic actors. The number of Western-educated and market-trained Ukrainians returning home will steadily grow, which will improve the quality of management, products and services. Foreign companies will come to Ukraine to employ the human capital in high-tech and IT sectors directed toward exports. Manufacturing will undergo restructuring and, augmented with better management, will become internationally competitive. The pro-market government will spur further privatization of enterprises. It will diversify energy supplies by focusing on domestic production of oil and gas and will actively promote the implementation of the energysaving technologies. The system of private land ownership will be implemented and agriculture will start to grow more rapidly. Following the removal of the main institutional barriers, as listed above, Ukraine can achieve high rates of growth.

7.

CONCLUDING REMARKS

The main lessons to be drawn from the analysis of Ukraine’s transition during the last decade are as follows. First, the mode of selection of the economic actors is crucial. The rent-seeking leaders of Ukraine during the 1990s discovered ‘soft’ borrowing, domestic and external, as substitutes for the ‘macro’ rent they were addicted to under the old regime. The promotion of the culture of rent-seeking strengthened the nomenklatura’s ‘grabbing hand’ and resulted in unfavourable business conditions. This led to the ‘implicit destruction’, manifested in high hidden unemployment, brain and muscle drain, wage and pension arrears, and declining national product. Second, institutional problems are deeply rooted. In order to encourage a market-driven economy, incentives and selection of ‘winners’, a competitive environment for business and for politics should be introduced.

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Third, externally imposed hard budget constraints can help. The end of the external macro rent pushed Ukraine to reforms in 1998–2001. The positive experience of 2000 has demonstrated that the major barriers to Ukraine’s economic development are of an institutional nature. With fewer resources, but with harder budget constraints, following the attack on nonmonetary payments, the economy started to demonstrate signs of revival. Fourth, privatization facilitated the transition of the economy to market patterns. The highest growth was achieved in the most privatized sectors of industry and in ‘semi-reformed’ and privatized agriculture. The institutional reform of property relations became the leading driving force for taking the economy out of the crisis. Finally, another potential contributing factor of growth is the fast assimilation of knowledge and skills, and the inflow of start-up capital earned by millions of Ukrainians working abroad. To summarize, the current sources of rents are expected to be exhausted soon, which will favour Ukraine’s long-term perspectives. Short-term developments depend on the prospects of shifts in the composition of the ruling elite. If the radical positive changes come before the human capital deteriorates, Ukraine has a good chance of achieving a two-digit rate of economic growth.

NOTES 1.

2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Latvia and Lithuania had slightly higher industrial output per capita than Ukraine (but lower than Russia). However, the industrial structure of these states was more consumeroriented compared to that of Ukraine, which gave them an advantage during the transition. Thirty per cent of the world’s black soil. Estimates of the total value of agricultural land vary from US$35 billion (Oxford Analytica Brief, 2000, 28 February) to US$70 billion (Harbuz, 2001). OAB (2000), 29 September. In 1992–93 the Parliament commission headed by Prof. I. Yukhnovsky concluded that most of Ukrainian ferrous metallurgy and coal mining is non-competitive against world prices. The commission was immediately dissolved and its findings were restricted. For example, many governors in Russia are of Ukrainian origin. Y. Shulha, TV interview with the NART company, 2001, 24 October. ‘Ukrainian Enterprises in 2000: An IFC Survey of Ukrainian Business’, Report by IFC Ukraine Business Development Project (2001). OAB (2001), 9 May. OAB (2000), 8 March. The planned volume was fulfilled by 60 per cent. See Tables 20 and 21 in the long version of this chapter available at www.eerc.ru/activ/ projects/GRP/papers/Ukraine_final.pdf.

5.

Barriers to growth in Moldova Artur Radziwill and Oleg Petrushin

The inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World. Douglass North

1.

INTRODUCTION

Gur Ofer (2000) offers an appealing metaphor of transition. In this metaphor communist and developing economies have long travelled distinctly different roads with the same aim of full economic modernization. When the communist countries hit a dead end in the late 1980s, transition was an attempt to converge to the market-based road without losing the previously covered distance. Central European countries are close to achieving this goal and are now members of the Organization for Economic Cooperation and Development (OECD), and at the gates of the European Union and NATO. Other countries were less successful, and Moldova is one of the least fortunate.1 In the world of Ofer’s metaphor, Moldova was subject to a dramatic reversal, which largely eliminated its previous achievements. It is enough to state that the output in Moldova during the 1990s retreated to the level of the late 1950s and early 1960s (De Broeck and Koen, 2000). Moldova has yet to find a new sustainable development path. For now it is still trapped in a web of uncoordinated policies and dysfunctional institutions. This chapter attempts to offer a comprehensive and consistent picture of growth in the Republic of Moldova under transition to a market economy. Developments in Transnistria, the self-proclaimed separatist territory on the left bank of the Dniester river, where market-oriented reforms were never implemented, are not studied in this chapter.2 The disappointing results of the transition in Moldova are intriguing if we believe that ‘the policies to ensure growth are well known’ (Fischer and Sahay, 2000), and realize that initially most experts were convinced that Moldova followed such policies. The first stage of economic transformation was initiated in 1990. Liberalization of prices, trade and enterprise operations were all introduced before 1992. An even more comprehensive 101

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programme of transformation and stabilization was introduced in cooperation with the IMF and the World Bank in 1993. The new Constitution (July 1994) stated that Moldova was ‘a market economy’. Moldova was the first of the post-Soviet countries to be admitted to the Council of Europe, and to sign a Partnership and Cooperation Agreement with the European Union in November 1994. A mass-privatization programme was implemented, and most industrial enterprises have been transformed into joint stock companies. The Council of State Creditors and specialized agencies restructured the first group of industrial enterprises. The National Bank of Moldova introduced a new, stable, national currency and initiated credit auctions. As a result, the rate of inflation was reduced from 1184 per cent in 1993 to 30 per cent in 1995. In June 1995 the Stock Exchange started its operations. At this time Moldova was viewed as a star performer. With respect to implemented reforms, the country was ranked by the EBRD higher than most CIS countries and even higher than Romania and Bulgaria. The Economist (1995) reported that ‘Moldova is a model of correct reform’. Moldova nevertheless failed to enter a period of economic growth. Reforms slowed down significantly after 1995. Foreign loans were used for consumption, structural reforms were postponed, politics prevailed upon economics. Many of the earlier reform achievements started to look illusionary. The situation of the economy after 1995 could be described as a ‘stable depression’ that under the impact of external and internal pressures developed into an open crisis in 1998. Prospects of growth in the post-crisis period are far from clear. Another article in The Economist (2000) is titled ‘Can Moldova get worse?’ In this study we try to understand why transition in Moldova was so difficult. Fischer et al. (1996) note that there are ‘two forces: those arising from the transition and transformation process and the basic neoclassical determinants of growth’. In this chapter we will deal mainly with the first set of forces that are responsible for the decline in Moldova. Focusing on growth, we argue that the initial decline of GDP is relatively easy to understand even if its scale seems shocking. The devastating combined impact of the disintegration of the Soviet economic system, the extremely negative changes in the terms of trade and the civil war, was difficult to offset. However, the prolonged economic decline was a result of bad policies. While many ‘paper reforms’ were introduced, the most important structural reforms were not, notably the privatization of land was not implemented until the end of the decade. This constrained for many years the growth prospects in the most promising sectors of the Moldovan economy: agriculture and agro-industry. The rapid accumulation of external debt softened the budget constraint and therefore helped to perpetuate the

Barriers to growth in Moldova

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wrong policies. More generally, the government failed to create institutions conducive to the growth of private entrepreneurship, to restructuring and to investments. Weak rule of law, low trust and perverse incentives are crucial in explaining the dismal performance of Moldova. Consequently, we focus on the importance of the quality of formal and informal institutions in determining economic performance during the transition and of the possibility of falling into an institutional growth trap. Only the introduction of proper institutional foundations and incentives may set the stage for the future growth, subject to better understood neoclassical mechanisms. This chapter goes one step further and attempts to identify sources of the particular weakness, indeed failure of government institutions in Moldova. First, Moldova is truly a newly independent state: it did not have a real government during the Soviet period but also historically it was always part of larger countries (Russia and Romania) and lacks the tradition of national independence. There is a weak and fragmented national identification, and national independence seems to be the second-best option for the majority of the population. Civil conflict, the separatist war and the still unsettled status of Transnistria further undermine the concept of Moldovan statehood and the credibility of the government and its institutions. As integration with Romania is politically explosive, and integration with the European Union seems unrealistic, it is very difficult to build a wide consensus around a unified national identity and therefore also upon credible direction of policies. As a result, the time horizon of agents is short and the commitment to tough but necessary reforms nearly impossible. The rapid accumulation of external debt is one visible symptom of such shortsightedness. The remainder of this chapter is constructed in the following way. Section 2 presents an overview of economic developments in Moldova during the transition period. Section 3 discusses the performance of major sectors of the economy and focuses on the shortcomings of the reform of agriculture. Section 4 outlines and analyses important cases of institutional failure. Section 5 concludes.

2. OUTPUT COLLAPSE AND EXTERNAL DEBT ACCUMULATION During the Soviet period Moldova was developing relatively fast due to the rapid industrialization and accumulation of factors of production supported by transfer of financial and human recourses as well as technologies from the centre. The Moldovan economy was also heavily subsidized in the form of

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distorted trade prices with the rest of the Soviet Union in its favour. Economic growth, urbanization and investments in the infrastructure of the social sector led to large improvements in human capital. However, due to the absence of competition and deformed economic incentives as per the Soviet planning system, growth was characterized by failure to improve production efficiency and to stimulate innovations. Accordingly, positive growth rates, declining over time, had to be maintained by increasingly high investments, the notorious ‘extensive growth model’ that reduced enterprise profits. Finally, growth and the standard of living stagnated, creating political tensions and a quest for new ways of development. Reforming the system proved to be very difficult, and attempts at partial reforms contributed among other things to the system’s economic and political collapse. Since the disintegration of the Soviet Union in 1991, the Moldovan government had to assume responsibility for policies for the first time in its history as Moldova had never been an independent state before. At the same time the Moldovan economy had to become self-sustainable, as trade was collapsing and most Soviet subsidies were gone. Despite this, the new situation was welcomed with much enthusiasm. Political independence could open the way for closer proximity with neighbouring and culturally close Romania, and with the Western world. The introduction of market mechanisms, entrepreneurial spirit and incentives and importing Western organization and technological know-how were expected to bring with them better static allocation of resources and dynamic efficiency through investments in human and physical capital. Regaining access to new technologies and the world stock of capital, in combination with the relatively high level of human capital in Moldova, were expected to contribute to fast growth and improved welfare, even in the face of expected difficulties related to the transition. Unfortunately, things did not turn out exactly that way. Unlike successful transition countries, Moldova suffered from a very deep initial decline in output and its failure to recover in accordance with the typical U-shape transition growth pattern. Following an initial dramatic collapse, the output stabilization in 1993 was followed by further decline in 1994 and a ‘stabilized’ recession in 1995 and 1996. Similarly, the moderate recovery in 1997, welcomed at the time as a breakthrough, was followed by deeper declines in 1998 and 1999. It is still uncertain whether the positive growth rates achieved afterwards are sustainable and mark a new trend. The depth and persistence of the transition recession position Moldova as a particularly unsuccessful member of the group of European Former Soviet Union (FSU) countries. This low position of Moldova was not obvious at the outset of the transition process. Although in 1990 Moldova resembled the FSU countries in the extent of trade distortions, the country was under communism for a shorter period of time, and was less developed in terms of over-industrialization,

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schooling and income per capita in comparison with Ukraine and Russia, and more similar to Romania. As a country with a predominantly Romanian population, and part of Romania before the Second World War, Moldova could have been expected to converge to the Romanian pattern of development. This did not happen as the record of Moldova was much worse than that of Romania and more similar, but still worse, to that of Ukraine (see Figure 5.1). 140 Poland

120 100 Romania

80

Russia

60 Ukraine

40

Moldova

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0

1989

20

Source: IMF IFS and IMF Country Reports.

Figure 5.1

Output path in transition countries (1989–2000)

Falling total factor productivity (TFP) was the main force behind the failure of the Soviet model. It is therefore somehow paradoxical that growth accounting demonstrates clearly that the economic decline in Moldova during the transition was caused mainly by an additional and dramatic collapse in TFP. Some of this decline could have had a temporary character as indicated by the V-shape pattern of TFP that is characteristic for more successful economies. Unfortunately, in Moldova, as shown by De

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Broeck and Koen (2000), efficiency losses were not reversed. In addition, there were important factor input losses that are poorly reflected in official statistics. There was a massive outflow of high-skilled migrants to Russia and Israel and also to some Western countries. Many Moldovans work abroad as seasonal workers. Deterioration in access to education, especially in the rural areas, and contraction in secondary school enrolment rates will reduce human capital well into the future. Depreciation of capital was even more rapid and investments much lower than accounted in official statistics. These developments as well as the TFP decline are all results of the failure to introduce a proper institutional framework that would encourage domestic entrepreneurship and investments in human and physical capital. An interesting piece of evidence comes from a study of growth regression analyses. Very divergent transition paths are not well accounted for by easily measurable factors like initial conditions, macroeconomic stability or progress of privatization and liberalization. This failure is particularly strong for Moldova: most growth regressions consistently exhibit a large negative residual for this country, unlike the positive residuals for the successful economies of Central Europe. Increasingly, attention is diverted towards less tangible factors that can explain these residuals: quality of government and of institutions and the rule of law, and the geographical and cultural distance from Western Europe. While these recent studies demonstrate the quantitative significance of these factors, let us describe some key qualitative aspects for Moldova.3 Given the dismal performance of the real economy, the initial enthusiasm about the effectiveness of Moldovan reforms was caused by the achieved signs of macroeconomic stabilization. As other countries in the rouble zone, Moldova experienced hyperinflation between 1992 and 1993, but after the introduction of the national currency in 1994 inflation rates were reduced sharply and remained low until 1998. However, the stabilization was not supported by fiscal tightening, a fact that reflected the failure to address structural problems. Dabrowski (1999) writes: Experience of transition process gives a lot of evidence that fiscal policy performance reflects the quality of economic policy and systemic reforms in the specific country. Any inconsequence of the conducted policy, delay in transition on the microeconomic level, weakness of government institutions and favourable political climate for intensive rentseeking negatively influence fiscal balances. Thus fiscal equilibrium depends not only on the fiscal policy itself but also on the speed, quality, and consequence of overall reform process.

Short-term monetary stabilization is possible, however, even under unsustainable fiscal policy; in Moldova it was achieved through a stabilized

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exchange rate. In order to support a stable exchange rate and finance excessive budget deficits Moldova relied mainly on official transfers from bilateral and multilateral donors and on contracted foreign debt (see Figure 5.2).4 The resulting twin deficits (of the budget and the current account) led to the accumulation of very large external debt that finally ended with the financial crisis. The Russian crisis played the role of a mere trigger that tipped the inevitable collapse to the unsustainable policies of the Moldovan authorities.5 120

100

80

60

40

2000

1999

1998

1997

1996

1995

1994

1993

0

1992

20

Source: IMF IFS.

Figure 5.2

Foreign debt of Moldova, % of GDP

High domestic absorption generated by expansionary fiscal policy is usually expected to stimulate growth at least in the short run. However, the aggregate demand was not met by the response of the supply side due to the institutional impediments and lack of key structural reforms as described below. The ultimate result of this micro and macro policy mix was economic decline and rapid accumulation of external debt.

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3. TERMS-OF-TRADE SHOCK AND DELAYED LAND REFORM Moldova declared its independence in August 1991 in the midst of extensive economic turmoil. The introduction of market economy institutions in Moldova coincided with the collapse of traditional trade links and the worst negative terms-of-trade shock in the region. Gradual price liberalization across the USSR combined with relaxed monetary policy generated increasing rates of inflation. Moldova was forced to purchase energy products at world prices.6 Accordingly, energy import prices grew 4.5 times during 1991 and the share of energy products in total imports rose from 7.3 per cent in 1989 to 17.1 per cent. At the same time, the non-competitiveness of Moldovan production in traditional Soviet markets in respect to both price and quality started to be evident. As a result export prices of the main food processing and agriculture products (40–45 per cent of exports) grew only 3.3 times. During the period of hyperinflation before the introduction of the national currency, the terms of trade deteriorated further. Energy prices grew by 4350 times with the share of energy products in total imports rising up to 42 per cent. Export prices of the main food processing and agriculture products (50 per cent of exports) grew by only 968 times. It is evident that during the first years of transition the real windfall loss was huge and contributed a large share of the cumulative 60 per cent output loss in Moldova during 1991–94. The strong negative impact of terms-of-trade shock on GDP was, however, partly reversed between 1995 and 1998, when Moldova maintained a stable national currency and low inflation. During this period average import prices grew by 1.4 times, including energy products by 1.6 times, the share of these products in imports thus declined to 28.8 per cent. At the same time average export prices grew by 2.3 times, including the main food processing and agriculture products by 3.4 times. Unfortunately, the Moldovan authorities did not create conditions for restructuring the economy and for attracting domestic and foreign investments, steps that would allow it to take advantage of this improvement. The favourable conditions proved temporary. As a result of the regional financial crisis of 1998 the demand in the Russian and CIS markets for Moldovan goods declined, bringing down the volume of its exports. In 1999 the export volume to CIS countries declined to half its 1997 level and Moldovan producers were generally unable to obtain significant offsets in the non-CIS markets. The external economic situation reversed itself again and constrained economic growth possibilities as import prices of energy products grew 2.7 times while the export prices of the main food processing and agriculture products grew by only 1.8 times (see Figure 5.3).

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30%

15%

0%

– 15%

– 30%

GDP growth

– 45%

Windfall profit as % of GDP GDP growth adjusted on windfall profit

– 60% 1990–1991

1992–1994

1995–1998

1999–2000

Source: Authors’ calculation, data from Department of Statistics of Moldova and Custom Department of Moldova.

Figure 5.3

GDP growth and impact of changes in terms of trade

The terms-of-trade shock also helps to explain the pace of the necessary changes in the structure of the Moldovan economy, from the distorted structure inherited from the Soviet period and the Soviet model of development. Heavy industrialization, especially during the 1960s and 1970s, did not correspond to the basic comparative advantage of the country. Immediately following the declaration of independence Moldova lost its markets in the instrument making, electronics and machinery industries. The refusal of the Moldovan authorities to privatize and/or to induce managers to restructure and improve their performance resulted in wholesale bankruptcy of these enterprises by 1996–97. Early attempts to support these enterprises with subsidies only delayed the de-industrialization process and increased its economic costs. The industrial output of Moldova shrank by more than two-thirds during the 1990s. Within manufacturing the share of the energy sector rose, mainly due to the introduction of world

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energy prices. On the other hand the energy-intensive and non-efficient machine building industry was dwarfed. Similarly, the textile, clothing, leather and footwear industries registered deep declines. The food processing, beverages and, especially, tobacco industries maintained their leading position well in accordance with the natural endowments of Moldova (see Figure 5.4). However, the food processing industry was not able to revitalize the economy due to institutional barriers (which we describe in section 4), and to the failure to introduce important changes in the agricultural sector in particular. 90% 80% 70% 60% 50% 40% 30% 20%

Electricity, gas and supply of water

Machines and equipment

Construction materials

Glass production

Leather and foot wear

Clothes

Textile

Tobacco

Food processing and drinks

0%

Industry-total

10%

Source: Author’s calculations, Department of Statistics of Moldova.

Figure 5.4

Industrial output by branches in 1999 (1990 100%)

Agriculture is the most important sector of Moldova’s economy and together with the food processing industry generates 33 per cent of GDP, 44 per cent of employment and 61 per cent of exports (data for 2000). Growth in agriculture is therefore a necessary condition for the economic development of the country in general. Yet, Moldova’s agricultural sector

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110% 100% 90%

Crops

80% Total

70% 60% 50%

Livestock

40% 30% 2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

20%

Source: ARA (2001b).

Figure 5.5

Agricultural output (1990 100%)

performed very poorly since independence: production and exports of the sector declined by more than 50 per cent (Figure 5.5). Tax arrears and bad debts reflect its persistent bad financial situation. A large part of contraction in agriculture can be explained by the termsof-trade shock and the sharp reduction in subsidization following independence. During the Soviet period farm products were procured by the state at much higher prices than world prices, while inputs (fertilizers, pesticides and fuel) were provided to state and collective farms at a fraction of world prices. Before 1990 the annual direct subsidies to agriculture consisted of about 9.5 per cent of gross national income (GNI), and indirect subsidies, embodied in input and product prices mentioned above, were about 4.5 per cent of GNI. During the transition period total subsidies to agriculture declined sharply, down to 3.3 per cent of a much smaller GDP in 1998 (ASA, 1998), still too heavy a burden for the government budget. The demand for exports of agricultural products also declined sharply in the aftermath of the collapse of the Soviet Union and the old trade links. The

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financial crisis in Russia in 1998 exposed the remaining excessive dependence on the traditional CIS markets. Also, the domestic demand for primary and processed agricultural products has been declining, together with contracting disposable incomes. Although the share of agricultural products in overall household consumption increased from 28 per cent in 1990 to 65 per cent in 1999, per capita annual consumption of the main food products declined to about half of its 1990 level. This difficult situation required rapid and flexible adjustments. These could not take place within the then existing state-dominated ownership and control. Indeed, the heavy subsidies were directed almost exclusively to the collectivistic sector that needed state support to offset its very low productivity. The small individual sector with at least twice-higher productivity could remain competitive and sustain general growth if its development was not hampered by the extremely slow pace of structural reforms in the sector. In the first stage of ownership changes in 1991, the state farms were turned formally into joint stock companies and from the legal point of view agriculture became private. But the change was illusionary. The former kolhoz management remained in charge, the mode of operation unchanged. The importance of political contacts and lobbying for subsidies hardly diminished. The interaction between the market economy and large insider-dominated and state-supported farms created opportunities for rent-seeking and asset-stripping. The former kolhoz lobby was determined to protect these rents and opposed any key reforms in the sector that would reduce its control over the sector. As a result, reforms were basically suspended. Only in 1996 did the pace of reform accelerate somehow when the Constitutional Court declared some restrictive provisions of the Moldovan Land Code unconstitutional. This enabled the full restructuring of 30 large-scale farms before 1998. However, the significant progress of the breaking-up of the large-scale collective farms and of the real privatization of land was made only during 1998–2000 (Figure 5.6). As a result of the acceleration of reforms in 1998, 854 out of 1034 largescale agricultural enterprises participating in the National Land Programme were liquidated (96 per cent of the total number and 75 per cent of the agricultural land) by the end of 2000. New and debt-free entities were created, mainly individual peasant farms; 54 per cent of all eligible individuals received land before October 2001. As a result the individual agricultural sector (made up of peasant farms and households) owned by 2001 nearly half of the country’s agricultural land, while the collective sector lost its traditional dominance (Figure 5.7). This is undoubtedly the largest achievement of structural reforms in Moldova in recent years. For the first time since the Second World War, farmers can again make their own decisions about the optimal usage of land, capital and labour.

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80 70 60 Corporate

50 40 State

30 20

2000

1998

1996

1992

1990

0

1994

Individual

10


Figure 5.6

Structure of land ownership (% of total agricultural land)

Unfortunately, the gradual individualization of agriculture did not lead to an increase in the productivity of the sector.7 In 2000 land and labour productivity in the individual agricultural sector was only 30 per cent and 25 per cent of the 1990 level, respectively. Nevertheless, the productivity in the individual sector remained still higher than in the collective sector: in 2000 labour productivity was higher by 9 per cent, while land productivity in individual possession was twice as high as in the collective sector (Figure 5.8). The financial outcomes of small and medium-sized farms bring more optimism. According to the results of a farm survey, small to medium-sized farms are more efficient than large ones.8 Both gross output and net value (gross output minus production costs) calculated per hectare of small and medium-sized farms are significantly higher than those of large individual and corporate farms. Only 8–9 per cent of small and medium-sized farms have net negative value, compared to 25 per cent of the corporate farms.

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800

Collectivist Individual

700 600 500 400 300 200 100 0

1990

2000


Figure 5.7

Employment in agriculture by ownership, thousands

Sales per hectare by small and medium-sized farms are up to two times higher than those of large (individual and corporate) farms, net profits per hectare of small and medium-sized individual farms are about three times higher than those of corporate farms. Micro evidence shows, therefore, that the real land privatization did work, although its results are not yet clearly seen at the aggregate level. We conclude that the importance of the real owner who considers various possibilities and chooses the most profitable options of land use is far more important than theoretical efficiency considerations about the optimal size of the plot.9 We can only speculate how much better would have been the performance of agriculture and the entire economy during the transition period if the government in Chisinau had the will and strength to distribute land to the farmers at the beginning of the 1990s. We believe that the neglect of this fundamental reform is one of the gravest mistakes in the transition process in Moldova. Again, the responsibility for this is to be found in the weakness of the government, in

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300

250 Land – individual Labour – individual

200

Land – collectivist Labour – collectivist

150

100

50

0 1990

2000


Figure 5.8 Indices of labour and land productivity (collective sector in 1990 100) failing to represent the interests of the society and economy against the strength of the kolhoz lobby. In spite of recent progress in land reform implementation, major impediments to growth in the sector still exist. Agriculture in Moldova today has a subsistence character. Individual farmers sell only 15–37 per cent of their output. This tendency is reflected in the change in the structure of production away from market-oriented and input-intensive vineyards and orchards towards staple crops grown mainly for own needs and with minimal requirements of commercial inputs. Between 1995 and 1999, chemical and natural fertilizer consumption declined by four and 12 times, respectively. There are several institutional barriers to market-oriented growth of production by the new private farms. As a result of the initial disorganization the crucial irrigation system is now largely malfunctioning, which greatly amplified the impact of droughts that occurred in 1992, 1994, 1996 and 2000.10 Characteristically this is another example of the failure of

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the state to provide important public goods. Financial resources for investment are largely unavailable as better access to banking and credit is delayed until the final settlement of land ownership issues is achieved, followed by the establishment of a functional national cadastre and land market. Agriculture in Moldova still suffers also from lack of open and free markets at all levels, and of free and uniform prices and their transparency. There is a high geographical segmentation of agriculture input and output markets, creating ample opportunities for local vested interest groups, concentrated around former collectivist farms, for arbitrage and rent-extracting. These groups still oppose the free trade of land as well as the fully transparent and liberalized trade in agriculture products. Artificial and non-transparent prices distort cost and profitability calculations, and prevent normal functioning of credit markets. Therefore the importance of organized open and transparent wholesale markets, commodity exchanges as well as market-supporting institutions in agriculture, including insurance financial services, cannot be overestimated. Most of these have so far hardly begun. A three-year post-privatization programme was launched on 1 January 2001 with the aim to support and develop mortgage crediting, offer juridical consultations and create agricultural shops and centres to serve farmers. The results of the programme are difficult to predict, also due to political constraints.

4.

INCENTIVES AND A WEAK STATE

Institutional arrangements that benefit vested interest groups and are maintained due to their pressure became the greatest barrier for economic growth in Moldova. Resources – especially entrepreneurial energy and human capital – are wasted in non-productive or even value-detracting activities. Most of these activities are linked to various forms of rentseeking – searching for profits created by state-induced distortions. The most common distortions include hampering competition through extensive licensing and barriers to entry – that encourage monopolistic practices – and lobbying for unequal treatment of enterprises through subsidies or tax exemptions. The energy sector in Moldova is the single most costly example. Strikingly, it demonstrates that it is not necessary to have natural resources in order to produce ‘political Dutch disease’, that is, economic and political life dominated by struggles over rents associated with natural resources. Due to actions of organized vested interest groups and partly due to social considerations (reluctance to impose market prices of energy), the energy market in Moldova was extremely non-transparent and very dis-


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torted throughout the transition period. Large economic rents were available and protected by state-supported barriers of entry and through all possible forms of financial leakages, such as underpricing of energy, arrears, non-monetary payments, overconsumption and theft. In this situation, the only real game in town was about gaining control over imports of energy resources. The state remained the ‘payer of the last resort’ due to its implicit guarantee of payments for energy to foreign providers (especially Gazprom of Russia). The weak and corrupted governments never prevented the accumulation of external payment arrears. Consequently, following the siphoning of rents by well-positioned individuals, the state budget was left with the large external debt related to energy arrears (the energy debt was at 32 per cent of GDP in 1999). Characteristically, the situation was improved only when in the aftermath of the Russian crisis, foreign energy suppliers refused to extend credit to Moldovan importers and as a result the most important source of soft budget constraint and rents dried out.11 The problem of the vicious circle made of vested interests, barriers of entry and high economic rents in Moldova is, however, far more general.12 The opportunities for making endogenous regulations that support rentseeking have been empirically documented by Hellman and Shankerman (2000). They show that state interventions, state-financed benefits to enterprises and corruption are positively correlated across transition countries, although they are negatively correlated at the individual enterprise level. The ‘grabbing hand’ and ‘state capture’ are two sides of the same coin. They also argue that countries with high state capture implement less genuine reforms and suffer from lower quality of governance, a claim that is fully confirmed by the experience of Moldova. Beyond rent-seeking, and more damaging and dangerous, weak state structures, corruption and lack of effective law enforcement give rise to criminal and verging on criminal actions, ranging from smuggling and tax evasion through asset-stripping, to fraud and racketing. Incentive Trap Rent-seeking and criminal activities, in addition to the diverting of economic resources from productive activities, also discourage the development of honest businesses. ‘Prisoners’ dilemma’ situations are then observed, where each economic agent is taking optimal decisions from his or her personal perspective, but in the end everybody is worse off. In the extreme case, when, if it is more attractive for everybody to get involved in predatory activities rather than in production, nobody chooses to produce and everyone attempts to detract. In the end, there is almost nothing left to be seized, everybody is worse off and nothing is being produced. The risk of this insti-

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tutional trap is higher if the fixed entry costs of honest economic activity are higher than the costs of predation.13 The interplay and balance between the liberalization of private sector development, and the creation of effective and enforceable sanctions against predatory activities, are what determine the nature and quality of the developments during the transition. The key ratio between the costs of production activities and those of predatory ones was particularly high in Moldova. This can be inferred from responses to a survey conducted by the EBRD among enterprises in countries in transition (Hellman and Shankerman, 2000). In the case of small business start-ups we use the amount of red tape and corruption as the indicators of administrative barriers of entry. In this respect the environment in Moldova is extremely unfriendly for entrepreneurs, somewhat better only than in Ukraine. In Romania and Poland firms are forced to spend much less time and pay smaller bribes (Figure 5.9). 20 Time tax Bribe tax

15

10

5

0 Russia

Ukraine

Moldova

Romania

Poland

Source: Hellman and Shankerman (2000). Enterprise survey.

Figure 5.9 Time spent (% of time of managers) and bribe ‘tax’ paid (% of revenues) in connection with registering a new business


119

State capture is a good indicator of the extent of rent-seeking. The EBRD survey results also show that many more firms were significantly affected by pressures of other enterprises on policy decisions in Moldova than in Romania and Poland, and the pervasiveness of this experience is significantly higher in Moldova than in other FSU countries (Figure 5.10). 40

30

20

10

0

Russia

Ukraine

Moldova

Romania

Poland

Source: Hellman and Shankerman (2000).

Figure 5.10

Pervasiveness of state capture, % of firms

Even more striking are the differences in costs of predating in business activities, measured here by trust in contact and the enforcement of property rights. In Moldova, here similar to other CIS countries, more than 70 per cent of the surveyed firms believe that their property was not adequately protected by the state. In Poland and Romania, these shares are only 20 per cent and 40 per cent respectively (Figure 5.11). This negative assessment of the security of private property is well explained by the extent of corruption, the incidence of street crime and mafia activities. Moldova is an outlier in all these measures (Figure 5.12).

120


80 Tend to disagree

70

Disagree in most cases Strongly disagree

60 50 40 30 20 10 0 Russia

Ukraine

Moldova

Romania

Poland


Figure 5.11 law?

Responses to the question: Is your property well protected by

Judging from the results of the surveys it is the very weak government institutions in Moldova that allow and tolerate the economic environment to deteriorate to the level of anarchy, resembling the vision of life described by Hobbes as ‘solitary, poor, nasty, brutish and short’.14 How could such an institutional failure happen? Formal Institutions Formal law enforcement institutions were weakened during the transition period as the old Soviet state structures collapsed and new structures failed to gain the necessary authority. Moldova, lacking its own legal tradition, was in a particularly difficult situation at the point of independence. Although the country was under Soviet rule for a shorter period than any other CIS country it was never independent in modern times. This is in contrast to the

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80

Corruption Street crime/theft/disorder

70

Organized crime/mafia

60 50 40 30 20 10 0 Russia

Ukraine

Moldova

Romania

Poland


Figure 5.12

Main obstacles to growth

Baltic states where a strong pre-Soviet modern statehood and legal tradition had existed. While important progress in legislation consistent with the requirements of a market economy has been achieved in Moldova since independence, the new legislation was introduced in an unsystematic and often contradictory way and therefore failed to create and internalize a perception of the stability, consistency, transparency and credibility of the legal base. Moreover, the lack of tradition, of appropriate human capital and trained practitioners, and of strong authority, all characterized the new legal and enforcement institutions, rendering them practically ineffective. More fundamentally the legal environment cannot be stronger than the state that is supposed to enforce the law. The ratio of the shadow economy to the official GDP, one popular measure of the effectiveness of government institutions, is estimated at the exceptionally high level of 60 per cent in Moldova. Tax evasion and the consequent decline of government revenues reached the point at which the state was not able to deliver even basic

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services – elementary education and health care and, most importantly, the enforcement of law and order. The cuts in fiscal expenditures were made on an ad hoc basis avoiding any prioritization, thus leading to further decline in their effectiveness. Not surprisingly the dissatisfaction with the quality of public administration reached 81–83 per cent of the population (SISI, 1998). The key question arises: why was it so exceptionally difficult in Moldova to establish a stable and effective democracy that could guarantee individual rights and encompass wide interests? Olson (2000) shows that any war conflict or territorial dispute leads to such a high level of uncertainty that short-term considerations start to be predominant. As a result, no meaningful social contract can be achieved. Moldova experienced civil war in 1993 and the country lost its territorial integrity afterwards. Transnistria conducts independent and often hostile policy towards government in Chisinau. Although in recent years the risk of open military conflict was relatively low, the potential danger remains. Many authors show that ethnic problems are generally conducive to political instability or violence, rentseeking, difficulties in providing public goods, and inefficient and unstable policies (Zak and Knack, 1998). National identity often serves as an encompassing idea helping in building a strong state structure. This was clearly the case in most of the Central European and the Baltic countries. In Moldova, per contra, the national identity was low and fragmented. The accession to Romania is an attractive option for one part of the population, while very close links with Russia or Ukraine are preferred by other groups. Forty-one per cent of surveyed Moldovans believed that independence brought more harm than good to the republic, while 37 per cent opposed this view. At the same time only 19 per cent commended the collapse of the USSR, with a strong 63 per cent judging it a harmful development. Fifty per cent of all respondents saw in it the most harmful development in recent years (SISI, 1998). As integration with Romania is politically explosive, and integration with the European Union seems unrealistic, it is very difficult to build a wide consensus around a general policy direction. The internal political life in Moldova was very unstable with frequent electoral periods (1990, 1992, 1994, 1995, 1996, 1998, 1999 and 2000). While in Central European transition countries with frequent elections there were compensating factors, (such as invitations to join the EU which provided clear policy goals and paths to follow), in Moldova, without such prospects, political instability was translated into major policy reversals and uncertainty about future policy directions. Democracy based on such patterns was not stable and failed to protect individual rights. In spite of democratic procedures, the polls are continuously showing a pronounced detachment of


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the governing institutes from people’s needs, problems and interests. That further undermined the authority of the state and therefore increased the costs of the rule of law, as the credibility of law enforcement was already low. Informal Institutions J.S. Mill stated that ‘much of the security of person and property is the effect of manners or opinion’ and of ‘fear of exposure’ rather than ‘the direct operation of the law and the courts of justice’. Informal disciplinary institutions, the culture of economic behaviour, are therefore as important as formal law sanctions, at the same time being much more cost-effective. However, informal discipline could not serve its purpose efficiently in Moldova. Informal institutions operate on the basis of a generally accepted system of values. To this end, the Soviet system of values combined universal ethical principles with particularities of the communist ideology, making the two elements quite difficult to separate. It distorted the generally accepted ethics, and made people cynical about these ethical principles. Olson (2000) quotes a popular saying that ‘refraining from taking state property amounts to robbing your family’. The collapse of the Soviet system was the final accord in this process but also showed the full extent of the vacuum in the ethic sphere, unrestricted now by the hypocrisy of the previous ideology. In Moldova this discontinuity is seen clearly in every aspect of life, starting from changes in manners, fashion, leisure activities and so on. The vacuum could not be rapidly refilled: in the absence of strong religious influence and developed civil society institutions there was no easy return to universally accepted principles. There are additional conditions that worked against strong informal sanctions in Moldova. The reputation effect that brings ostracism and loss of profits to reneging parties depends on socialization and the dissemination of information – free press, credit bureaus or gossip. In particular, public opinion is essential in disciplining politicians and constraining corruption. Moldova, similarly to other CIS countries, has a very low score on ‘accountability and voice’ (as defined by Kaufmann et al., 1999) than more successful transition economies. Rapid changes and weak national identity (with many who are planning to leave the country) induced short-sightedness and short horizons that further undermined the importance of reputation. Informal institutions and trust are also shown to be higher among people with strong ethnic and family links, common history and similar living standards (Zak and Knack, 1998). Large migrations to Moldova during the Soviet times, tensions between Slavic and Romanian populations, emergence of poverty and large income differentials, all reduced social cohesion in Moldova at the time when it was most needed.

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The Speed of Reforms Gradualism may allow for a trial and error policy and more efficient reforms. However, the gradual approach in Moldova suffered from most of its weaknesses: reforms were unsystematic and often contradictory, leading to a weakening of political support for subsequent rounds of reform efforts. The gradual approach allowed the emergence of strong vested interest groups that became a barrier to attempts to get rid of distortions. Moldova is often classified as a fast reformer; however, there was never, except only very recently, the readiness to address the most difficult though most crucial issues. In the macroeconomic sphere, while it was relatively easy to maintain prudent monetary policy (social costs are very dispersed and therefore not politically risky), fiscal adjustment required real life and hard choices. Accordingly, tight monetary policy was combined with lax fiscal policy. The foreign debt problem is the result of this strategy. In the sphere of structural reforms it was relatively easy to convert kolhozes to joint stock companies. It was much more difficult to distribute land to farmers and really make a difference. As a result, agriculture, the leading sector of the economy, did not have a chance to restructure and develop until the end of 1998. In general it was easy to legislate a new law or to create an institution on paper. It was much more difficult to make it truly operational, to develop formal and informal codes of procedures and eventually to enforce the law effectively. The best law can be used against its very spirit if such is the general attitude toward it and the practice. All the above emphasize again the importance of informal institutions, legal tradition and political culture, as well as the credibility of government actions.

5.

CONCLUSIONS

We argued here that the fundamental weakness of the economic reforms in Moldova was the failure to create an environment in which the supply side responds to market demand. The failure is a combination of some poor initial conditions and inappropriate policies. But what singles out Moldova from other transition economies are, first, an extreme government failure resulting most likely from the lack of any national tradition and experience of independence, and the internal conflict between the Slavic and Romanian population on the orientation of the country. This tension, that resulted in a civil war and the break-up of the country into two parts, further demoralized any sense of national cohesion and clouded the future horizon. Second, Moldova is also an extreme example where the ability to rely on heavy borrowing helped the country to postpone reforms and to


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finance rents and other non-productive vested interests. The heavy burden of the debt will restrict prospects for growth in the future. Thirdly, economic growth prospects in Moldova depend heavily on reforms in agriculture. This proved to be more difficult to reform than other sectors due to the sensitivity, vested interests and other special difficulties of the privatization of land, to the heavy subsidization of agriculture during the Soviet period, and to the collapse of the traditional trade networks and the difficulties of finding alternatives channels of marketing agricultural products. All these resulted in institutional failures: institutional incentives worked against structural adjustments. Prevailing rent-seeking, lobbying for subsidies and racketeering make honest businesses in Moldova unprofitable and insecure – therefore new businesses were not established and only dishonest operations were attractive. This vicious circle must be broken up by decisive efforts of the state to improve law enforcement, to struggle against corruption and to withdraw from involvement in real production and economic life. Channelling human resources from rent-seeking and valuedetracting activities towards value-adding ones is an essential condition for growth. In human terms, the real success of transition is therefore the creation of conditions in which relative well-being or even affluence can be achieved through high levels of education, experience and hard work rather then through political contacts or readiness to engage in morally doubtful operations. Behaviour according to homo Sovieticus is still encouraged by the incentives that the people continue to face (compare with Filer et al., 2000). Accordingly, the most crucial task of the government in Moldova is to reintroduce confidence among economic agents in the rule of law. Such confidence generates foreign direct investments and interest in trade with Moldova and it also reduces, but more profoundly, the attractiveness of permanent emigration of the most skilled individuals and diminishes capital flight. It is necessary for investment decisions and business start-ups. It also discourages fraud as chances of getting away unpunished are reduced and the importance of good reputation increases. Key conditions include political stability, most importantly, the resolution of the Transnistrian conflict. This is absolutely essential as the lack of territorial integrity and even the slightest possibility of an armed conflict puts in question the authority of the state and confidence in law enforcement, and therefore discourages any serious productive economic decisions. Also necessary is the establishing of a European-oriented course of development strategy and sticking to it. This would make all the reform efforts irreversible and thereby provide much more credibility. A focus on increased law enforcement and the fight against corruption should be part of a wider effort to improve state structures and to rebuild the authority of the state as the guardian of legal order. A neces-

126


sary precondition for a more effective enforcement of economic laws is a strict budget prioritization of expenditures to the judiciary. Only if the institutional factors that led to the prolonged economic decline in Moldova are overcome will the country have a chance to start a normal development path. Privatization of land would be then the crucial factor contributing to sustained long-term growth. Still, prospects for growth will be diminished by the heavy debt burden and the deterioration of human capital due to the crisis in the education and health care systems and the large amount of emigration. Moldova was ranked according to the Human Development Index in 75th place in 1994, 81st in 1995, 98th in 1996, 110th in 1997, 113th in 1998, 104th in 1999 and at 102nd (out of 174 countries) in 2000. This deterioration will influence growth prospects even in the longer term. This is the additional price that the country and its population will have to pay for the mismanaged transition.

NOTES 1.

2.

3. 4.

Changes in ranking of transition economies according to GNP per capita at purchasing power parity demonstrate this fact. Campos and Coricelli (2000) show that transition countries that were initially clustered in the upper-middle income group are far more dispersed across the ranking ten years later. Specifically, in 1998 Moldova is the third-poorest transition country (after Tajikistan and Kyrgyzstan), neighbouring by international comparison with Haiti and Mauritania. Since 1998 Moldova has also been classified as a highly indebted poor country (HIPC) by the IMF. The political and economic conditions in Transnistria were quite different than in rightbank Moldova even before the collapse of the Soviet Union. Transnistria became a part of the Soviet Union shortly after the First World War, while right-bank Moldova remained part of Romania until the Second World War. Transnistria was also much more industrialized during Soviet times (in particular, heavy industry was located predominantly there) and populated mainly by Slavs, unlike mainly rural right-bank Moldova with the dominant Moldovan and Romanian population. These differences would obviously not justify exclusion of Transnistria from this analysis. However, the separatist unrecognized state was created on the territory of Transnistria as a consequence of armed conflict in 1992 and it has conducted practically independent and contradictory economic policies ever since. Transnistria has its own customs system (uncoordinated with that of Moldova) and currency as well as monetary and fiscal policies. While Moldova has chosen the strategy of democratization, transition to a market economy and close links with the West, Transnistria never officially abandoned communism and never recognized the collapse of the Soviet Union. Liberalization and macroeconomic stabilization were not achieved and privatization was never on the policy agenda. Indeed the authorities never accepted the need for structural reforms, and the printing press remains the major instrument of economic policy, providing resources necessary to support unrestructured state-owned enterprises. Transnistria does not publish statistics based on international standards and the disclosure of available statistics is subject to the discretion of its security apparatus. See Havrolyshyn et al. (1998), Berg et al. (1999), Fischer and Sahay (2000). See Antczak et al. (2001) for the analysis of the role of international financial institutions in this respect.

Barriers to growth in Moldova 5. 6. 7. 8. 9.

10. 11.

12. 13. 14.

127

See Radziwill et al. (1999) for the analysis of character and causes of financial crisis in Moldova in 1998. Prices are occasionally still lower in exchange for political and economic concessions. No comparable data on capital intensity in agriculture is available for this period and therefore it is not possible to evaluate the most important TFP changes. The short time since the privatization of land has not allowed for many changes to take place yet. The survey was carried out by the Agency for Restructuring Agriculture (ARA) in 80 rural communities in all the counties of Moldova during October–November 2000 and covered 350 agricultural enterprises of all organizational forms. See ARA (2001a). Privatization of land was often opposed on the grounds that it may create plots of suboptimal size, therefore leading to further efficiency losses. The early decision to transform kolhozes into joint stock companies was motivated by such considerations but it failed to bring a real change to the sector. Land consolidation following privatization proved to be a natural development anyway. As for 2001, farms greater than 500 hectares have been formed on over 41 per cent of all the land distributed under the National Land Programme, and farms between 100 and 500 hectares on 28 per cent of land. Consolidation proceeded mainly through lease agreements. It is very important that farmers choose to enter these contracts on a voluntary and individual basis and are not forced into new collectivist structures. Unlike during the Soviet era, when the land was polarized between large collective structures of over 1000 hectares and small household plots, there is currently a wide range of farm sizes between 100 and 1000 hectares reflecting the active search for the optimal landholding size in terms of technical efficiency, the type of crops and management skills. The share of irrigated land declined from 49 per cent in 1995 to 4 per cent in 2000. Under pressures from the international financial institutions part of the energy distribution sector was privatized in 1999 with the participation of major Western companies. Part of the energy debt to Gazprom was rescheduled and collateralized, while an important stake was swapped into equity in the Moldovan gas pipeline system which helped to reduce the amount of debt to some extent. Unfortunately, it is possible to extract and struggle for rents, even when those are negligible for an outside observer. Anecdotes about mafias of retired persons struggling for control over trash bins in the richer parts of Chisinau illustrates the point. The formal model demonstrating this argument is provided in the longer version of this chapter. A similar approach was introduced by Shleifer et al. (1993). The survey conducted by SISI (de Serviciul Independent de Sociologie si Informatii) ‘Opinia’ in 1998 showed that the main concerns of ordinary Moldovans, apart from those directly influencing their welfare like inflation, poverty (77–87 per cent), salary and pension arrears (66–73 per cent), were the chaos and anarchy, lack of discipline and order at all levels of power (48–68 per cent), and corruption, criminality and massive fraud (45–54 per cent).

6. Explaining growth in Armenia: the pivotal role of human capital Heghine Manasyan and Tigran Jrbashyan 1. INTRODUCTION TO ARMENIA: ANCIENT LAND, NEW DIRECTION Armenia is one of the countries of Southern Caucasus. It gained independence in 1991 after the collapse of the USSR and started to implement political and economic reforms aimed at the establishment of a marketoriented democratic society. This study aims to explain growth patterns of the country focusing on the special features of its development and composition of its economy. Armenia’s relatively high ranking in the human development index (72nd compared with 98th in per capita GDP PPP, Table 6.1) is due to the relatively high educational level of the population, a factor that helped to cushion the most negative initial impacts of the transition. The Wall Street Journal ranked Armenia in 45th place in its economic freedom index, that is, as one of the fastest reformers. During the last decade Armenia experienced numerous drastic changes. Economic recovery started in 1994 and continued to 2001 with an average annual growth rate of 5.9 per cent. Even so, while by 2001 Armenia’s GDP recovered to a little less than threequarters of its 1989 level, this quantitative indicator does not fully reflect the dramatic decline in the quality of life and social cohesion, and in belief in the future. Among the issues yet to be understood are the factors behind the long-term development trends. In this chapter we present data on longrun growth trends of the Armenian economy, analyse the factors behind it and the reasons for the present difficulties and try to understand the sources of past and further growth.

128

129

Explaining growth in Armenia

Table 6.1

Basic facts about the Republic of Armenia1

General Religion

Armenian Apostolic Church

Official language

Armenian

Currency

Dram (AMD)

Exchange rate

US$ 1555.1 AMD (2001)

Fiscal year

January/December

Human development index

72/162 (HDR 2001)*

Land area

29 743 km2 1990

2002

Population (at the beginning of the year)

3 545 000

3800000**

Life expectancy at birth (at the end of the year) of which: Male–Female

71.7 years

72.5 years (for 2001) 70.5–74.5 (for 2001)

Education I; II; III level gross enrolment ratio (7–21 years, per 000s) Including: General education system (7–16 years) Secondary vocational education (17–20)

68.4–75.2

601

466

892

766

200

105

Tertiary education (17–21)

239

180

Economic indicators

1990

2001

Gross domestic product (GDP)

4123.8 US$ mln

2117.6 US$ mln

GDP per capita (nominal/PPP, current intl)

na/3286.7 US$

557.3/2559 US$

Real GDP growth (annual % of change)

5.5

9.6

GDP composition (% of total in current prices) Industry, % Agriculture, % Construction, % Services %

30.2 15.8 17.6 27.7

20.2 25.0 10.7 34.4

Inflation (December to December/Annual)

9.8%/7.8%

2.9%/3.1%

Total revenues, %

34.0

16.4

Total expenditures, %

35.6

20.8

Public finances, % of GDP

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Table 6.1 (continued) 1.5

4.3

Exports (FOB)

1443.4 US$ m

342.8 US$ m

Imports (CIF)

1910.7 US$ m

874.3 US$ m

Current account deficit

467.2 US$ m

196.3 US$ m

External debt (at the end of the year)

na

881.0 US$ m (41.6% of GDP)

Unemployment rate, %

na

10.3

Fiscal balance (consolidated budget, cash) % External sector

Notes: na means non-available. *Human Development Reports present data with a two-year lag. **These are official data. Independent experts and the last census (2001) preliminary estimates suggest that the current population is close to 3 million. Source: World Development Indicators, 2002.

2. THE LONG-RUN GROWTH OF ARMENIA’S ECONOMY: WHAT HAS BEEN ACHIEVED SO FAR? General Economic Development of Armenia Within the Last 50 years The main development trends of the Armenian economy during the last 50 years are presented through the dynamics of the net material product (NMP), employment and the capital stock. During the Soviet period the NMP of Armenia grew very fast but at a declining rate in the years 1996–70, reaching almost zero growth during 1986–90. There was a sharp decline during the first years of the transition, followed by a significant recovery that continued throughout 2002 (Figure 6.1). Major Determinants of Long-run Economic Growth in Armenia: Turning Points Labour and capital Figure 6.2 compares output with input growth since 1960. It demonstrates that the growth of output up to 1990 was driven mostly by a very high rate of growth of fixed assets, in most periods even higher than that of output, but also, until 1985, by a significant rate of growth of labour. The rates of labour productivity remained modest while the output–capital ratios are either low or even negative, an annual rate of –1 per cent for 1970–90. These

131


10

5

0

–5

Figure 6.1

1996–2000

1991–95

1985–90

1981–85

1976–80

1971–75

1966–70

–15

1961–65

–10

Annual average growth rates in Armenia: 1960–2000, %

results are in line with those of Easterly and Fischer (1995), which single out Armenia and Azerbaijan as two countries having in 1970–90 ‘only mildly negative capital productivity growth’ while labour productivity changes have been markedly positive at least up to the mid-1980s. Analysis of economic development during the last decade year by year shows a sharp decline during 1990–93, and fluctuating growth during 1994–2001 (see Figure 6.3). The sharp decline in output and in other indicators during the first years of the transition was a result of a decline in labour and in the rate of investment, but was mostly due to a sharp decline in productivity, an outcome of the complex interplay of a number of factors, including political and institutional, that created uncertainty. Total factor productivity growth Total factor productivity calculations, à la Solow, are shown in Figure 6.4, and are based for the National Income and capital stock on 1973 prices, and for labour on 1973 wages. The data show that TFP growth was negative until 1975 (1.1 per cent

132


10 8 6 4 2 0 –2 –4 NMP Capital stock Employment Labour productivity Output-capital ratio

–6 –8 –10 –12

1996–2000

1991–95

1985–90

1981–85

1976–80

1971–75

1966–70

–16

1961–65

–14

Figure 6.2 Annual average rates of change of key macroeconomic indicators: 1960–2000, % per annum), it was positive during 1975–90 (at 0.9 per cent a year) and again negative during the 1991–2001 period (1.3 per cent). The positive growth of TFP in Armenia during 1975–90 (like some East Asian countries such as Hong Kong, Taiwan and South Korea) can be ascribed to human capital accumulation due to the shift to ten-year compulsory education introduced since 1965. During the first years of the transition TFP was sharply negative, and only recovered back to positive territory in 1998. The general growth profile of Armenia resembles the record of most other former Soviet republics turning into independent states, featuring firstly declining growth and TFP during the last decade under the Soviet regime and depending on ‘intensive growth’ mostly through high investment rates. Then, under transition, there is a period of sharp decline in output, accompanied by negative growth of labour and TFP (in Armenia this reached its lowest level of –4 per cent in 1992) and a declining rate of investment, followed by recovery fuelled mostly by recovery of TFP, but with a continued decline in labour and sometimes even a negative rate of investment.

133


12.5

NMP Capital stock

Employment Labour productivity Output-capital ratio

10.0 7.5 5.0 2.5

0

Figure 6.3

2001

2000

1999

1998

1997

1996

1995

–5.0

1994

–2.5

Key indicators of Armenian economy in transition (% change)

As can be seen from Figures 6.1–6.3, 1975, 1991, 1994 and 1998 are turning points in the long-run growth of the Armenian economy. As the above analysis demonstrates, until the 1970s Armenia was experiencing extensive economic growth (the expansion of capital and labour). The period between the early 1970s and late 1980s may be viewed as the ‘golden era’ of the country’s technological progress, which was built on the foundation of the extensive growth period. Unfortunately the intensive technological development was confined to military industry and also confined to branches that caused structural economic distortions. The main reasons for the technological decline during 1991–94 were the collapse of the USSR, the disruption of production and trade networks, the energy crisis, the decline in production of the industrial technological ‘giants’, the earthquake of 1988, the conflict over Nagorno-Karabakh, the lack of appropriate infrastructure for the introduction of a market economy, sharp changes in economic structure in favour of agriculture, and the negative effects of the policy of ‘shock therapy’. These included, among others, hyperinflation and the ‘loss’ of savings.

134


2%

1%

0

–1%

–2%

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

– 4%

1966

–3%

Note: Calculations have been done with the assistance of Mr Vardan Markosyan.

Figure 6.4 Dynamics of total factor productivity residuals, 1965–2001 (YOY, %). The resumption of growth since 1994 can be credited to the ceasefire, the slowdown in inflation, the stabilized exchange rate of the newly introduced national currency, improved energy supply with the resumption of the operation of the nuclear power stations, some reinvigoration of external trade, further improvements to the banking sector, and mass privatization that was accompanied, however, by partial ‘squandering’ of assets of the enterprises. The productivity growth that resumed in 1998 reflects the fruits of the structural and institutional changes. In summary the analysis above demonstrates that the actual technological lag of Armenia developed during the early 1990s, the era of new technological breakthroughs and their introduction to the world, and not in the 1970s or early 1980s as argued by numerous economists of transition. The technological lag was dramatically increased by the failure of the programme of large-scale ‘conversion’ started in 1986–87, the failure to eliminate the economic distortions aggravated by the collapse of the USSR,

135


inconsistent reforms, and the dismantling of large enterprises with their considerable technological potential and assets (which were stripped). Human capital and growth In order to clarify how human capital growth supports economic developments we have added an educational variable into the Solow model, the average years of schooling of the employed population. In order to avoid the monotonous effect of the average growth rate over TFP growth, education was weighted by the actual labour share weight sL for every year. In this way the estimated the contribution of education took away a major part of the previously estimated TFP growth (Tables 6.2 and 6.3). Accordingly, in the equation indicator sL is negative (). g

d lnY d ln K d lnL d(ED) sk sL sL dt dt dt dt

where ED is labour force qualification growth rate. Table 6.2

Educational level of employed population* Number of employed persons

Educational level

Code

Years of schooling

1970

1979

1989

H1 H2 H3

8 10 12

236555 247355 79542

309316 521630 197951

174238 507846 288538

H4 H5

13 15

21530 97690 7.21

19181 202848 9.27

18827 249198 10.72

Incomplete secondary Secondary Secondary special (vocational) Incomplete higher Higher Average years attended

Note: *Our estimation of educational level of the employed population, based on census data, is somewhat biased because we did not take into account people employed with less than 8 years of schooling. This can hardly affect the results.

Table 6.3

1970–79 1980–89

Influence of human capital quality on TFP growth TFP growth, %

TFP growth with ED, %

0.14 1.08

0.81 0.82

sL

d(ED) ,% dt 0.67 0.26

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As is evident from Table 6.3, the impact of human capital on growth during 1970–79 was much higher than afterwards. The naturally diminished human capital growth rate during 1980–89 (0.26 per cent compared to 0.67 per cent in 1970–79) probably also affected growth in the 1990s, although we lack data needed for the quantitative analysis. Even so, the results show a significant elasticity of the impact of human capital over TFP growth in Armenia.

3. TRANSFORMATIONAL RECESSION AND POSTRECESSION GROWTH OF THE ARMENIAN ECONOMY During the early 1990s the Armenian economy recorded a significant drop in output and all macroeconomic indicators significantly worsened. GDP declined by 60 per cent from 1989 to 1993, consumer prices rose 110 times just in 1993. During the first year of introduction of the dram as the national currency in 1993 it devalued from 14.5 to about 400 drams for one US dollar.1 Among the contributing factors to the economic crisis were the devastating earthquake, the collapse of the common market of the USSR and the inability of the CIS to effectively replace the Soviet economic structures, and the political and military instability in the region. At the same time independence allowed Armenia to take control over all economic levers, thus to lay the foundations for economic stability and reforms. The government of Armenia launched a major structural reform programme shortly after independence in 1991. It called for the liberalization of prices of most goods and services, liberalizing trade and the foreign exchange regime and support for private sector development. Enterprise and land privatization were initiated. However, an effective implementation of macroeconomic adjustment programmes became possible only with the cessation of hostilities in the Nagorno-Karabakh conflict in 1994, when international financial organizations and donor countries became involved in financial and technical assistance to Armenia, in addition to the continuation of humanitarian assistance. Tight monetary and fiscal policies during the following two years halted hyperinflation and curtailed the decline in the national real income. Armenian policy-makers adhered closely to the orthodox adjustment strategy offered by international financial organizations, mainly the International Monetary Fund (IMF) and the World Bank (WB). Armenia’s small size, economic weaknesses and regional isolation gave the IMF and the WB an unusual influence over national economic policies, especially the rapid stabilization of the economy. The adoption of the

137


offered policies was motivated also by the acute need to attract foreign investments in order to put Armenia on a growth path. Only external support made it possible to overcome a crisis. However, the Armenian economy continued to experience difficulties, which endangered its development prospects. First of all, despite the high rates of growth, personal income levels remained far below those of the pre-transition period and lagged behind those of most other transition countries. Second, the stabilization policy did not attract foreign direct investment inflows, contrary to initial expectations. Third, Armenia accumulated a significant external debt as the balance of payments remained largely negative, due to its weak export capability (Figure 6.5). Finally, the development of the Armenian economy during the transition period was accompanied by the expansion of such negative social phenomena as poverty, emigration and unemployment. All these raised serious doubt over the sustainability of Armenia’s long-term growth. In order to better understand the specific factors that determine Armenian economic growth and its prospects we have to take into account its special initial conditions and analyse its weaknesses in the transition to a market economy. 900

560 540

External debt

600 Nominal exchange rate (right axis)

Min US$

450

520 500

300 480 150

State budget deficit

460

0

440

–150

Figure 6.5

Dynamics of trade balance and external debt

2001

420

2000

1999

1997

1996

1995

– 450

1998

Current account

–300

400

Dram/US$

750

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Initial Economic Terms and Adjoining Conditions at the Entrance to Market Most of the relevant literature concludes that the main factors responsible for the variance of growth path across transition countries are initial conditions along with macroeconomic stabilization and structural reforms. The list of initial conditions contains a large range of variables, such as income levels, urbanization rate, industrialization, natural resources, geographical location, prior economic growth rates, economic distortions (repressed inflation, trade as share in GDP, black market exchange rate premium, institutional characteristics (market memory) and so on (De Melo et al., 1997b, p. 84; Kushnirsky, 2001). According to the data set used by Campos and Coricelli (2000), Armenia was characterized at the point of entrance to the transition as a low-income, highly urbanized, over-industrialized country with poor natural resourses, with repressed inflation and medium (among FSU countries) black market level. When we try to assess the impact of the various initial conditions on the chances of successful transition in Armenia, we first of all have to add the unstable political and military situation in the region and the devastating earthquakes in Spitak – both with devastating effects on the Armenian economy. The Spitak earthquake of December 1988 substantially crippled the economy, so much so that economic hardship and chaos started in the country far earlier than in the other CIS countries. The earthquake affected about 40 per cent of the country’s surface area. Infrastructure entities in some 20 per cent of the country’s territory ceased to function; 230 production enterprises were destroyed. In general, 40 per cent of Armenian industrial potential was destroyed, making transition even more difficult. The burden of involvement in the Nagorno-Karabakh conflict was one of the most unfavourable non-economic factors seriously affecting the economic performance of Armenia. Data on changes of national income during 1988–92 among NIS countries demonstrate that Armenia experienced the deepest fall, by about half by 1992, compared with 1987, along with Azerbaijan and Tajikistan, countries that were also involved in military conflicts (with a drop of national income by –41.2 and –32.8 per cent, respectively). The conflict resulted in the transportation and economic blockade of Armenia, first by Azerbaijan and then also by Turkey. The main transport highways of Armenia, including the gas pipeline that used to provide above 80 per cent of all imported gas from Russia, pass through Azerbaijan, and were now blocked. In addition, the Abkhaz and Ossetian conflicts, which simultaneously started at the same time in Georgia, blocked trunk roads that connected Armenia with Russia to the north. As a result Armenia

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found itself in full economic isolation. According to the World Bank, the Turkish and Azerbaijani blockades of Armenia cost between 30 to 38 per cent of its GDP (that is, US$570 million to US$722 million annually).2 Recent estimations show that reopening of Armenia’s borders with these countries would reduce just transport costs by 30–50 per cent with total benefits of more than 300 million euro.3 The cost of the blockade was especially high because of the high dependence of Armenia on external trade. Under the Soviet Union and central planning, Armenia traded almost exclusively inside the Union, mostly with Russia and with a very narrow range of commodities. The share of trade in GDP was quite substantial (in 1988 imports comprised 66.9 per cent of GDP, and exports covered 47.3 per cent). Open trade in all directions is essential for Armenia as a small country with a limited domestic market, lacking natural resources and endowed with a surplus of qualified labour.4 Even the apparent openness of the Armenian economy quickly disappeared, before the collapse of the USSR (Table 6.4). Table 6.4

Imports and exports in 1988–91 1988

1989

1990

1991

Million current roubles Import OW inter-republican Export OW inter-republican

5389 4531 3813 3729

4898 3842 3691 3598

4662 3508 3523 3428

5809 4428 3732 3613

Share to GDP, per cent Import Export

66.9 47.3

51.6 38.9

48.1 36.3

36.4 23.4

Share of inter-republican flows, per cent of total Import Export

84.1 97.8

78.4 97.5

75.3 97.3

76.2 96.8

During the transition period export volumes have severely decreased as a consequence of old and new factors. There were the earlier production and trade distortions, low competitiveness of products, lack of communication with the outside world, absence of global marketing skills, landlocked geographical position, and high transportation costs. Then came the dissolution of the USSR that disrupted unified payment and settlements systems.5 Coming back to other components of initial conditions, the levels of income and material wealth, Armenia was far below the USSR average.

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For example, per capita capital stock in 1988 was only about 70 per cent of that of the USSR average.6 The only comparative advantage of the Armenian economy at the entrance to the market was the higher than average educational level of the population – that is, the level of its human capital. Shock Therapy: Inevitable Losses in the Size of the Armenian Pretransition Economy In this section we estimate the losses to the Armenian economy caused by the external geopolitical and other non-economic circumstances during the early period of independence and transition. As a base case we assume that Armenia enjoys open trade relations at world market prices, which are also applied to the domestic market. We also adopt the estimates of Shmelev and Popov (1989) on the value of explicit and implicit (through favourable terms of trade) transfers of Russia to the Armenian Soviet Republic on the eve of independence, of US$3.5 billion (out of a total to all republics of US$50 billion). We discuss four shocks: trade, demand, financial and administrative. In order to estimate the potential of losses from the trade shock, we calculated the dollar value of the Armenian GDP and of its trade flows and balance in 1987, the last normal year (before the earthquake) at world market prices. As shown in Table 6.5, the value of GDP stood at US$5.2, the trade deficit at US$964.5 million, 18.5 per cent of GDP, and the real rate of exchange (of value added) at 1.36 R/US$, (1.55 for value added), significantly higher than the rate in domestic prices of 1.15. It follows that Table 6.5 Trade balance of Armenia in 1987, in current and international prices

Output Intermediary inputs Gross value added Export Import Trade balance Trade balance to GDP, %

000s of roubles*

000s of US$**

Real exch. rate

16 381 684 8 280 381 8 101 303 4 114 937 4 250 804 135 867 1.7

12044537 6827089 5217448 2472846 3437308 964461 18.5

1.36 1.21 1.55 1.66 1.24

*Sources: Statistical handbook ‘National economy of Armenia in 1987’, Yerevan, 1988. **Yerevan office of The World Bank. We are grateful to Mrs Lev Frienkman and Vahram Avanesyan for providing necessary data.

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if Armenia had to trade in 1987 the same assortment of goods at world market prices it would have lost an additional US$829 million or about 16 per cent of its GDP. The losses due to the shock of decline in demand were connected with the fall in output due to the low competitiveness of Armenian industrial output, income deterioration across the post-Soviet area and the collapse of the defence industry of the FSU, to which the industrial production of Armenia was strongly tied. Calculations in rouble and dollar prices of the Armenian GDP by economic branch reveals the weaknesses of the structure of the Armenian economy as well as the sources of trade benefits (Table 6.6). The higher real ‘exchange rate’ (by 80 per cent) for most exportoriented (80 per cent) industrial production along with its large share in GDP contributed mostly to these benefits. Table 6.6 Composition of GDP in 1987 (in current roubles and international dollars) GDP by sector

Share of GDP, %

Real exch. rate R/US$

Mln of roubles

Mln of US$

Rouble terms

US$ terms

Industry Construction Agriculture Services

4298.0 776.0 1211.0 1816.0

2433.6 742.1 343.1 1698.7

53.1 9.6 14.9 22.4

46.6 14.2 6.6 32.6

1.77 1.05 3.53 1.07

Total GDP

8101.0

5217.4

100.0

100.0

1.55

The calculations show that the losses to Armenia by selling its industrial exports to the FSU at world market prices rather than actual ones are estimated at 13–14 per cent of GDP. The combined effect of the decline – almost complete disappearance – of these exports, as well as the shrinking of demand (also due to the earthquake and war), is very extreme, as can be seen in the different calculations in Table 6.7, especially in scenario IV. The financial shock was caused by the losses of transfers and capital investments from the federal Soviet government to Armenia’s social services budget (health, education, housing and so on). These transfers are estimated at about US$1.7 billion or 14 per cent of 1987 GDP. The institutional and administrative shock contributed to the general disorganization thus added to an even deeper transformational recession in Armenia. The negative impact of the disorganization and the weak and incapable government is still underestimated. In addition to the very important

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Table 6.7 Armenia’s economy in transition: 1996 (thousands of US$, except when indicated otherwise)

Output Intermediary Gross value added Total demand Total final demand Private final consumption Government Gross capital formation Total intermediary demand Export Import Trade balance As % of original 1987 level Output, % Intermediary inputs, % Gross value added, %

Original 1987 level

Scenario I (1996)*

Scenario IV (1996)**

12 044 537.2 6 827 089.2 5 217 448.0 13 042 543.7 6 167 347.2 2 405 270.2 1 025 536.0 2 736 541.0 6 875 196.5 2 472 846.1 3 437 307.6 964 461.5

8185712.3 4773750.8 3411961.5 8185712.3 3411961.5 1330667.6 567357.3 1513936.5 4773750.8 2472846.1 2531173.1 58327.0

3523759.6 1968810.6 1554949.0 4032270.9 2063460.3 1660918.9 206341.7 271886.8 1968810.6 526922.2 1029107.2 502185.0

100.0 100.0 100.0

67.96 69.92 65.40

29.26 28.84 29.80

Notes: * Without adjustment to external demand shock, original shares of final demand, trade balance – actual for 1987 (1.7 per cent). ** Export demand shock, final demand shares of 1996, trade balance32.7 per cent of GDP actual for 1996. Source: Constructed on data from WB Yerevan office.

impact of the cut of all FSU networks, one has also to remember that a relatively large share of the Armenian economy was controlled directly from Moscow. The loss of control over these centrally subordinated sectors and the difficulties in establishing domestic control with little time to prepare and no ready institutions, added to the chaos that accompanied independence. Little early warning and the absence of real national government for many years brought about a largely spontaneous character of most transformation processes. All these together weakened the institutional power of the state and the general economic situation in Armenia to a greater extent than in other FSU economies. The process of reconstruction of the administrative system and other institutions was very slow, and this increased the level of uncertainty and adversely affected economic activity. It also contributed to the expansion of the hidden economy (see the box below) with its longterm negative consequences.


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BOX MEASURING GROWTH AND GDP RIGHT: SOME NOTES ON ESTIMATION OF HIDDEN ECONOMY IN ARMENIA. The liberal stance towards economic agents as well as the policies of transition resulted in a wide expansion of the hidden economy in Armenia: 1. The stabilization efforts, including restrictive monetary policy and heavy taxation overwhelmed the capabilities of economic agents to adjust. 2. Institutionally, the vacuum of authority and the weak accounting discipline and supervision. 3. The macroeconomic situation, for example high inflation and the dollarization of the economy. 4. The social environment of low incomes, high unemployment and job mobility, including massive emigration and unregistered transfers. All the above encouraged and facilitated activities outside the legal economy. Thousands of small enterprises founded over the last decade are neither recorded nor regulated. Depending on availability of data, various methods have been used to estimate the extent of the hidden economy in Armenia. One indirect estimation method produced the following figures for t the hidden value added: 75.8 per cent of total value added in trade and catering, 79.7 per cent in housing services, and 38.6 per cent in public education. Estimates of the share of the hidden economy in GDP attract much effort but vary a lot. According to official estimates the share of the nonobserved economy in GDP in 1995 was between 31.6 per cent (using the production and income methods) and 37.3 per cent (using the final consumption method). In 1996 the figures were 34.3 per cent and 44.4 per cent respectively. Other estimates of the hidden economy fluctuate between 30 per cent and 70 per cent of the officially announced GDP. The highest figure computed for Armenia, using Gutman’s ‘monetary’ method of estimation, was 66.3 per cent in 1997 up from 33.4 per cent in 1994.7 However, an alternative monetary method produced the lowest estimate, just 16–18 per cent.8 Such large gaps between alternative estimates preclude us from coming to a definite conclusion on the level of the hidden economy. It is very clear

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that its scope and level increased significantly compared with the Soviet period and probably also over time during the first decade. Post-recession Growth and Changes in the Structure of the Economy: A Forced Blind Alley The dynamics of GDP: sources of growth by branch and structural shifts The purpose of this section is to explore the sources of post-recession growth and fluctuations of the Armenian economy, examining their industrial sources and patterns. The reform efforts and policies, even if inconsistent and delayed, resulted in positive rates of growth after 1994. The recovery process of GDP during 1994–2001 showed ups and downs,9 only partially consistent with the expectations of policy-makers (Table 6.8). Table 6.8 Real GDP growths: actual versus projected (1993–2000, per cent over a year before)

Projected Actual Difference

1993

1994

1995

1996

1997

1998

1999

2000

2001

22.3 08.8 31.1

7.5 5.4 2.1

5.0 6.9 1.9

8.0 5.9 2.1

5.8 3.3 2.5

5.2 7.3 2.1

5.0 3.3 1.7

5 6 1

6.0 9.6 3.6

Source: Programmes of socio-economic development of Armenia for corresponding years and NSS.

The process of capital accumulation was also affected during the transition period. According to SNA of Armenia the ratio between gross savings and GDP in the post-recession period stabilized at a level around 18–20 per cent of GDP. At the same time, the changes in gross investments were lagging behind changes in GDP, even having negative performance during 1994–97 (Figure 6.6). The contribution of the main components to GDP growth over 1994–2001 varied. Considering total growth as 100, about half of the increase in real GDP during 1994–2001 should be credited to the expansion in the service sector in its broader definition: including (in this case also) construction (CST), as well as transport and communications (TCO), trade and catering (TRD) as well as other services (SER) – mainly public ones: education, health, police and administration and so on. Agriculture (AGR) contributed 19.6 per cent, and the contribution of the industrial sector (IND), where Armenia’s skilled labour showed a strong comparative advantage in the past, was only 9.8 per cent (Figure 6.7). The remaining

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10 8 6 4 2 0 –2

1994–97

–4

1998–2001

Net exports

Fixed capital formation

Gross investments

Public consumption

Private consumption

Final consumption

Domestic demand

GDP by expenditure

–8

GDP

–6

Figure 6.6 Annual average changes of expenditure-based GDP components TAX 22.7%

SER 2.2%

TRD 22.4%

Figure 6.7

TCO 8.4%

IND 9.8%

AGR 19.6% CST 14.8%

Contribution of components to GDP growth in 1994–2001

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40% Weight 1994, % of GVA

35%

Weight 2001, % of GVA Annual growth rate, 1994–2001

30% 25% 20% 15% 10% 5% 0% IND

AGR

CST

TCO

TRD

SER

GVA

TAX

GDP

Figure 6.8 Average yearly growth rates of GDP components for 1994–2001 22.7 per cent came from net indirect taxes (VAT minus subsidies) that have grown by an abnormal rate of 23.2 per cent per year. The contribution of net taxes evidently cannot be considered as a real or sustainable element of further growth, as during this period it reflected a better collection of VAT and a sharp decline in subsidies to the economy, and both are not expected to change further in the future. So, while GDP at market prices grew over the period by 5.9 per cent, GDP in factor prices (GVA) grew by only 5 per cent per year (Figure 6.8). Figure 6.8 contains data on the total growth of individual branches and on the evolution of the relative shares during the period 1994–2001. The growth rates and shares are calculated in constant prices of 1996. It shows that rates of growth varied between branches, resulting in significant structural changes. In this way the traditional leading sectors, industry, agriculture and public (government) services, with the highest initial shares, grew at the slowest rates, while trade and catering exploded. The intermediate growth in construction, and transportation and communications, reflect to some extent


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a shift from serving investment and government to serving the private sector and services. The most important sector of the Armenian economy in the early 1990s, industry (44.5 per cent of output in 1990), was heavily dependent on imports of raw materials and intermediate goods from the rest of USSR, especially from Russia. It produced mostly semi-finished products, which were then assembled outside Armenia. After the collapse of the USSR and the dissolution of traditional economic links, industrial production fell dramatically and its pre-transition levels have not been recovered since. In the year 2001 the volume of industrial production hardly exceeded half (53.3 per cent) of its 1990 level. The structure of industrial output was also altered. Currently Armenian industry is composed of three main sectors: electricity, food and food-related industry, and mining and processing of precious stones. Structural changes in demand and investments The structure of demand in Armenia changed in parallel to the structure of the economy, indeed it brought it about. There are two important changes (Table 6.9). Internally there was a sharp and abrupt decline right at the beginning in the share of investment in aggregate demand (and a similar increase in the share of consumption). Investment declined to less than 20 per cent of GDP and consumption grew from 67 per cent in 1990 to 105 per cent in 2001. The net increase in aggregate demand resulted in a sharp rise in the current account deficit, to almost 40 per cent in 1995 then down to 20 per cent in 2001. The sources of formation of capital investments have also been changed. The decline in economic growth in Armenia sharply decreased the potential of domestic savings and made foreign financing the main source of investment, mostly through government borrowing and the financing of the deficit of the balance of payments, as shown above (and in Figure 6.10). Foreign direct investment (FDI), played part of this role, though despite legislative privileges for FDI, Armenia was able to attract since 1988 only US$648 million, FDI about US$170 per capita (see Figure 6.9), which is far below FDI flows to neighbouring countries and initial expectations. Foreign investments were connected with mass privatization and declined recently due to its slowdown. By 2001, the external debt of Armenia rose to about US$881 million, close to 42 per cent GDP. As can be seen in Figure 6.10, until 1998 the government was the main borrower abroad and only after then did the business sector of Armenia start to take the lead. This trend is similar to that in other small transition countries.

148

Source:

102.8 114.1 66.9 47.2 11.3

92.5 113.8 112.2 1.6 21.3

1992

Data from the National Statistical Service.

GDP expenditure based Domestic demand Final consumption Gross investments Net exports

1990 95.5 129.3 105.8 23.5 33.8

1994 97.6 135.9 117.5 18.4 38.3

1995 98.9 131.7 111.7 20.0 32.7

1996 95.8 133.8 114.7 19.1 38.0

1997

Table 6.9 Gross domestic product: demand side (share of GDP in current prices, %)

96.4 130.3 111.2 19.1 33.8

1998

97.6 126.6 108.3 18.4 29.0

1999

99.1 126.5 107.4 19.1 27.4

2000

102.3 122.6 104.8 17.8 20.3

2001

149


60 200 Foreign direct investments

50

Per capita FDI

120 30 80

20

Figure 6.9

2001

2000

1999

1998

1997

1996

1995

1994

1993

0

1992

0

1991

10

1990

40

1988–89

FDI, min US$

40

Per capita FDI, US$

160

Dynamics of FDI, 1990–2000

Human capital: beyond the slippery path of losses? Transition has its effects on the human capital of Armenia as well. There have been several conflicting trends that can critically effect the development of Armenia in the next decade. They include demographic changes in the population, changes in quantitative and qualitative parameters of education, the widening of social stratification, negative trends in public spending on education, and institutional changes in educational and other social services. We confine our analysis of human capital to educational and demographic data. Traditionally, under the old regime, education was considered a priority target and value of Armenian society and it was supported by large public spending – 6–7 per cent of GDP – high enrolment rates and levels of educational attainment. Following independence spending on education jumped in 1992 to about 9 per cent of (a much smaller) GDP but then gradually decreased to just around 2–3 per cent of GDP. This is extremely worrying considering the economic characteristics of Armenia and those of contemporary, post-industrial growth, which is rich in information and

150


1400 1300

Net international investment position

1373*

1200 1100 1000 900 800 700 600

External debt

500 400

2001

2000

1999

1998

1997

1996

200

1995

300

Note: *At the end of September 2001.

Figure 6.10 The public external debt and net international investment position (mln US$) high-tech and is human-capital-intensive. The numbers are more in line with the general trend of the structure of a transitional economy, with the large expansion of trade and catering and other services and even with increased employment in agriculture. While it is still early to assess the impact of the accumulation of new human capital during the period of transition, Armenia suffered from very serious out-migration: of nearly 700000 people who left the country after 1988, the majority of whom left during 1992–94, 30 per cent were professionals, 39 per cent with vocational education and 16 per cent with secondary education. In Table 6.2 we saw the rapid increase in average years of schooling in Armenia during the Soviet period, ending with an average of 11.7 years for the working population. There is no comparable data for the transition period and Table 6.10 presents the available data on graduates with various levels of schooling. It is observed that the rate of graduation of students

151

Source:

99.6

15.5

11.5

1994/95

99.4

1993/94

Statistics on graduates of ten-year schools.

Students of 10th grade of high school to graduates of 10th grade Students enrolled in tertiary level education after graduating 10th grade as per cent of graduates of 10th grade

Ratio of

18.6

99.8

1995/96

22.6

99.6

1996/97

Table 6.10 Dynamics of human capital accumulation in post-recession period

24.2

85.4

1997/98

23.6

95.0

1998/99

24.5

93.5

1999/2000

26.1

90.3

2000/2001

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of ten-year schools declined until 1997/98 and then turned around. The table also shows that the proportion of graduates going on to tertiary education institutions has been growing significantly. Both are hopefully good indications of positive changes in the structure and quality of human capital, necessary for sustained growth of the country in the modern world. Two areas that depend heavily on the availability of human capital, and are also among the main pillars of growth in general, are R&D and IT. The IT industry in Armenia has experienced comparatively high growth rates during the past several years. This industry has the potential to become a main leverage of growth for the Armenian economy. With high value added, high return on investments, and comparatively low costs, the industry is ideally suited to overcome the negative conditions of the geopolitical, economic and institutional environment of Armenia. While the government took active steps to encourage the development of the IT industry in Armenia, it failed to see the importance of the dissemination and intensive use of IT throughout all other sectors of the economy. This resembles a similar practice of the Soviet government path that contributed to declining growth.

4.

INSTITUTIONAL POLICY AND GROWTH

Economic growth is just one of the indicators that signals how successfully the transition is progressing. In this chapter we tried to emphasize and understand the multifaceted nature and complexity of the process. We tried to balance the presentation of economic theories with an analysis of Armenian economic realities and problems. Different growth theories give different answers to questions which policy-makers ask experts. Analysing our specifics we tried to stress the importance of finding the right balance between short- and long-term domestic policy planning, the importance of proper adaptation – and not blind imitation – of policies to make them work in different settings. The appropriate mix of policies conducive to make Armenian growth sustainable has yet to be determined. After gaining independence, the primary focus of the economic policy of the government has been on ‘first-generation reforms’ of stabilization and structural reforms, but not on institutional reforms. Today, the gains of the first-generation reforms are in danger of being dissipated unless sustained ‘second-generation reforms’, focusing on institutional development, are implemented. The basic problem could be summarized as follows: existing distortionary micro regulations and administrative discretionary practices


153

prevent Armenia taking advantage of the potential gains associated with strong macroeconomic performance. To date institutional development has lagged far behind its economic counterpart, being partly responsible for huge distortions and inadequacies in the Armenian transition. Continuation and completion of institutional reforms, proper public policy directed to alleviate excesses of shock therapy, and externally funded and directed growth can create the necessary impetus for the quest for sustainable development and economic growth of Armenian state and society.

NOTES 1. All figures are officially published by the National Statistical Service of the Republic of Armenia. 2. Sources: 1) Trade, Transport and Telecommunications in the South Caucasus: Current Obstacles To Regional Cooperation, World Bank, 2001; 2) World Bank (2001a) and World Bank (2001b, v.2, p. 89). 3. European Commission: Country and Regional Strategy papers. Country Strategy Paper 2002–2006 National Indicative Programme 2002–2003 Republic of Armenia, http://europa.eu.int/comm/external_relations/sp/index.htm, p. 5. 4. A. Granberg has discussed the issue of autarky of FSU countries. According to Granberg et al. (1993) the contribution of Caucasus countries to the final product of the USSR in 1987 was only 3.4 per cent, while their population share was 5.6 per cent. According to Campos and Coricelli (2000), the corresponding shares for Armenia in 1988, were 1 per cent and 1.2 per cent respectively. 5. If one 1988 rouble is conditionally equal to one US dollar, export volumes in 2001 has fallen more than elevenfold. The share of exports of goods and services contribution to GDP in 2001 was extremely low – 16.6 per cent. 6. Valentey et al. (1993), p. 53. 7. Gutman (1997) and national Human Development Report: Armenia, UNDP (2001), p. 70. 8. Tunyan Bagrat, ‘Shadow Economy in Armenia and Struggle Against It’, PhD thesis, defended in the Economic Research Institute of the Armenian Ministry of Finances and Economy, December 2000, using a method developed by V. Tanzi. 9. The highest rate of growth was observed in 2001 at about 9.6 per cent, while the lowest was in 1997 and 1999 (about 3.3 per cent).

7. Turkmenistan: economic autocracy and recent growth performance Alexandre Repkine Turkmenistan is a largely desert, landlocked country in the Central Asian region that possesses the fourth-largest gas reserves in the world.1 Its oil deposits are also significant. Water is an extremely scarce natural resource in this country. Since both gas and oil are potentially highly marketable commodities in world markets and water is essential for life support, the success of the economy is determined by the efficiency with which Turkmenistan, being landlocked, resolves the issue of access to carbohydrates for world markets while managing its scarce water resources efficiently. The discussion in this chapter centres around these two issues, although the political aspect of the country’s economy is essential as well. Before proceeding to the discussion of those issues in detail, we provide a brief overview of the Turkmenistan economy. The Turkmen population was estimated at 5.5 million by the end of 2001. The GDP of Turkmenistan was valued at US$4.4 billion in 2000 if measured at the official exchange rate.2 In per capita terms that corresponds to about US$800 at the official exchange rate, which is relatively high for the Central Asian region. Wages are low, averaging about US$40 per month in real terms. The Turkmen economy is tightly controlled by the government. Thus, full employment is an officially stated objective, nominal wages and prices are rigid due to the numerous regulations, and private property rights are largely not established, with the private sector accounting for between 20 and 30 per cent of GDP.3 Directed subsidies and state procurement are widespread. Investment in key sectors of the economy is provided by the state and major economic decisions are only taken after approval by President Niyazov.

1. ECONOMIC PERFORMANCE DURING THE FIRST DECADE OF TRANSITION Figure 7.1 displays the evolution of output in Turkmenistan in the first ten years after gaining independence. Output collapse was the common feature 154

155

Turkmenistan: economic autocracy

100% 90% 80% 70% 60% 50%

2000

1999

1998

1997

1996

1995

1994

1993

1992

30%

1991

40%

Sources: Berg et al. (1999); Turkmenistan statistical office for years 1999 and 2000; IMF staff country report on Turkmenistan (2001).

Figure 7.1

Evolution of output in Turkmenistan

of the newly transitional economies of the former Soviet Union. Even against that background, Turkmen output underwent one of the largest contractions in the CIS so that it shed more than a half of its 1990 level by 1997. In the three years from 1998, however, Turkmen GDP grew at an impressive 13 per cent per year on average, so that in the year 2000 it reached 70 per cent of its pre-independence level. In this section we attempt to describe and then explain both the magnitude and the causes of Turkmenistan’s output collapse as well as the reasons behind its remarkably high recent growth rates. We assess the extent to which the key sectors of Turkmen economy contributed to the collapse of output and emphasize the importance of Turkmenistan’s unique initial conditions in forming the mix of those contributions and explaining the extent of output collapse. We then argue that Turkmenistan’s recent high growth rates are mainly explained by the government’s policy of importsubstituting industrialization and infrastructure investments. The content

156


of this section, however, should be put into the context of the economic policies conducted in the country as well as of their implications for the sustainability of the observed economic growth, which are the issues we analyse in section 3. Which Sectors Contributed most to the Collapse of Output? Table 7.1 shows the relative contributions of the key sectors of the Turkmen economy to the collapse of output. According to Table 7.1, agriculture and industry account for more than 60 per cent of the output fall, each of them individually contracting more than construction, transportation and communication, and the unidentified residual. In the next sub-sections we consider more closely the developments in the industrial sector and agriculture in order to understand why these two sectors contracted so much. Developments in the Industrial Sector For most economists the actual extent of output fall in transition countries far exceeded the extent of contraction they had envisioned (for example, Portes, 1994; Roland and Verdier, 1999). Among others, Blanchard (1997) notes: The fact that transition came with an often large initial decrease in output should be seen as a puzzle. After all, the previous economic system was characterized by a myriad distortions. One might have expected that removing most of them would lead to a large increase, not a decrease, in output.

Among the many explanations put forward by the transition literature for the collapse of output in the former socialist countries the process of disorganization seems to be most relevant for the case of Turkmenistan (Blanchard, 1997). Disorganization refers to the phenomenon of breaking inherited production links due to the specificity and/or complexity of the latter. Specificity in this context entails highly specialized products that are not marketable outside of the isolated Soviet-type economic space such as the former Soviet Union or the Warsaw Pact states. Complexity results from a high extent of vertical integration of the production process where the inability of any one member of the production chain leads to its halt. Both specificity and complexity are characteristic of the complex industrial and military sectors inherited by most of the republics of the former Soviet Union. Since Turkmenistan inherited no developed industrial sector, it may appear that the problems of disorganization were of little relevance in

157

18.80 38.25 15.38 35.91 30.88 34.87

19.03 12.56 36.21 36.77 32.59 39.11

GDP growth rates, % Agriculture, % Industry, % Construction, % Transportation and communication, % ‘Residual’, %

38.20 17.79 10.39 31.43 30.27 30.89

1994–95 3.00 3.90 0.06 4.22 0.70 3.97

1995–96

24.00 32.64 29.33 31.74 32.15 32.27

1996–97

55.51 17.09 17.34 35.96 35.40 39.72

1990–97

Source:

Author’s calculations.

Note: For each sector and time period the table reports changes in the real percentage points of the sector’s share in GDP in the base year. See Appendix for a more detailed description.

1993–94

1990–93

Years

Table 7.1 The contribution of key sectors to the collapse of output, 1990–97

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explaining the collapse of industrial output in the republic. Also, given Turkmenistan’s acquired freedom to charge world market prices for its gas makes the observed collapse of industry ever more surprising. Diminishing the share of gas supplied to the traditional gas importers such as Russia and reorienting the exports towards the more lucrative markets of the developed countries appears to have been a natural way for Turkmenistan to avoid the collapse of industry. As we shall see below, however, this reorientation did not happen and in fact, Turkmenistan’s output of its most easily marketable product shrunk drastically during the first years of independence. In what follows, we attempt to demonstrate that the disorganization faced by the Turkmen industrial sector at the outset of transition was not of the specificity or complexity of the type discussed above. It was, rather, the disorganization of access to world markets for its otherwise competitive and easily marketable product. As demonstrated by Table 7.2, during the first six years of independence Turkmen gas production plummeted fivefold, with exports tumbling twice as much. It is interesting to note how domestic consumption of gas (chiefly as the country’s only electricity source) changed little in terms of physical volume but soared in terms of the overall production share of gas. Even if Turkmenistan was charging half of the world market price for its gas in 1997, the gas component of Turkmen GDP was losing in significance ever since independence, as demonstrated by the more than sixfold drop in the US dollar value of exports in the period 1993–97. Contraction of both real production and export value of gas during the period of output contraction was accompanied by the rapid and continuous decline in earnings from gas exports to CIS countries, while export proTable 7.2

Gas production, exports and domestic consumption, 1991–97

Years Total production, million Exports, million m3 Domestic consumption, million m3 Domestic share, % Gas exports, million US$ Implied US$ price per thousand m3

m3

1991

1993

1994

1995

1996

1997

74 500 62 580 11 920

65 317 51 000 14 317

35722 24733 10989

32264 22560 9704

35182 24331 10851

17323 6518 10805

16.00

21.92 1860

30.76 1430

30.08 1292

30.84 1022

62.37 274

36.47

57.82

57.27

42.00

42.04

Note: The 1997 world market price for gas was around US$70 per thousand m3. Source: IMF country report (1998) and IMF economic memorandum (1994).

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Table 7.3 Gas exports to CIS and non-CIS countries, 1994–97 (million US dollars) Years

1994

1995

1996

Armenia Azerbaijan Georgia Kazakhstan Russia Ukraine CIS total

70 212 207 261 136 600 1669

130.8 54.6 53 253.5 159.5 686 1422.4

0.9 11.2 0.2 54.1 1055.5 0.3 1142.2

0.2 29.2 10.5 29 331 1 450

3.9 4.9 68.9 143.6 117.2 14.7 46.7 661.6

12.9 16.9 12.7 79.3 110.2 17.8 104.1 548.9

20.9 123.5 1 51 18.2 2.7 16.2 300.3

Afghanistan Iran Pakistan Turkey Switzerland Germany Hong Kong Non-CIS total

19.8 21.2 0 71.7 39.6 47.9 11.9 507

1997

Note: The apparent surge of Turkmen gas exports to Russia in 1996 results from changes in the accounting system; in that year all exports of Turkmen gas to countries other than Russia were accounted against Russia if the latter provided its pipeline network for gas transit. Source: Turkmenstatprognos.

ceeds from non-CIS countries remained relatively stable, resulting in a substantial decline in the gap between the two (Table 7.3). The data, however, provide no evidence of reorientation of Turkmenistan’s gas exports towards the more lucrative markets. Turkey, Switzerland and Germany’s shares of gas exports declined significantly, with the only non-CIS country sharply increasing its share in Turkmenistan’s gas exports being Iran. The sevenfold increase in gas export value to Iran in 1997 is a result of construction of a pipeline connecting the two countries and, although it was a major breakthrough in Turkmenistan’s way of gaining access to world markets, it was unable to offset the general slump in Turkmenistan’s gas sector. We believe the reason why Turkmenistan was unable to take advantage of the world market for gas was the extremely unfavourable geopolitical situation. In 1991, the year of independence, the only way Turkmenistan could export its gas to the world markets was by using the United Gas Supply System (UGSS) that was originally designed to provide for the gas needs of the former USSR. In other words, Turkmenistan’s ability to sell its

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gas for world market prices depended on the size of the gas exports quota allocated to the republic. The size of the quota was set proportional to Turkmenistan’s share of gas production within the former Soviet Union (which was about 11 per cent) and corresponded to 11 billion cubic metres (bcm) in 1992, which is one-eighth of its pre-transition production level. Although not even once did Turkmenistan try to persuade Gazprom to increase its exports quota, Gazprom was always very reluctant to do so because it is a major low-cost gas exporter itself with long-term commercial connections to Western Europe. Since in the absence of any alternative pipelines Turkmenistan depended on Gazprom for infrastructure access, transportation, and sales negotiations and contracting, there was little Turkmenistan could do in the beginning of transition to increase its gas exports proceeds. In a move to reduce the extent of dependence of Turkmenistan on Russia for gas exports, the government pursued the policy of constructing alternative pipelines for access to existing and new hard-currency markets. The two key projects were chosen to be the TransCaspian pipeline that would ship Turkmen gas to Western Europe via Turkey, and the pipeline connecting Turkmenistan with Northern Iran. Other routes included the pipeline to Pakistan through Afghanistan and possible exports of liquefied gas to Japan through China. However, by 1997 only one of these routes was exploited, namely the southern pipeline to Northern Iran. The construction of this pipeline was completed in 1997 and, although its capacity amounted to 4 bcm, the actual exports hardly reached one-third of this volume due to the undeveloped gas distribution grid in Iran, which naturally imposed demand constraints. Even then, with Iran experiencing payment problems, part of the Iranian debt for Turkmen gas was settled by barter arrangements. The TransCaspian pipeline would connect Turkmenistan with the Turkish distribution network, allowing it to export up to 30 bcm per year, or nearly 30 per cent of its pre-transition gas exports volume. However, the geopolitical constraints related to that construction project proved to be so severe that construction never began. Since Turkmenistan has no land border with Turkey, the only way to connect to the latter’s distribution network is by constructing a pipeline that would run under the Caspian sea and reach Turkey through Azerbaijani and Georgian territory. Since the construction costs were estimated to be too high for Turkmenistan to cover by itself, production-sharing agreements (PSAs) were concluded with two American companies PSG that is jointly owned by two American companies. Credit Suisse First Boston agreed to act as the financial advisor, while Royal Dutch Shell intended to do upstream development and gas deliveries. The comprehensive agreement between the above parties, however, was

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never concluded because of the continuing row between Turkmenistan and Azerbaijan over the undetermined sea border status of the Caspian Sea and the dispute over the transit fees charged by Azerbaijan. Thus, Azerbaijan insisted on a 50 per cent transit fee, while Turkmenistan, arguing that would render the TransCaspian pipeline project a loss-maker, offered a 30 per cent fee instead. The dispute was never resolved. Apparently as a result of perceived uncertainty as to the outcome of these disputes, the Western contractors withheld their participation in the project before any sensible agreement was signed. The remaining option was the pipeline to Pakistan through Afghanistan, but continuing political instability in the region made it impossible for Turkmenistan to find investors for the project. Thus, Turkmenistan’s unfavourable geopolitical conditions made it very difficult for the republic to reorient its gas exports towards lucrative hardcurrency markets, even when the construction of alternative pipelines was physically feasible and it was possible to find investors willing to finance their construction. Being unable to access the hard-currency markets directly, Turkmenistan remained heavily dependent on its traditional gas importing partners for its hard-currency earnings, substantially limiting its ability to receive hard currency for its gas exports. Thus, the provisional agreements Turkmenistan concluded with ITERA (a Russian gas marketing company) stipulated that 50 per cent of the gas exports’ value would be paid in goods (grain being the most frequently negotiated barter payment). However, both kinds of payments were frequently delayed or not paid at all. Thus, in 1997 Turkmenistan was only partially compensated for its 1996 gas shipments, while it received no payment at all for the first quarter of 1997. As a result, all gas exports were suspended by the republic on 26 March, which is reflected in an obvious slump of the Turkmen GDP in 1997 (Figure 7.1). The severity of the gas debt problem for Turkmenistan becomes evident from the fact that the gas debt amounted to 80 per cent of Turkmen GDP in 1996 and 70 per cent in 1997 (Table 7.4). Table 7.4 Gas debts owed to Turkmenistan, 1993–97 (million current US dollars) Years Value of exports Gas exports for transit Net payments due Received % payment due Source: Turkmenstatprognos.

1993

1994

1995

1996

1997

1860.0 287.7 1572.3 657.0 41.8

1429.7 351.4 1078.3 484.0 44.9

1292.3 325.0 967.3 638.0 66.0

1022

273.7

1022 603 59

273.3 27.0 9.9

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As shown by Turkmenistan’s attempts to attract foreign investors into the construction projects of the alternative pipelines (especially the TransCaspian one), the government was well aware of the perils of remaining dependent on Russia for its gas exports as well as of the benefits of reorienting its gas export flows towards hard-currency markets. However, the republic’s inherently adverse geopolitical situation at the outset of transition made it virtually impossible for the government to exploit the benefits of reorientation, thus depriving it of the much-needed funds that potentially could be channelled into the development of the tertiary high value-added sector. We thus suggest that both the extent of Turkmenistan’s collapse of industrial output and the government’s inability to mitigate it are endogenous outcomes linked to the country’s initial conditions. Developments in the Agricultural Sector The agricultural sector performed disappointingly poorly during the first seven years of independence. Production of cotton, Turkmenistan’s key agricultural output, fell more than a half in real terms and its yield per hectare in 1997 was hovering above 50 per cent of its 1991 level. As illustrated by Table 7.5, Turkmenistan’s yields of cotton continuously remained below those for Tajikistan, a country that suffered through civil war after gaining its independence. The comparison with China is even more disappointing. Tables 7.5 and 7.6 show a similar decline in real production and yields for the other basic crops during the period of 1995–97. The inefficient usage of scarce water, shortages of material inputs and difficulties with finding access to the world markets for cotton appear to be the three key factors behind the observed deteriorating performance of the Turkmen agricultural sector. Inefficient usage of water Turkmen agriculture depends heavily on irrigation, with the country’s rivers and the Kara-Kum Canal supplying water. With more than 90 per cent of the country’s territory covered by desert, efficient usage of water is a self-evident matter, which should normally result in the government providing incentives to farms and individuals to use water sparingly. In Turkmenistan, however, water supply has been free during the decade of its independence since in 1991 President Niyazov, apparently for populist reasons, declared the right of every citizen and farm to free access to water. With no charges reflecting the scarcity of water the incentives to use it efficiently are virtually non-existent. The absence of these incentives results in low-quality drainage, inefficient irrigation technology and simple leakages of water because of the worn-out Kara-Kum Canal lineage, resulting in

163 304 826 2.7 5588 14536 2.6

Tajikistan Area, thousand hectares Production, thousand metric tons of raw cotton Yield, tons per hectare

China Area, thousand hectares Production, thousand metric tons of raw cotton Yield, tons per hectare

Data provided by Turkmen statistical authorities.

623 1409 2.3

Turkmenistan Area, thousand hectares Production, thousand metric tons of raw cotton Yield, tons per hectare

Source:

1990

Years

6539 18328 2.8

298 796 2.7

604 1384 2.3

1991

6835 14536 2.1

286 407 1.4

570 1258 2.2

1992

5000 12078 2.4

275 484 1.8

579 1299 2.2

1993

5530 13974 2.5

280 423 1.5

540 1129 2.1

1994

Table 7.5 Cotton production and yields in Turkmenistan, Tajikistan and China, 1990–97

5422 15379 2.8

270 386 1.4

563 1000 1.8

1995

4722 13553 2.9

235 288 1.2

530 437 0.8

1996

4500 14817 3.3.

214 351 1.6

482 635 1.3

1997

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Table 7.6 Agricultural production of basic crops in Turkmenistan, 1995–97 Years Wheat Production, thousand tons Yields, tons per hectare Vegetables Production, thousand tons Yields, tons per hectare Feed crops Production, thousand tons Yields, tons per hectare Orchards and vineyards Production, thousand tons Yields, tons per hectare Fruits Production, thousand tons Yields, tons per hectare Potatoes Production, thousand tons Yields, tons per hectare Corn Production, thousand tons Yields, tons per hectare

1995

1996

1997

896.0 1.6

453.0 0.8

707.0 1.4

199.3 8.4

189.8 8.8

117.8 7.1

460.0 2.1

450.0 2.3

308.1 1.8

199.2 4.2

118.0 2.8

161.2 3.9

376.4 16.4

309.9 14

241.2 12.8

20.5 3.4

21.3 2.8

17.1 2.5

66.0 2.3

15.2 0.8

5.3 0.3

Source: Data provided by Turkmen statistical authorities.

increasing levels of salination of irrigated land. The economic cost of such inefficient water usage is apparently high since increasing salination rates result in increases in the demand for water in order to keep the yields constant. Obviously, in Turkmenistan where water supply is extremely scarce, supply would eventually fail to meet increasing demand, resulting in decreasing yields and volumes of agricultural production. Shortages of material inputs Tractors, cotton-picking machines and fertilizers were key material inputs employed by Turkmenistan’s agricultural sector. Pre-transition Turkmenistan wholly depended on Russia for the supply of machines and to a lesser extent on shipments of fertilizers. After acquiring independence Turkmenistan’s ability to maintain the volume of imports of machinery depended on its ability to generate hard currency with which it could pay Russia or an alternative supplier. This ability was seriously hampered by the


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gas sector problems discussed above, which resulted in the continuing decrease of the number of imported machines as well as the deterioration of their quality. Thus, Turkmenistan was receiving 7500 new tractors per year from the rest of the USSR before 1989. That number dropped to 6600, or 12 per cent, by the next year and has continued to decline ever since. The process of quality deterioration was exacerbated by shortages of spare parts used for maintenance. Similarly to machinery, the extent of Turkmenistan’s dependence on the rest of the USSR for shipments of fertilizers was relatively high.4 With the collapse of the Soviet Union, Turkmenistan’s ability to maintain the inherited level of fertilizer imports diminished due to hard currency shortages, while its demand for fertilizers increased. The reason for that increase was the inefficiently high fertilizer rates inherited from the Soviet time and the continued inefficient usage of water discussed above. The continued increase in salinization of irrigated land entailed a corresponding increase in fertilizer rates, resulting in irrigated land’s deteriorating quality, which naturally contributed to the decreasing real volumes of production. Remote access to world markets Similarly to the industrial sector, Turkmen agriculture produced a readily marketable product that, had world markets been within easy reach, would have generated much-needed hard currency with the start of transition. Also similarly to the industrial sector however, access to world markets proved very difficult to achieve. The only way Turkmen cotton can reach world markets is through the Baltic or Black Sea ports. These ports are in turn only accessible through the Volga-Don Canal,5 whose capacity is limited, so that waiting time prohibitively increases transaction costs. The railway connections to the abovementioned ports were hindered by the underdeveloped railway network in Turkmenistan itself, as well as by the higher freight costs compared to the water route. Turkmenistan’s railway connection to Iran did not exist prior to independence, making the potential link to Turkey and the markets of Western Europe impossible. In the absence of easy access to world markets and the lack of adequate domestic textile plants (in terms of both capacity and technological modernity), the only country the republic could sell its excess of raw cotton to was Russia. Realizing Turkmenistan’s difficulties accessing the world markets and experiencing cash shortages itself, Russia bought Turkmen cotton at prices significantly below the world market ones, thus reducing the agricultural sector’s ability to generate hard currency and offset the effect of inefficient water usage and material inputs shortages.

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2. THE ECONOMIC RECOVERY OF TURKMENISTAN Turkmenistan’s economic growth rates in the period 1997–2000 were among the highest in the world. During these three years the country’s GDP soared to the level of almost 145 per cent of its 1997 value, with yearon-year growth rate in 2000 reaching 17.6 per cent.6 These high growth rates come as a surprise since they cannot be explained by Turkmen gas exports. In 1998 the country did not export gas to the FSU countries at all (following Ukraine’s default on payments in 1997); in 1999 gas exports to Ukraine were also stopped due to the same payment problems, while Turkmenistan’s ability to compensate for reduced exports of gas to the FSU countries was largely constrained by the limited capacity of its only alternative gas pipeline to Iran and the latter’s small market size. We conducted the type of analysis described in the previous section in order to see which sectors of the Turkmen economy were mostly accounting for its growth. Table 7.7 displays the results. Table 7.7 Turkmenistan’s economic recovery: the contribution of key sectors Years

1997–98

1998–99

1999–2000

1997–2000

5.00 5.73 2.32 1.22 0.54

16.00 5.63 7.95 0.81 1.24

17.60 3.40 12.69 0.76 5.88

43.24 15.78 21.48 3.00 9.00

0.16

0.37

5.12

6.02

GDP growth rates, % Agriculture, % Industry, % Construction, % Transportation and Communication, % ‘Residual’, %

Note: For each sector and time period the table reports changes in the real percentage points of the sector’s share in GDP in the base year. See Appendix for a more detailed description. Source: Author’s calculations.

The recovery in industry and agriculture account for more than 85 per cent of the Turkmen output recovery, underscoring the growing importance of the two sectors to the economy. In contrast to the period of decline, however, the developments in the two sectors were not so much influenced by external factors as by the Turkmen government’s specific investment policy aimed at reducing the extent of Turkmenistan’s vulnerability with respect to external demand and supply shocks.

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Table 7.8

Structure of investments, 1995–98

Years

1995

1996

1997

1998

Industry, % Electrical energy, % Oil extraction, % Oil processing, % Gas extraction, % Chemicals, % Light industry (includes textiles), % Agriculture, %

40.0 11.0 8.0 2.0 28.0 0.0 7.0 11.0

38.0 3.0 11.0 8.8 21.0 5.6 25.0 4.6

53.0 10.0 15.0 25.5 17.0 0.5 19.0 3.4

51.0 7.0 14.0 26.0 15.0 0.6 17.8 12.8

Source: Turkmen statistical authorities.

Table 7.8 provides insights into the Turkmen government’s investment priorities around 1997, the year of the biggest output decline. The share of the government’s investment in industry grew by 25 per cent in the period 1995–97, with oil processing and oil extraction being the priority. Investment in light industry, which includes textiles that were underdeveloped during the Soviet period, also grew quickly, gaining ten percentage points in just four years. It is remarkable how the gas extraction industry, the first priority under Soviet rule, attracted continuously less investment funds with the course of time. Investment agriculture on average remained relatively stable. The investment breakdown presented by Table 7.8 illustrates the Turkmen government’s key objective of creating a tertiary, high value-added sector in the economy. Given the difficulties Turkmenistan faced in accessing world markets for its carbohydrate resources, it appears natural for the government to start with the creation of a domestic petrochemical processing sector, which would simultaneously help reduce the extent of Turkmenistan’s vulnerability to external demand shocks. The bulk of the observed increased investment in the oil-processing sector is accounted for by the renovation of the Turkmenbashi (formerly Krasnovodsk) oil refinery that was built in 1943 and was therefore in major need of replacement of obsolete equipment and of changes in the product mix. Thus, instead of specializing in producing the low value-added mazut, the newly renovated refinery is producing more valuable middle distillates. The observed increase in investments in oil extraction mostly reflects foreign investment under PSAs under which the foreign firms invest in the development of new oil deposits and the upgrading of existing deposits, and get paid in crude oil, which they export. As already mentioned, Turkmenistan’s textile sector was underdeveloped during the Soviet period because the republic was viewed as a major supplier

168


of raw cotton, so that the textile plants were given low investment priority, resulting in poor output quality and obsolete equipment by the start of transition. The Turkmen government’s rationale for developing its textile industry was not only to deepen the extent of diversification of the Turkmen tertiary sector, but also to resolve the problem with excess domestic supply of raw cotton. As a result, by 1999 the Ashgabat plant, the country’s largest textile factory, was alone processing around 40 per cent of the domestic raw cotton supply, a remarkable increase from the overall 3 per cent of the domestic raw cotton processed domestically during the Soviet period. Reallocation of arable land away from cultivating raw cotton and towards growing wheat was the key development in Turkmenistan’s agricultural sector during the period starting from the year before the first positive output growth rate was recorded. Attempting to reduce Turkmenistan’s inherited dependence on food imports from the FSU, the government declared a programme aimed at achieving self-sufficiency in grain. Under that programme, the arable area dedicated to wheat increased from 259,000 hectares in 1993 to 650,000 hectares in 1998, with wheat production reaching 1510000 tons, or 300 per cent of the 1996 production level. The selfsufficiency programme resulted in an overall decrease in food imports, thus further reducing the extent of Turkmenistan’s vulnerability to economic fluctuations outside the country.

3. THE TURKMENISTAN GOVERNMENT’S TIGHT GRIP ON THE ECONOMY AND ITS IMPLICATIONS FOR GROWTH Turkmenistan’s economic policies still differ very little from those of the former Soviet Union. While the Central Asian countries in general retained relatively more state control over the economy compared to the other CIS countries, the extent of presidential control in Turkmenistan is no doubt the greatest in the post-Soviet region. In what follows we discuss the key elements of Turkmen economic policies along with their implications for the observed growth patterns. Turkmenistan retained wage controls, price regulations and the system of state procurement from the Soviet period. The Turkmen population is provided with free gas, water, salt and energy up to very generous usage limits and a highly subsidized pricing beyond those. All wages in the republic are effectively pegged to the centrally fixed wages in the state sector through the system of excess wage taxes. In principle, private firms are free to set wages at will. However, private sector wages set in excess of twice the official ‘average economy-wide wage’ are subject to a 60 per cent excess wage tax.


169

The Turkmen government maintains the system of price controls through the Turkmen Commodity Exchange (COMEX) established in 1994. The official purpose of the exchange is to ‘facilitate provision of goods to the economy by matching buyers and sellers, to regulate import and export transactions, to regulate prices in exports and imports contracts and to regulate costs of investment contracts’, among other stated objectives. By law, every transaction in excess of US$5700 at the official exchange rate must be conducted through COMEX, with government officers deciding on the ‘fairness’ of the contract price for both external and domestic transactions including barter. COMEX thus acts as an insurance instrument against sudden movements in supply and demand, contributing to price stability or at least managed inflation. Turkmenistan maintains the mechanism of matching supply and demand for hard currency. In the Soviet-type economy in general, hard currency is not in free supply and exchange rates are artificially pegged. The parallel (often illegal) exchange rate typically far exceeds the official rate. Before the end of 1998, Turkmenistan apparently took efforts to liberalize hard currency markets; commercial banks gained access to the foreign exchange window and any individual was free to sell and buy foreign currency at the commercial banks. The discrepancy between the official and curb exchange rate soared to almost 300 per cent after the Russian financial crisis of 1998, so that the Turkmen authorities closed the foreign exchange window and only allowed purchases of hard currency by ordinary citizens in exceptional cases.7 These days hard currency is traded at the weekly auctions conducted by the Central Bank that matches supply and demand for hard currency. Fluctuations in the exchange rates are avoided by shifting excess demand for hard currency over to the next trading session. By means of this mechanism the official exchange rate has been kept stable ever since the foreign exchange window was closed. The mechanism of rolling over excess demand for foreign currency also cuts the channel through which fluctuations in world foreign exchange markets could influence domestic inflation. Privatization in Turkmenistan never actually took place. There are strong indications that, as of 1999, the private sector in Turkmenistan contributed only insignificantly to total value added. Indeed, out of 2000 firms privatized by 1999, only 4.25 per cent were medium-sized and large firms. Almost all of the other newly private firms were small firms, operating mainly in trade and catering and consumer services (96 per cent of all privatized enterprises by June 1999).8 The small number of manufacturing firms that were privatized are most likely to be loss-making firms whose ability to increase the private sector’s contribution to value added is more than doubtful. It is also worthwhile noting that the share in GDP of the

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Table 7.9 Privatization of state enterprises, 1993–99 (number of privatized units) Years Consumer services Trade and catering Manufacturing Unfinished construction Motor vehicles Total Small-scale enterprises Medium- and large-scale enterprises

1993 1994 1995 1996 1997 1998 13 0 0 0 0 13 13 0

1003 201 61 201 0 0 0 0 0 0 1064 402 1064 401 0

1

1999 (Jan–Jun) Total

45 167 2 0 10 224 219

1 96 3 0 38 138 97

1 89 16 1 0 107 91

2 28 22 0 0 52 30

1266 642 43 1 48 2000 1915

5

41

16

22

85

Source: Turkmen statistical authorities; IMF staff estimates.

trade and catering sector that has the bulk of privatized firms has been shrinking from the already insignificant 5 per cent in 1993 to 3.8 per cent in 1998 (see Table 7.9). In agriculture, land privatization never really occurred, so that farmers heavily depend on the state system of orders and subsidies, are required to grow certain crops and are not allowed to exchange or sell the land. Land in individual ownership only constituted 3 per cent of the total, so that the contribution to GDP of the private part of the agricultural sector in Turkmenistan is negligible. Two state organizations oversee the production and marketing of Turkmenistan’s two key agricultural products: wheat and cotton.9 The two organizations purchase the products at significantly below market prices (Table 7.10). To compensate for the low procurement prices, the two government bodies take responsibility for production and supply of seeds to farmers, provision of fertilizers, purchases of machinery and provision of technical maintenance. The state exercises full control over the two key sectors of the Turkmen economy: the gas and oil sector, and agriculture. All enterprises in the gas and oil sector are fully state-owned and are not subject to privatization. Five state enterprises constitute the sector. Turkmenneftegas is responsible for exports, and the domestic sale and distribution of gas and oil. Turkmengas and Turkmenoil operate the extraction facilities and must sell their output to Turkmenneftegas. Construction works in the sector are the responsibility of Turkmenneftegasstroi, while the determination of new deposits is implemented by Turkmengeologia. None of these bodies, however, is entitled to make independent decisions on development prior-


Table 7.10

171

Procurement prices in Turkmenistan, 1995–97

Years

1995

1996

1997

Cotton procurement price, manat/ton procurement price, US$/ton) Export price, US$/ton

100 000 500 1 300

1000000 246 1520

1000000 240 1585

Wheat procurement price, manat/ton procurement price, US$/ton Export price, US$/ton

38 000 190 212

143000 35 230

400000 96 149

Source: Turkmen authorities.

ities and policies, so that every key decision pertaining to the sector requires the issuance of a presidential decree. Taxation of gas and oil sector revenues is another instrument of control of the sector by the Turkmen government. Under Turkmen law, 50 per cent of gas export proceeds in cash (note that a significant share of gas debts to Turkmenistan continues to be settled in barter, especially in the case of Ukraine) must be submitted to the Turkmen Foreign Exchange Reserve Fund (FERF), while the remaining hard currency must be sold to the Central Bank of Turkmenistan and is then subject to VAT, profit tax, natural resource tax and property tax (Table 7.11). All of these taxes are paid into the state budget, which is equivalent to channelling virtually all gas exports hard currency cash proceeds to the government coffers. The taxation arrangements for oil production are similar to those for gas. Such all-encompassing control by the Turkmen government over the economy obviously has its positive sides. Thus, whereas apart from the lack of investment resources, any transition economy faces the risk of diversion of investment funds away from projects ensuring long-run growth (for example asset-stripping), Turkmenistan’s system of state control over key hard currency sources and over virtually any significant transaction in the economy provides more chances for long-term growth-oriented investments to take place. As we attempted to show in the previous section, the Turkmen government appears to have succeeded in setting sound investment priorities, favouring investments into the tertiary sector and actively seeking ways to circumvent the problem of isolation from world markets for gas and cotton.10 Political and social stability were also Turkmenistan’s unique achievements, although they came at the cost of democratic freedoms.

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Table 7.11


Effective tax rates on key economic sectors, 1998

Economic sectors Gas exports Cash sales 50% payable to the FERF 43% average taxation Non-cash sales 43% average taxation Total effective tax rate on gas exports Cotton fibre 33% allocation to the FERF 32% average taxation of the remaining proceeds Total effective tax rate on cotton fibre exports Oil and oil products Oil proceeds allocated to the budget 35% average taxation of the remaining proceeds Total effective tax rate on oil and oil products

% of total sales proceeds

20 9 26 55 33 22 55 6 33 39

Source: IMF Staff Country Report (1999).

At the same time, Turkmenistan is experiencing the same type of economic problems that led to the collapse of the Soviet Union. Inflationary pressures are huge, with the curb exchange rate exceeding the official one by several times, and a substantial number of prices as well as most wages being controlled by the government. The extent of coordination problems appears to be large and still mounting due to the requirement of every transaction to be registered with the Turkmen Commercial Exchange and the State procurement system in agriculture (Pomfret, 2001). The fact that the Turkmen government writes off on a regular basis (July 2001 was the last time) inter-enterprise arrears amounting to a substantial share of GDP lends indirect evidence to the existence and magnitude of such problems. Finally, the country’s scarcest resource, water, continues to be wasted due to the government’s unwillingness to introduce charges for water usage reflecting its scarcity. That results in rapidly deteriorating arable land quality, creating downward pressures on agricultural output, and potentially resulting in an environmental crisis. As one can see, the Turkmen government did disappointingly little in terms of implementation of market reforms. Large- and medium-scale privatization programmes were not implemented, prices were not liberalized, the Soviet-type system of subsidies and state orders is still in place, and the legal framework ensuring smooth operation of market mechanisms is highly intricate and often seriously lacks enforceability.


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Given the unlimited power over Turkmenistan’s resources enjoyed by President Niyazov, he can be considered as the sole decision-maker facing the resource allocation problem. Resources are to be allocated between investments that start paying-off in the longer run, and investments whose long-run pay off is negligible. The former may include, for example, financing (outsider, large- and medium-scale) privatization, acquiring new technologies and upgrading existing facilities accordingly, subsidizing de novo firms starting up in the high value-added sectors, creating incentives for entrepreneurs to engage in high value-added activities and promoting market reforms in general. Very importantly for Turkmenistan as a landlocked country, funds are needed to ensure its access to world markets for gas by investing in the construction of gas distribution networks that do not depend on those of the Russian Federation. Investments that produce little or no pay-off in the long run include prestigious construction projects, subsidizing loss-makers, ensuring low energy and basic commodities prices, and financing the unnecessarily large bureaucracy. The key question is why President Niyazov’s incentives are such that he apparently prefers to postpone the introduction of market reforms as much as possible, accumulating exactly the kind of problems that resulted in the collapse of the Soviet economy. A seemingly obvious answer would be that an autocrat’s only objective is to extract maximum resources out of his society, which is only possible when the autocrat retains as much control over the economy as possible, and which is what one observes in today’s Turkmenistan. However, maximizing an autocrat’s rents extracted out of an economy does not necessarily preclude retaining full control over the economy. In fact, it was theoretically shown in McGuire and Olson (1996) that the fewer limits there are to the powers of an autocrat, the more incentives he has to ensure the society’s well-being in the (long-run) future. This conclusion stems from a theoretical model that is based on a production function that depends (in a usual Inada-type way) on the amount of public goods supplied by the autocrats. The key idea of the model is that, once the autocrat allocates too much of society’s resources to his own needs at the expense of the public good, he will punitively tax his own future benefit flows. For that reason the autocrat stops taking resources out of society at the point where his marginal losses due to decreased productivity of the society are beginning to offset the marginal benefits he accrues by taking more resources for himself. The authors of the model note, however, that an autocrat prefers to confiscate the society’s resources once he realizes the present discounted value of the resources is less than their spot value. Insecurity of tenure and uncertainty of succession turn the outcome of the model from one of benevolent public good supplier to one of a short-termist rent-squeezer.

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In our view, the above model has strong explanatory power with respect to the observed economic policies conducted by the Turkmen president in the following way. The public good in this context is the propagation of market-oriented reforms and encouraging investments ensuring sustained long-run growth. Obviously, part of the public good in the above context is being provided in Turkmenistan. As already discussed, the government places a high priority on investments into tertiary activities that produce high value added and are conducive to higher growth rates in the future. Investment in gas compressor stations, petrochemical facilities, textile plants and transportation infrastructure are the fields where Turkmenistan’s government has been investing heavily, especially during recent years. Market-oriented institutional reform is the most essential part of the public good that is not being provided by the government. In terms of the model, the president and his government must feel insecure about their ability to hold power in the near future. However, given the highest extent of political stability in all of the CIS, that interpretation of President Niyazov’s economic policies seems to be unlikely. We believe that, in transition countries in general and in Turkmenistan in particular, there exist strong interactions between the composition of public good in McGuire and Olson’s (1996) sense and an autocrat’s perceptions and/or beliefs on the extent of what the two authors call an encompassing and stable interest in the society. In other words, even if both the president and the government realize they are providing the public good suboptimally in society’s welfare function sense, they at the same time lack incentives to increase the level of the public good’s provision (by implementing market-oriented institutional reforms) beyond a certain threshold where the extent to which the government’s interest in the economy is encompassing becomes unacceptably low.

4.

CONCLUSIONS AND POLICY IMPLICATIONS

As we have tried to show in this chapter, the way Turkmenistan manages its natural resources is crucial to the country’s economic prosperity. Overcoming the problem of landlockedness and finding access to world markets on the one hand and efficient use of scarce water on the other, are the key issues on Turkmenistan’s economic agenda. The extent of output collapse and recovery in Turkmenistan are impressive and, we believe, are closely linked to the way Turkmenistan’s government managed its natural resources. Thus, we attempted to show that the collapse of output was caused by a disorganization of access to the tradi-


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tional market for gas. This type of disorganization problem proved hard to resolve due to geopolitical reasons like the instability in Afghanistan and a difficult political dialogue with Azerbaijan on joint usage of the Caspian Sea oil deposits. With reorientation of gas export flows towards hard-currency markets not fulfilled, the government faced difficulties obtaining investment funds for tertiary sector development as well as difficulties obtaining basic material inputs, thus exacerbating the output collapse. We then argue that the collapse of output is an endogenous outcome linked to the country’s initial conditions, rather than a direct consequence of the government’s erroneous policies. Along the same lines, Turkmenistan’s recovery is closely linked to the government’s policy of channelling the available (hard-currency) investment funds into tertiary sector activities such as oil refinery and textiles. While it is essential that Turkmenistan’s speed of recovery must be revised down due to its low starting level of output, the way the government managed the proceeds from its carbohydrate sales played an important role in staging the economic recovery. In not all instances, however, did Turkmenistan’s management of its investment resources contribute to growth. The politically motivated construction projects, such as the international airport or grand monuments to President Niyazov, are just one example of wasteful resource usage. Another instance of resources mismanagement is the wasting of water, the key example being the politically motivated free supply which causes the lack of, or complete absence of, incentives to consume water efficiently. The implications for policy appear to be quite obvious. They include scaling down prestigious construction activities and introducing an incentive system for efficient water usage by, for example, charging for water consumption so that the amount of the charge may reflect water’s opportunity cost. Establishing and then maintaining a relative price system that would reflect opportunity costs is, however, far more serious a problem in Turkmenistan, in that it involves removing much of the state’s tight control of the economy, including wage controls, price regulations, state procurement and exchange rate control. These control instruments obviously introduce sizeable distortions into the relative price system, so that introducing a system reflecting opportunity costs will require removing a substantial part of the controls. The latter seems hardly feasible since, as we attempted to demonstrate before, President Niyazov is determined to keep the current extent of control over the Turkmen economy. The policy implications in this case are far more vague than those related to natural resources management. As we tried to show in section 3, the much-needed institutional and market reforms are the kind of a public

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good the autocratic power in Turkmenistan is not willing to provide, since this provision would weaken their grip on power. Therefore, it appears the type of policy aimed at creating a sound market-oriented relative price system would involve inducing President Niyazov to reduce his craving for power. The latter, however, is beyond the boundaries of economic science.

NOTES 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

The Russian Federation has the world’s third-largest gas resources. The curb (illegal) exchange rate is approximately four times higher than the official one. Compared to Western estimates, such as those of the EBRD, official estimates exaggerate the private sector’s share in the economy. Since chemicals were the most developed tertiary activity in Turkmenistan during the Soviet time, the republic produced some of the chemicals used as fertilizers, but far from all of the chemicals it needed for employment in agriculture. The Volga-Don Canal connects the Caspian and Black Seas. According to the Turkmen Statistical Office, Turkmenistan’s GDP grew by 17 per cent during the period of January–October, 2001. These exceptional cases included medical treatment abroad and official trips among others. IMF data. Turkmenpahta is responsible for cotton, while the Turkmen Bread Association oversees wheat. Of course, there is also evidence of investments whose rationale is beyond economic thinking. Examples include construction of the numerous monuments to the President all over the country, the Ashgabat international airport whose operating capacity far exceeds the current demand for its services, and a series of luxury hotels in the capital that seem to be permanently empty.

APPENDIX This Appendix describes the methodology we used to assess the extent of sectors’ relative contribution to the collapse or recovery of output. We compute a sector’s contributions to real output growth as follows: j s j Y j Ctl t l t l s tYt

where Yt is the index of real output in year t and s jt is the share of sector j in output in year t. By definition, C tj Yt for any t.

j

C tj l C ktl if

and only if sector j’s contribution to growth of real output is greater than that of sector k.

8. The Uzbek paradox: progress without neo-liberal reform Martin Spechler, Kuatbay Bektemirov, Sergei Chepel’ and Farrukh Suvankulov The ‘Uzbek paradox’ which this chapter sets out to explore is this: although Uzbekistan has been very reluctant and slow to adopt the neoliberal economic reforms recommended by the ‘Washington Consensus’, particularly the International Monetary Fund, its measured economic growth has been rapid and robust. By contrast, neighbouring Kazakhstan and Kyrgyzstan have not achieved the economic rebound envisioned by IMF models and advice. Uzbekistan’s comparatively mild transition depression1 can perhaps be traced to its lack of industrialization and lesser need for structural change, yet this very absence of structural change should have led to reduced growth, as has been repeatedly predicted by the IMF, the Economist Intelligence Unit, and other outsider observers.2 Eppur si muove! And yet it grows! As Galileo insisted, such movement requires fundamental re-examination of conventional models of the universe. We believe inclusion of ‘institutional capital’, especially the role of the state in Uzbekistan’s semi-developed and remote situation, is the key omitted variable. While certain policies, including state investment and support of the industrial sector with direct subsidies and credits, may have failed in most other transition countries, they have succeeded better so far in Uzbekistan’s relatively confined setting. What is more, the availability of energy and raw materials, when exported to world markets and taxed effectively, relaxed the financial constraints other countries faced. The ability to do this is evidence of institutional effectiveness. The diversified and dynamic agricultural restructuring in Uzbekistan is another element neglected by most research up to now.3 After briefly discussing Uzbekistan’s role in Soviet economic history, we describe policy during the transition decade in agriculture and industry, analyse the growth record in comparative perspective, describe the important role of the government in Uzbek growth, give our views of the foreign sector, and conclude. 177

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1.


LEGACY OF THE SOVIET PERIOD

Moscow’s main economic goal for Soviet Uzbekistan throughout the planning era (1928–91) was to create a reliable source of cotton fibre, together with some related machine-building and chemical production. Greater specialization in cotton and the achievement of high yields per hectare involved retention of a high proportion of the labour force in agriculture and a relatively low urban–rural income differential. Systematic use of price incentives in favour of cotton led also to a sharp shift in the area sown to ‘white gold’ – particularly irrigated land. Use of material incentives probably explains the relative success of the strategy even though it was implemented within the institutional framework of collective agriculture, an institution which proved to be a hindrance to agricultural growth elsewhere in the USSR and outside. Demand for farm labour, including women and children, and improvement in farm living standards weakened the incentive to emigrate from rural areas to the cities. Industrialization proceeded during the Second World War, when about 100 factories were moved to Uzbekistan, chiefly around Tashkent. During the primacy of Nikita Khrushchev, new chemical and non-ferrous metals plants were established, but investment in Uzbekistan flagged under the stagnation associated with Leonid Brezhnev, as well as under Mikhail Gorbachev’s perestroika. Throughout communist rule, however, considerable progress was achieved in social, health and cultural matters, at least compared with surrounding non-Soviet countries.

2.

POLICY SINCE INDEPENDENCE

President Islam Karimov, an economist who had been a high official of the Communist Party of Uzbekistan, declared that the newly independent state would be the agent of gradual market reforms and increased democracy and openness. Indeed, all the new states of Central Asia devoted their first energies to assuring their integrity and continuity (Islamov, 1998). Karimov’s gradualist policy prevented the economic crises which afflicted Russia, Ukraine and some other CIS countries, where the state did not or could not control asset-stripping, organized crime, ethnic violence and capital flight. New laws had to be adopted on property rights, taxation, banking, joint stock companies, stock exchanges, privatization, antimonopoly regulation, foreign investment and so forth. In East-Central Europe, unlike Central Asia, these laws either pre-existed or could be more easily borrowed from neighbouring countries.

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In Uzbekistan growth has not been the principal objective sought by policy-makers. Considering the likely costs to vulnerable parts of the population of a ‘Big Bang’ growth strategy, any poor country would hesitate to risk it (Roland, 2000, Chapter 6). Instead, stability, equality and political sustainability have been priority goals, endorsed both by the Uzbek elites and by public opinion (Islamov, 2000, pp. 117–18). During the early years of transition, for example, price liberalization had to be temporarily reversed to ration basic food commodities and prevent large-scale export of such vital items. From 1991 for two years, while the country was still in the rouble zone, as advised by international agencies, a loose monetary policy led to trade deficits and excessive external borrowing – a situation which the Russian Central Bank terminated in 1993. Introduction of the new soum currency allowed Uzbekistan to begin an independent monetary policy, to exercise more control over banks, and to reduce its rate of price inflation. Subsidized or free loans to enterprises were reduced, and most prices released. The notion of Uzbek procrastination in adopting stabilization reforms is thus not fully justified by facts. Key to Karimov’s success was control over gold and uranium mining and receipts from the export of cotton procured at prices fixed by the authorities. In 1999, for example, the cotton procurement price was only 21.5 per cent of the world market price. The government then sold it at 85 per cent of the world price FOB at the Uzbekistan border. About half of this export taxation has been offset by implicit subsidies on inputs, water and credits. Such indirect taxation could only be a first step to long-run sustainable growth, however. As part of the ‘Uzbek Road’, the country’s authorities understood that rapid growth would require creating market institutions, a large and viable private sector, functioning capital markets, clearly defined corporate governance mechanisms, enforceable and transparent laws, and a stable, convertible currency (Pomfret, 2000; Spechler, 2000a and 2000b). While maintaining de facto control of many joint stock companies, the government has tried gradually to privatize major enterprises and utilities. Results have been slow to appear, but revenues from such privatization are said to have reached a record US$700 million during 2000. In September 2002 it was announced that 51 per cent of the shares of the national telecommunication operator, Uzbektelecom, will be sold to foreign investors. Transition countries elsewhere have shown that slow privatization of large state enterprises is by no means inconsistent with economic growth, for example in Poland, Hungary and Slovenia (Murrell, 1995). Building on Soviet Uzbekistan’s fairly diversified industrial base, the new government expanded machine-building, wood products and consumer goods plants and pursued self-sufficiency in oil, gas and chemicals, while

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cars and television sets were produced for the first time.4 New institutional forms of control put investible surpluses on a more rational basis. Most state farms were transformed to cooperative or private peasant (dekhan) farms with long-term leases. That did away with the obligation of the republican budget for wage payments on state farms, despite their lower productivity, as compared with the cooperatives. Fixed state procurement orders at low prices have continued, as in Soviet times, with the administrative structure of the former collective overseeing fulfilment of these orders. But procurement prices for cotton and wheat are being raised, and up to 2002 these are the only products still subject to state orders. The government further economizes on agriculture by devoting only 6–10 per cent of capital expenditure to the sector. As an offset, crop rotation, improved irrigation, and soil improvement projects are being considered with the World Bank and Asian Development Bank financing.5 Within the new co-operative framework, personal plots have much increased in size. Household and leasehold sectors produce approximately one-quarter of the net material product in agriculture, especially potatoes, vegetables and meat. Individual farmers may contract with the co-operative to manage actual production, with the collective providing certain services and inputs in exchange for a share of the revenues, especially the abovequota sales revenues. These institutional changes have contributed to the favourable contribution of agriculture to overall growth. In future, maintenance and management of irrigation facilities will be handed over to water users, a change which may improve efficiency in the use of this scarce resource, which is now provided free of charge to producers (Wegerich and Bektemirov, 2001). Cotton ginneries are also to be privatized. The government has encouraged substitution of wheat for cotton, increasing national income and profits despite a resulting loss of foreign exchange revenues (Sirazhiddinov and Ergashev, 1998). During 1999, according to a number of internal studies, Uzbekistan lost US$500 for every hectare transferred from cotton to grain. In the year 2000 an extra 100000 hectares shifted into grain production would cost the country approximately US$50 million in foreign exchange.6 This substitution, however, would seem to economize on water, at least as long as grain does not have to be heavily irrigated. Efficiency of the substitution differs by region, of course. In some areas, such as Syr Darya oblast, farmers do not have sufficient labour to sow cotton on their entire acreage, while in the heavily populated Fergana Valley substituting less labour-intensive crops would create redundancies and social instability. There, fruits and vegetables may be the best choice. Uzbekistan is already one of the top 20 vegetable oil producers in the world and also ranks among the biggest ten producers of tomato paste, raisins and dried fruit.

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The Uzbek paradox

3.

THE GROWTH RECORD

According to official figures, Uzbekistan’s GDP has grown 4.5 per cent on average from 1997 through 2001.7 Uzbekistan’s official series (Figure 8.1), the only raw material for analysing its growth, are subject to many of the same doubts as elsewhere in the CIS. The country’s statistical apparatus was not prepared for the sudden break-up of the USSR, and the large informal sector which existed, in part illegally, during Soviet times is not properly covered, owing to fear of exposure to taxes and interference from local authorities (Filer and Hanousek, 2000). High rates of inflation make fixed capital data the most hazardous. Selowsky and Martin (1997a), however, argue that correction for the unofficial economy does not affect analysis of the determinants of growth. Indeed, correction of the official data by fixed electricity input–output coefficients confirms the relatively shallow transition depression for Uzbekistan for the first four years but does not work well after 1995, owing to structural changes in many of the transition economies, including Uzbekistan. 120

100

80

60

40

Figure 8.1

Growth of real GDP, Uzbekistan, 1975–2001

2001

1999

1996

1993

1990

1987

1984

1981

1978

0

1975

20

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Table 8.1 Economic growth of Uzbekistan 1996–2001, by contributions of major sectors (%) Years GDP growth Industry Agriculture Transport and communication Construction Trade Other services Net taxes increase

1996

1997

1998

1999

2000

2001

0.70 0.32 1.28 0.03

5.20 0.35 1.56 0.33

4.40 0.34 1.05 0.30

4.40 0.15 1.56 0.22

4.00 0.04 2.24 0.20

4.50 0.62 1.36 0.11

0.05 1.60 0.47 0.40

0.21 1.42 0.92 1.05

0.46 0.90 0.61 0.73

0.31 0.80 0.64 0.70

0.36 0.71 0.81 0.36

0.38 0.51 0.75 0.77

Source: S. Chepel’ (1998) and update by private communication.

Chepel’ (1998), a researcher in the agency responsible for these data, considers the aggregate GDP and its branch structure to be fairly reliable, but the labour resource data less so. Alternative calculations performed within the Ministry of Macroeconomics and Statistics confirm the growth rates for GDP, personal consumption and government purchases of goods and services for 1995–2000. Fixed capital series are not regularly available for Uzbekistan after 1992, but statistical surveys are made infrequently and used to interpolate a smooth series. Nonetheless, Chepel’ believes the fixed capital series represents an overestimate. Hence the share of growth attributable to factor productivity – most likely sectoral shifts – would be even higher than presented below. A decomposition analysis of growth for 1996–2000 (Table 8.1) shows the crucial role of agriculture and services in accounting for the sustained and fairly rapid growth of the overall Uzbek economy. As compared with the early years of the 1990s, agriculture has accounted for about one-third of Uzbekistan’s overall growth, while trade and other services continue to be disproportionate contributors. Together with net taxes, which finance government services, the service sector accounted for about 58 per cent of total growth. The industrial production contribution decreased from 23 per cent of the growth increment in 1990 to about 3 per cent in 1999 before recovering to 15 per cent in 2001. Industry has fallen from 26 per cent to only 13.8 per cent of output, while services have increased their share from 26.3 per cent in 1990 to 37 per cent in the year 2000. Ignoring cycles, agriculture retained its share of output. Since measured labour productivity is almost twice as high in industry as in the economy as a whole, any decline in industrial share clearly will reduce the overall labour productivity.

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An econometric model8 of the growth dynamics for 1975–2001, constructed by Chepel’ (1998 and updates) on the basis of official statistics and IMF alternative estimates, showed an obvious break between the 1975–90 Soviet period and the subsequent experience for the entire period: Rate of growth of GDP0.26 (growth of fixed capital)0.54 (growth of labour) – 0.14 (dummy). R2 0.90, DW0.91. Only the dummy variable, set at one for 1991–2001, is significant at the 5 per cent level. The factor growth rates are marginally significant at the 10 per cent level. In contrast to the pre-transition years 1975–90, a noticeably greater instability revealed itself since 1991–92 in the GDP, investment, export and personal consumption series, but not in employed labour or fixed capital. The fixed capital series has remained about constant, as has energy consumption after a significant fall during the first half of the decade. Gross production in agriculture, influenced by water consumption, has a close connection to GDP, confirming its continuing role in the growth of Uzbekistan’s economy. During the first years of transition, 1991–95, overall productivity fell, while consumption retained more of its trend until incomes could no longer sustain that rate of increase. Using a standard Cobb-Douglas approach to calculate the residual, or total factor productivity (TFP): TFP(per cent change in real GDP) – (per cent change in labour) – (1– ) (per cent change in fixed capital). For the period of transition depression, when Uzbekistan’s GDP fell by about 4.2 per cent a year – considerably less than other CIS countries, as mentioned above – it is not surprising that total factor productivity explains much of the decline. Fixed capital and labour declined 1.2 and 1.3 per cent respectively, while TFP declined 2.93 to 2.96 per cent, depending on the choice of . The decline can be explained, in our opinion, by considerable macroeconomic instability, inexperienced state institutions and frictional losses from sectoral shifts. Once growth restarted in 1996, factor productivity was again a major contributor, as also occurred in neighbouring republics. For 1996–2000, GDP advanced 2.78 per cent on average, while fixed capital gained only 0.24 per cent and labour years continued to grow at a rate of 1.4 per cent yearly, leaving TFP growth of 2.1 per cent (with fixed capital coefficient, 1 – , taken as 0.6) to 1.68 (with 1 – set at 0.25). This was much better than the estimated 0.76 per cent rate for the 1975–90 period.

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Industrial production is, of course, an important factor for long-term sustainable growth, even though it has been a relatively modest contributor to Uzbekistan’s growth so far. Using the year-on-year quarterly figures for gross output of industrial products, deflated by the producer price index (1996100), growth since 1997 has been about 6 per cent per year, with the chemical and petrochemical industry (9 per cent) and the important light and food industries (11 per cent and 9 per cent respectively) the biggest contributors.9 Analyses conducted in the Ministry of Macroeconomics and Statistics indicate that established industries suffered from reduced investments and higher taxes, while the much smaller de novo and joint venture enterprises were handicapped by low levels of foreign investment10 and difficulties in securing foreign currency (Chepel’ 2001).

4.

COMPARATIVE ANALYSIS

Using the official figures, the transition depression in Uzbekistan was comparatively mild, –16.5 per cent from the previous peak of GDP to its trough in 1995. The comparable figure for the CIS as a whole was –38.5 per cent. Russia’s decline was (at least) –30 per cent; Ukraine’s –55 per cent; Belarus’s –32.7 per cent; and Kazakhstan’s –29 per cent. The war-torn economies of Armenia, Georgia and Tajikistan suffered even more. By now a number of researchers have attempted to explain the relative performance of the transition economies, both European and Asian. The most frequently mentioned is a single-equation model developed by World Bank economists and subsequently updated (De Melo et al., 1996). In this model the neoliberal reform programme is taken as the core of the right-hand independent variables. For example: Growth rateconstant – 9.02 (war dummy)** – 1.06 (inflation rate)* – 0.11 (fiscal balance)2.0 (small-scale privatization index)*5.98 (price liberalization index)**, where the explanatory variables are mostly significant at the 5 per cent level (*) or 1 per cent level (**), and the adjusted R2 is 0.484 for a sample of 18 Eurasian countries over nine years from 1989 to 1998. It is clear that such an approach underexplains the Uzbek growth record (Castanheira and Popov, 2000). When distance from Vienna and independence are added to the regression, essentially differentiating former Soviet Union countries from those of East-Central Europe, the background regression improves, but of course the Uzbekistan paradox is even more anomalous. Adding initial income as a negative factor would seem to help with

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Uzbekistan, but fails to deal with the later success of Slovenia, Poland and Slovakia. The definition and independent role of policy variables are very controversial in the literature. Heybey and Murrell (1997) and Roland (2000) make the point that policy choices may be endogenous, so that countries with good initial or political conditions can choose a more ambitious policy regimen, while poorer countries in difficult circumstances may not. In a more recent publication, World Bank economists have employed principal component analysis to allow initial conditions to influence both performance during the first five years of transition (1992–96 for the FSU) and liberalization of prices and entry into the private sector (De Melo et al., 2001). Their index of cumulative liberalization (lagged one year)11 explains a significant part of the variance in growth rates (14–20 per cent), while initial conditions (8–14 per cent) and war (12 per cent) also are significant. The first principal component, interpreted as representing ‘macroeconomic distortions’ (years under central planning, trade dependency, repressed inflation, distance from prosperous neighbours, and recent independence) emerges as a robust explanation of low growth and high inflation. The second principal component – high incomes, ‘overindustrialization’ with poor natural resources – is less salient, except in the reduced form system. Reference to these two artificial variables does explain the relatively mild transition recession in Uzbekistan through 1996. It also appears in the World Bank study that large macroeconomic distortions – which mark the countries of the FSU most distinctly – make the choice of liberalization less likely. That being so, this sophisticated study may still suffer from selection bias if countries most likely to succeed (for many reasons, some omitted) are just the ones who choose rapid liberalization.12 Possibly in recognition that the earlier neo-liberal model failed to explain the Uzbek ‘puzzle’, Zettlemeyer (1998) had also introduced additional variables to explain the mild transition recession in Uzbekistan, namely, underindustrialization and self-sufficiency in energy. Zettlemeyer failed, however, to explain subsequent growth. We agree with the World Bank authors that Uzbekistan’s readily exportable agricultural and mineral products were a key to its mild transition recession, but point out that significant institutional effort had to be made to maintain that production and redirect the export. What is more, we deny the premise of the IMF approach, which puts growth of GDP as the main success indicator for transition economies, when in Uzbekistan equality and stability were the conscious choice of the government. Another approach to explain the growth record of all the transition countries (including China and Vietnam) has been taken by Vladimir Popov (2000). He, too, tries to explain growth, but introduces two new elements:

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the measured ‘distortion’ of the prior economy and maintenance of order. One typical equation of Popov’s approach is: Growthconstant – 0.007 (distortions from ‘normal’ structure)* – 0.37 (war dummy)* 0.011 (decline in government spending)* – 0.018 (liberalization) – 0.14 (inflation)* 0.046 (rule of law index/democracy score)*, where* denotes significance at the 9 per cent level and the adjusted R2 0.87 for 28 countries – growth over 1989–96. Once again, inflation and war appear as negative factors, as is obvious in view of the experience of Armenia, Azerbaijan, Georgia, Moldova and Tajikistan. Note that, with these other regressors, liberalization appears with the wrong sign and is not significant. The Popov approach does fit the Asian experience better than the IMF’s universal neo-liberalism. Popov credits the maintenance of public sector functions such as education and public health; this helps explain the Uzbek success. But while no one doubts that transition involves changing the structure of the economy from its previous distorted structure, surely the ‘correct’ structure will not be uniform and probably cannot be determined a priori. This consideration introduces fundamental measurement error into the Popov equation, as it did also in the latest World Bank study. In any case, De Broeck and Koen (2000) report only a small reallocation effect on productivity. Furthermore, what counts as ‘rule of law’ for Popov surely differs from culture to culture and is quite difficult to determine from the outside. Asian economies seem to accept informal systems of regulation more readily than Anglo-Saxon and European economies. In Uzbekistan moderate growth was achieved with benefits to most of the population, unlike the strong polarization of incomes seen in many other transition countries. Uzbekistan’s national income per capita at purchasing power parity was estimated by the World Bank at US$2230 in 1999, about half the figure given for Kazakhstan, about US$1000 below Turkmenistan, and slightly below the Kyrgyz Republic. Wages are low, and personal consumption relies on in-kind provision. Households spend nearly 70 per cent of their money income on food. While the income distribution reported at the beginning of transition had been relatively egalitarian – a Gini coefficient of 0.26 in 1991 – it apparently grew to 0.42 by 1997 before diminishing to 0.37 estimated for 1999.13 Although there are still very poor regions in the country, Uzbekistan has had the least growth of the poor as a fraction of the population (24 to 29 per cent) among the five states of Central Asia, and its Gini ratio has risen less than elsewhere in the region.

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The Republic of Karakalpakstan, a region in the west of the country near the Aral Sea, has industrial production per capita less than one-half the average level for the country. The average monthly wage there is reported as US$12–13, hardly enough to buy minimal food. Money income for 1996–99 has been less than 70 per cent of the country-wide average, and retail turnover about half. Besides Karakalpakstan, with its 1.5 million people, the Fergana Valley (population 6 million) is the other depressed area in Uzbekistan. While no reliable unemployment figures exist for the regions of Uzbekistan – registered unemployed are a mere 1–3 per cent – experts generally assess the rate in this region as above 30 per cent and rising. Here more than 80 per cent of personal consumption is accounted for by in-kind provision. In the worst section, Namangan province, with about 2 million inhabitants and high density, only 64 per cent of ablebodied adults were employed in 1997, as compared with 74 per cent for the country as a whole. Its industrial enterprises lack investment, and many farms are in fact bankrupt, existing on handouts from government enterprises and budgets. Because parents cannot give allotments to all of their sons, migration to crowded Namangan City has increased, and its unemployment rate is unofficially estimated at about 50 per cent. As of 1999 Uzbekistan had a population of 24.4 million, having grown at an annual average 2.2 per cent from 1980 to 1999. That rate has decreased in recent years to about 1.3 per cent and is projected by the World Bank to remain steady for the next 15 years, another factor favourable to long-term growth (Barro, 1997). Uzbekistan’s age dependency ratio of 0.7 is comparable to other low income countries. Its infant mortality rate was 22 per 1000 in 1999, a significant improvement from 1990 and much below other countries of its level of income, as was material mortality. Life expectancy at birth is 70.3 years, about at the levels of lower-middle income countries worldwide. Public health measures, such as child immunization and prenatal care, are widespread. Public expenditures on health in 1998 were 3.4 per cent of GDP, comparable to upper-middle income countries, compensating for an undeveloped private sector. Expenditures on education in Uzbekistan, at 7.7 per cent of gross national income for 1994–97, are also very favourable compared even to middle-income countries, although participation of the relevant age cohorts appears to be falling somewhat from previous levels. The United Nations’ Human Development Index for Uzbekistan fell from 1991 to 1994, but less than elsewhere in the CIS, and has since recovered all the lost ground. Thus, public expenditure has moderated the deterioration of money incomes. There is also reason to think that social expenditure is positive for long-term growth in that it reduces opposition among those strata and regions which have been the losers so far.

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5.


AGRICULTURAL DEVELOPMENT

As we have shown, much of the surprisingly good Uzbek growth record comes from growth in the agricultural and trade sectors in recent years. Agricultural stability in the early 1990s accounts for the relatively mild transitional recession in Uzbekistan as compared with the agricultural depressions in Kazakhstan and Kyrgyzstan. In current prices agricultural output accounted for about one-third of GDP until 1994, when it began to fall irregularly to about 30 per cent in 2000. Agriculture employs about 35–40 per cent of the labour force directly, down from 44.5 per cent in 1993. In addition, much of Uzbekistan’s internal trade is in food; rural traders supply the cities of Tashkent, Namangan, Andizhan, Samarkand and Bukhara. Rural employment and prosperity are recognized as crucial for social and political stability in the country. Between 1989 and 1999, the rural proportion of total population grew from just under 60 per cent to 62.4 per cent. The increase in rural labour force probably represented a sharing of available work and an increase in the informal and household sector. Labour is not the limiting factor for the future: water is. Irrigated land covers about 9.5 per cent of the territory of the country, or about 15 per cent of its arable land. This irrigated land takes about 90 per cent of available water supplies and produces 97 per cent of all agricultural output. Annual demand for irrigation water is estimated at 50–55 billion m3. The irrigation system, some 190000 km in length, together with drainage collectors of about 270000 km and 54 reservoirs holding 16 billion m3 at capacity, is crucial to cotton, vegetable and fruit crops. The World Bank reports the irrigation system is deteriorating (World Bank, 1999). Its maintenance has been a crucial governmental responsibility. Long-time specialization in cotton and other irrigated crops has been a principal cause of the desiccation of the Aral Sea. Much-reduced tourism and fishing, together with consequent unemployment and emigration, have resulted. Dust and salt storms have affected the health of the remaining inhabitants and reduced yields of vegetables, cereals, fruits and cotton. In view of declining yields and scarcity of irrigation water, diversification away from cotton would be efficient in many areas of Uzbekistan (Sirazhiddnnov and Ergashev, 1998). Cotton fibre alone furnished between 40 and 50 per cent of exports in the past, about 30 per cent in 1999–2000, earning the country US$884.4 million, but world market prices have fallen. The share of the cotton crop reached 26.5 per cent of total GDP in 1994 before falling off to around 10 per cent in the last three drought-stricken years. Since 1994, therefore, Uzbekistan has been substituting foodstuffs for cotton on marginal irrigated and non-irrigated land. The result is a

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189

halving of the share of foodstuffs in imports between 1994 and 1998. In addition, a major change in technique has restored the role of hand labour in the cotton sector. In the early 1990s machines were used to harvest about 40 per cent of the crop, but by 1996–97, this was reduced to 4–6 per cent, thus reducing the demand for fuel and improving the quality of the fibre. In the Fergana Valley and Bukhara, manual labour is now used exclusively.

6. FISCAL DEVELOPMENT AND SIZE OF THE GOVERNMENT As an explicit part of its transition strategy, the ‘Uzbek Road’, Uzbekistan has maintained a large state sector. Total expenditures have declined somewhat but remain at 30 per cent of GDP. In 1993, state expenditures, still reflecting responsibilities carried over from communist times, amounted to 38.8 per cent, of which 7.6 percentage points (nearly one-fifth of the total) were net social safety net expenditures. In 1994 social safety net spending dropped dramatically to 2.7 per cent of GDP, accounting for the entire drop in total expenditures. Some recovery in both was registered in 1995–96, but since that time the social safety net has accounted for only 2–3 per cent of GDP, much of it going direct to family and children’s allowances, rather than commodity subsidies, which were largely ended by 1995. Social safety net payments, distributed through the neighbourhood or mahallah system, supported social and political stability during the early years of national independence. Besides subventions from regional and local governments, a mahallah receives some voluntary contributions from richer neighbours and a fee for collecting utilities bills (Bektemirov and Rahimov, 2002, p. 477). Neighbourhoods comprise about 500–1500 families, so the elders in charge can knowledgeably and inexpensively target needy older, female-headed and low-education households for assistance. This reduced burden of welfare payments compares with the excessive levels experienced in Kazakhstan, Hungary and Poland. While local governments have been gaining a larger share of expenditures since 1997, the central government still allocates the money according to its own, poorly articulated, priorities (Bektemirov and Rahimov, 2002). Significantly, socio-cultural expenditures have been maintained better than many of the former Soviet republics. Spending on education has stabilized at 7–8 per cent of GDP after a small drop in the earliest years. The social sector increased its share of gross investments rapidly from about 8 per cent in 1996 to 18 per cent by 2000, notably by building new colleges and lyceums. Health and sports still account for about 3 per cent of total expenditures, a small decline despite the fact that Uzbekistan has only a

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rudimentary private health care system. Redirection of government spending to the active population constitutes one positive element of Uzbek long-term growth policy. Direct government spending on the economy has actually grown. ‘Economy’ investments accounted for 2.7 per cent of GDP in 1993; they jumped to about 4 per cent in 1995–99, before falling off to 3 per cent in 2000. ‘Centralized investments’, which had been a mere 2.2 per cent in 1993, rose steadily to a peak of 7.4 per cent of GDP in 1997, before falling off to around 6–6.2 per cent more recently, owing to difficulties with gold and cotton receipts. Considering the difficulties of raising private capital from domestic or overseas sources, the state investments still constitute a critical source of growth for the Uzbek economy. In recent years there has been a noticeable shift in gross investments towards residential facilities and away from the energy sector and transportation and communications, while investments in other industries and agriculture have fluctuated around a stable share. Defence and public order accounts for about 5.6 per cent of total investments, up from 2.6 per cent in 1996. Perhaps as a result, private corruption (‘mafia’) is quite limited by FSU standards, and the shadow economy has not grown, as it has elsewhere in the CIS. ‘It is easier to guarantee property and contract rights, to enforce state regulations . . . with the authoritarian regime’ (Castanheira and Popov, 2000, p. 51). State administration, at least according to official figures, has absorbed less than 1 per cent of GDP. Note that the state budget does not include four extra-budgetary funds for pensions (7.1 per cent of GDP in 2000), employment (0.3 per cent), roads (1.3 per cent) and the State Property Administration (Goskomimushestvo), 0.2 per cent. Extra-budgetary funds have some productive significance, as well as serving as part of the social safety net for the unemployed. The employment fund provides unemployed students with state stipends during retraining. The road fund, financed through payments from business entities and excises on new cars, buses and trucks, serves for building and maintaining this crucial transportation asset. The State Property Fund, which receives the proceeds of privatizations, helps finance the primary budget deficit and promotes small and medium-sized businesses. Of course, extra-budgetary funds, which are obligatory taxes, are administered by government officials. Aside from this efficient pattern of expenditures, the Uzbek government has succeeded in raising sufficient revenues to keep its on-budget deficit below 2 per cent in recent years. This is significant because of the undeveloped financial sector and unwillingness of the public to finance a larger fiscal deficit by buying government short-term bonds (GKOs). Total revenue as a share of GDP has declined a few percentage points to about 30

The Uzbek paradox

191

per cent in 1997–2000; hence the official budget deficit has been 2 per cent since 1996 and was just 1 per cent in 2000.14 The small primary budget deficits have helped reduce the rate of price inflation to its present 20–25 per cent per annum from triple digits earlier in the 1990s – a relative stabilization expected by all studies to improve growth prospects (Barro, 1997). Salaries, pensions and grants have been paid on time, unlike the situation in Russia. Indirect taxes finance about 60 per cent of Uzbekistan’s state budget. Owing to the Soviet-era pattern of low taxation on individuals, the newly independent government has had to rely on business entities to collect its taxes. Private businesses are subject to numerous levies, some of them fees for use of land, water and social infrastructure. There is also an enterprise profit tax, at a current rate of 26 per cent,15 as well as taxes on advertisements and other items. Businesses are responsible for collecting individual income tax,16 pension, unemployment and road fund levies, as well as VAT and excises. Though this gives businesses a temporary cash flow, the multiplicity of taxes, collections and surcharges is often cumbersome and nontransparent, subject to rapid changes of the rates and base of each tax. For example, businesses may not deduct from revenues such items as advertising, entertainment and business expenses above a low maximum, payments on non-bank and term bank loans, and interest payments exceeding the discount rate of the Central Bank. High taxes are one reason businesses have reduced their share of finance for new investments from about 50 per cent in 1995 to 26 per cent in 2000. The tax regime for small and medium-sized enterprises is a good deal simpler, but these enterprises still suffer from their inferior access to foreign exchange and natural resources, together with lesser ability to attract highquality labour. Without government assistance, these enterprises can hardly participate in foreign commerce, except for the informal shuttle trade. Remaining lack of transparency or discretion in tax collection impedes the formation of new businesses, too. The government has tried to offset these handicaps by preferential loans from the European Union’s TACIS programme and from the European Bank for Reconstruction and Development. An internal study by Suvankulov of several Uzbekistan budgetary proportions as compared with the weighted average of the three Asian comparator countries indicated that from 1993–97 Uzbekistan converged to the Asian pattern, but since that time there has been a divergence, owing largely to the greater Uzbek reliance on taxes of goods and services. If one compares the budget structure of Uzbekistan with three Asian countries during a comparable period of their economic development, Malaysia raised 20.6 per cent of its GDP on average in taxes during 1975–95; South Korea, 15.1

192


per cent; and Turkey, 13.4 per cent. Uzbekistan’s markedly higher revenue is more than accounted for by its greater and greater reliance on taxes on goods and services (excises, VAT). The enterprise profit tax has declined as a share of budget revenues since its peak of 10 per cent in 1996 to below 4 per cent in 2000, indicating a certain weakness in the private production sphere, possibly caused by excessive tax burdens or decreasing business turnover. On the expenditure side, South Korea had averaged spending of 15 per cent of its budget on education, somewhat more than Malaysia (13.4 per cent), but much more than Turkey (7 per cent in the years 1975–95). Besides Uzbekistan’s young demographic profile, the comparatively large share of budgetary expenditures on education (24 per cent of the total) reflects an ambitious programme of training. The three Asian countries devoted 36 per cent on (unweighted) average to public educational investments; Uzbekistan’s lower (but rising) share is channelled towards the construction of technical colleges and academic lyceums.

7.

CAPITAL INVESTMENT

Owing to lack of capital replacement during the last years of Soviet rule and the need to adjust to new input prices, renovation and re-equipment of the capital-intensive industries (oil and gas, agricultural chemicals) in Central Asia had reached a critical point by 1992–94. Internal sources of savings would have to replace subventions from the Union budget and, for a time at least, foreign sources. But national savings were small, owing to low or negative expected real interest rates for savers, and largely unavailable for industrial investment. Banks still provide less than 10 per cent of all investment financing (Figure 8.2). According to estimates by the IMF, Kyrgyzstan and Tajikistan hardly managed to keep a positive savings rate at all. Uzbekistan was more fortunate than its poor CIS neighbours to the east. Its savings rate rose from 5 per cent of GDP in 1991 to a reported peak of 24 per cent by 1995 before falling off to a mere 8.4 per cent by 1998 and 5.3 per cent in 1999. But East Asian countries had savings rates during 1980–95 of 30–45 per cent. As expected, national investments followed available savings fairly closely in general trend, but because of lack of savings, Uzbekistan – like Kyrgyzstan and Tajikistan – was forced to borrow from abroad to finance capital renovation projects, especially during the first years of independence. Most of these credits came from multilateral sources such as the World Bank, the European Bank for Reconstruction and Development, the Asian Development Bank, and bilateral credits from donors such as Japan,

193

The Uzbek paradox

120

100

80

60

40

Figure 8.2

2001

1999

1996

1993

1990

1987

1984

1981

1978

0

1975

20

Gross investment volumes, 1975–2001

Germany, Turkey and the USA. Uzbekistan obtained financing mainly in the form of trade credits and commercial bank credits with government guarantees, as well as standby loan facilities from the IMF as of 1995. Because of the high interest rates and short maturity of these credits, as well as low monetization of the economy, loan servicing became a problem almost immediately, and therefore net new loans declined after 1996. Public external debt cumulated rapidly through about 1996 and then levelled off in Uzbekistan at levels much below that assumed by Kyrgyzstan and Tajikistan. The incremental capital–output ratio (ICOR) in Uzbekistan is rather high, 6–7, as compared with 3–4 in the East Asian countries. One reason for this high ICOR is the disequilibrium between the shadow interest rate and the lower rate actually paid. Savers are disconnected with investors, and the governmental agencies often favour enterprises with below-market profit expectations by granting cheap credits and foreign exchange. Observers have credited much of the superior performance in North-East Asia to ‘clear performance criteria for selective interventions and to

194


monitor performance’ as a way of addressing coordination failures, much as French indicative planning was supposed to do. Such targeting required a high quality civil service ‘insulated from political influence’ (World Bank, 1993). While Uzbekistan has many quality civil servants and bank officials, it is not clear that they are sufficiently independent in targeting investment funds. Unlike Kazakhstan and Azerbaijan, Uzbekistan did not attract large amounts of foreign direct investment for development of petrochemical reserves. Despite legislation guaranteeing full repatriation of foreign profits, exemptions from hard-currency conversion requirements, and other tax breaks, FDI has remained rather small, around 1 per cent of GDP. In the present authors’ opinion, the lack of FDI in industry is to be attributed to weak property rights and lack of transparency and accountability, political uncertainty on the borders, high transportation costs to major markets from this double-landlocked country, and past macroeconomic instability.17 Weak business infrastructure outside Tashkent accounts for the heavy concentration of joint ventures in and around the capital. Government officials still intervene in corporate governance, a practice which encourages enterprises to attempt to bribe or lobby corruptible state officials and legislators for subsidies, privileges and import protection, as recently modelled by Acemoglu and Verdier (2000).

8.

FOREIGN TRADE POLICY AND PERFORMANCE

In 1996–97 Uzbekistan instituted a system of multiple exchange rates and restrictions on current account transactions in order to protect its foreign exchange reserves, finance its external debt inexpensively, subsidize basic food imports for the sake of social stability, favour the import of capital goods for industrialization, and protect import-substituting industries, such as chemicals. The two official rates have been maintained at a substantially overvalued rate, requiring the government to enforce supply and restrict demand. Administering Uzbekistan’s restrictions on the import volumes which otherwise would be forthcoming at the official and heavily overvalued exchange rate requires cumbersome and lengthy review of import contracts at the Ministry of Foreign Economic Activity and the Central Bank. The heretofore illegal curb market (and offshore cash market) has reflected the situation: its much weaker soum rate was available to small shuttle traders, tourists and others in small amounts without too much difficulty. The East Asian NIEs (newly-industrializing economies) financed much of their investment booms from export revenues of the order of

195

The Uzbek paradox

US$ 2000–4000 per capita. Export potential encouraged foreign multinational corporations to invest in production of parts and components for assembly in the advanced markets of the world. Despite its desire to emulate this globalization process, Uzbekistan has not succeeded. After some increase in the mid-1990s, Uzbekistani exports are still low, US$200 per head in 1997, about 40 per cent less in 1999–2001, owing to the poor cotton crop and low prices. Exports totalled US$3.3 billion in 2000; imports were similarly reduced (Figure 8.3). 120

100

80

60

40

Figure 8.3

9.

2001

1999

1996

1993

1990

1987

1984

1981

1978

0

1975

20

Export volumes for Uzbekistan, 1975–2001

CONCLUSIONS

Uzbekistan has managed gradual growth of about 2–3 per cent per capita since the mid-1990s with reasonable economic and social stability. It appears that sectoral shifts in the direction of agriculture (and within it) and services explain a significant part of this latter-day growth. While reform of the industrial and financial sectors has barely begun, institutional developments in agriculture and social services have also allowed the

196


country to avoid widespread unemployment and deeper poverty. At first, state support for enterprises, large and small, prevented their liquidation before new ones could develop. The state maintained its Soviet-era system of taxing the surplus in cotton agriculture and gold mining to finance improvements of the infrastructure, educational institutions and energy sector. Without access to private or foreign savings in any great measure, public investment has remained rather large, 20 per cent of the total. Since 1991 the country has achieved self-sufficiency in oil, natural gas, wheat and several other consumer products. This import substitution seems not to have been a serious distortion, given the enforced monoculture of the past. Privatization of the irrigation system, price reform in agriculture, and impending restoration of the convertible soum will allow an objective appraisal of Uzbekistan’s import substitution policy, as well as stimulating new export lines. All these policy measures were carried out by a highly autonomous state apparatus operating within a weakly democratic regime.18 It does appear that the Uzbek record so far bears out the favourable view of the ‘evolutionary-institutional’ model, rather than the neo-liberal one, at least in Central and East Asian circumstances.

NOTES 1.

2.

3. 4.

5. 6.

Uzbekistan’s GDP recession lasted five years, less than anywhere else in Central Asia, with the output level falling back only to the level of the early 1980s. Its industrial output declined only for one year, as contrasted with 6–7 years elsewhere in the region. By 1999 Uzbekistan had achieved 95 per cent of its 1991 output level, as compared with the CIS average of 61 per cent. Its industrial output was 15 per cent higher, as compared with a 46 per cent deficit throughout the CIS (Islamov, 2000, Tables 1 and 2). Jeromin Zettlemeyer (1998) has demonstrated that Uzbekistan’s output and growth performance constitutes a puzzle, as a cross-country model of growth systematically underpredicts Uzbekistan’s growth from 1992 to 1996, even controlling for initial conditions. He finds that the exceptional mildness of Uzbekistan’s depression can be explained by its low degree of initial industrialization, its cotton production, and self-sufficiency in energy, but not the role of public investment. Several authors have argued that initial conditions have had small and declining influence on the growth rates of the late 1990s (Berg et al., 1999). Our findings accord with the ‘evolutionary-institutionalist perspective’ advanced by Roland (2000), who deals explicitly only with Russia, China and East-Central Europe. Crude oil output went from 2.8 million tons in 1990 to about 8 million tons late in the decade, and refining capacity was increased to allow a small export of crude oil and oil products to neighbouring countries. Natural gas output increased from 41 billion m3 to 56 bcm by 2000, allowing about one-third for export. Daewoo produces more than 50 000 vehicles yearly. As of April 2002, the World Bank had expended about US$400 million on water provision, sanitary and epidemiological services, and institutional development of the financial sector. According to Bektemirov’s calculations, a hectare of grain yields 1.98 tons, saving

The Uzbek paradox

7. 8. 9. 10.

11.

12.

13. 14.

15. 16. 17.

18.

197

US$323 in imports, while the yield in cotton foregone would be 2.43 tons of seed and 0.7776 tons of fibre at the prevailing ginning ratio. At a world price of US$1058 per ton, net of transportation costs, the value was US$823, hence a net loss of US$500 per hectare, assuming roughly equal labour and materials costs. The IMF correction of the figure for 1997 reduces the average to 3.9 per cent (EIU, Country Report Uzbekistan, March 2002). TACIS (Uzbek Economic Trends, 2001) gives an average closer to the official one. Chepel’ (1998; 2001a; 2001b) uses a generalized Cobb-Douglas production function with unconstrained exponents. Tests of the sum of and coefficients indicate lack of constant returns to scale. IMF estimates were used for real GDP from 1995 to 2000. TACIS, Uzbek Economic Trends, 2002. Devereux and Roberts (1997) theorize that foreign direct investment in non-distorted sectors could reduce national income when an export sector, for example cotton and gold, is heavily taxed. These authors, however, rely on a specific factor model without unemployment; their scepticism about technological and managerial spillovers relies on studies from Latin American countries long in contact with North American economies. Uzbekistan, moreover, has not tolerated loss of taxable base in agriculture and mining. In transition economies FDI and growth are generally correlated (Selowsky and Martin, 1997b). Contemporary liberalization, however, turns out to be negative, even though it is highly correlated with the lagged variable and a separate test of the ‘last step’ fails to show the supposed negative influence of recent changes. Interestingly, Uzbekistan is seen in this study as more liberalized than expected given its initial conditions and index of political freedom. The authors admit the possibility that their own ratings of liberalization may have been influenced by their knowledge of relative growth performance. By contrast, the 1997 Freedom House Rankings gave Uzbekistan a far worse rating for economic freedom than Kazakhstan, Kyrgyzstan or Russia (Shor, 1997). A similar point is made by Przeworski and Limongi (1993), who remark that attempts to adjust for selection bias, even when data are more abundant and better measured, are rarely robust. For this and other reasons, case studies are essential complements to the cross-section approach. UNDP National Human Development Report, Uzbekistan (Tashkent, 2001) and World Bank, World Development Indicators (various years). The Economist Intelligence Unit estimates the government deficit as 3.2 per cent in 1999 and 4.1 per cent in 2000, and the inflation rates as 29.0 and 24.9 per cent, respectively. The budget deficit for the first half of 2002 was 0.8 per cent of GDP, according to the Finance Minister’s report, while consumer prices rose during the first two quarters at a 25 per cent annual rate. The rate has been gradually reduced each year from its recent high of 37 per cent in 1996. However, one must add 6 per cent of profits for social infrastructure, 2 per cent for city maintenance and 1.5 per cent of revenue for the road fund. The rate has been reduced from 40 per cent in 2000 to 36 per cent for 2001. Experience throughout the transition and developing countries indicates clearly that lower inflation rates, influenced by smaller budget deficits, are associated with higher growth rates, though below a certain threshold level the positive effect is muted. Obviously, this statistical association is consistent with reverse or interaction effects, as effective governments promote both growth and stability. This confirms the suggestion of Przeworski and Limongi (1993), as well as Popov, that a strong state apparatus is necessary to protect investments from premature demands of workers and peasants for higher consumption, to furnish public goods, and to reduce inequality, provided the autocrat himself does not engage in excessive predation. This does not appear to be the case in Uzbekistan, whatever the regime’s other shortcomings (Spechler, 2000a; Pomfret, 2000).

9. Tajikistan’s growth performance: the first decade of transition Khojamahmad Umarov and Alexandre Repkine Tajikistan is located in Central Asia and borders Afghanistan, China, Uzbekistan and Kyrgyzstan. Mountains and highland deserts comprise 93 per cent of its territory. The climate is continental and arid, as a result of the country’s location in the inner part of the continental land mass, far from oceans. The country lies in the common hydrographical basin of the Amudarya and Syrdarya rivers, both of which flow north-westwards into the Aral Sea. Irrigation allows for the production of wheat, cotton, grapes, fruit and vegetables. Tajikistan’s population is around 6.35 million and is growing relatively fast at 1.3 per cent annually and the average family size is large. Rural population prevails and its size relative to the urban one continues to grow, the main reason being the ongoing de-industrialization of the economy. A substantial part of the labour force has migrated to the Russian Federation in search of employment. Real GDP collapsed drastically between 1991 and 2000, contracting by about 60 per cent. GDP per capita fell correspondingly from US$462 in 1991 to US$190 in 2000. The standard of living in the country is thus one of the lowest in the world, with 96 per cent of the population surviving on incomes below the minimal consumption basket. Average monthly wages are US$10.

1. THE EVOLUTION AND STRUCTURAL CHANGES OF OUTPUT, 1989–2000 The Collapse of Output and its Underlying Factors The depth of the decline in GDP is demonstrated by the following data: in 1992, compared to the previous year, GDP fell by 29 per cent, in 1993 by 16.3 per cent, in 1994 by 21.3 per cent, in 1995 by 12.4 per cent, and in 1996 by 16.7 per cent. In 1997 a tendency to increase began, and GDP increased 198

199

Tajikistan’s growth performance

by 1.7 per cent compared to the previous year; in 1998 it increased by 5.3 per cent, in 1999 by 3.7 per cent and in 2000 by 8.3 per cent.1 In the year 2000, the Tajik GDP reached US$1169 million, or about US$190 per capita, making Tajikistan the poorest country in the region. Tajikistan suffered from the civil war that began shortly after the republic gained independence and continued until June 1997. Economic growth in Tajikistan began later than in the other former Soviet republics, reflecting to a large extent the adoption of an Agreement on Peace and National Reconciliation in June 1997. The process of economic growth in Tajikistan was in a significant way affected by the measures aimed at achieving macroeconomic stabilization. Table 9.1 gives an idea of progress made in that area. Table 9.1

Tajikistan: progress with macroeconomic stabilization

Years Inflation rate, %, end of year Budget deficit, % of GDP Balance of payments, % of GDP

1992

1993

1994

1995

1996

1997

1998 1999

1363.8

7343.1

1.1

2131.9

40.5

163.6

3.2

30.5

23.4

5.4

11.9 5.8

3.3

3.8 3.1

18

30.7 20.5

14.6 6.8

5.2

9.3 3.4

30.1

Source: Tajik Statistical Committee.

As Table 9.1 shows, the main macroeconomic indicators show a trend for improvement starting from 1996. However, the sustainability of that improvement, at least in the short run, raises serious concerns for at least the following two reasons: 1) The virtual absence of a competitive environment in the Tajik economy. The antitrust legislation is immature and almost unenforceable. Commercial structures are divided into those which enjoy the support of high officials in the state structures, officials at regional and district level, support of the mafia and criminal groups, and the help of fighters or commanders. Those firms which act on their own, are subject to all kinds of abuse and are exploited by the legal institutions. 2) During the entire decade of 1990–2000 there occurred no real restructuring of the economy that would allow it to adapt to the requirements of the market environment. One of the key reasons behind this lack of deep restructuring is the state’s lack of financial resources and

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consequently, the low investment rating of the country. For example, due to the lack of post-privatization support, the privatized enterprises failed to restructure except nominally. Changes in the product mix are indicative of the regress of production activities away from the higher value-added ones and toward low value-added production. One anecdote tells of a large privatized footwear enterprise taking to organizing small tea-packing production since the latter involved less operating costs. It is thus not surprising to see how the beginning of macroeconomic stabilization of the economy is associated with the deteriorating financial position of Tajik firms. Thus, in 1995, the revenues of enterprises reached 11.5 billion Tajik roubles, while in 1996 the losses exceeded 27.2 billion; by 1997, the first year of observed economic growth, losses exceeded revenues by 71 billion, in 1998 by 99.5 billion, and in 1999 by 64.2 billion. Both agriculture and industry were operating at a loss. Losses in industry proved to be higher than in the overall economy of the country (1996, 28.9 billion roubles, 1997, 81.5 billion; 1998, 107.5 billion; 1999, 86.9 billion). The agricultural sector started operating at a loss in 1998, while in 1999 the losses in this sector grew by 4.4 times. The other unprofitable sectors are trade and housing. The profitable sectors are transport and communications, construction, material and technical procurement and services. Among them relatively high growth of revenue is taking place in transport and communications, exceeding the rate of inflation. In the other profitable sectors, the revenue growth rates fall behind those of inflation, effectively translating into the decline of real profits. However, within some of the sectors, including those with an overall negative balance, some enterprises operate at a profit (Table 9.2). Table 9.2 shows that even in the loss-making sectors most or about half of the enterprises make profits. In industry, about 50 per cent of the firms make profits, while in agriculture their share reaches almost 47 per cent. However, these figures fail to take into account extremely low levels of capacity utilization (in industry it ranges from 0.6 per cent to 32.6 per cent). Developments in Industrial and Agricultural Sectors Developments in the industrial sector were to a large extent affected by the civil war. The effects of the latter included robbery and destruction not only of personal private property, but also of state property, including bank assets. In addition, abuse of military positions took place, resulting in the sell-off of entire enterprises and equipment to other countries. Thus, asset

201

Source:

352 211 141

Industry

Tajik Statistical Committee.

1874 1005 869

Total 496 232 264

Agriculture 285 181 104

Construction 201 109 92

Transport and communication

Profitable and unprofitable enterprises (number of units), 2000

Total Profitable Unprofitable

Enterprises

Table 9.2

96 37 59

Utility

126 52 74

Trade

48 27 21

Consumer services

202


stripping appears to be an essential factor behind the observed decrease in the volume of industrial production. Physical depreciation and growing technological obsolescence are two other important factors explaining the Tajik industrial output collapse. The relatively high growth of GDP in 2000 (8.3 per cent) was achieved mainly through a rapid increase of production and export of aluminium produced by the country’s only gigantic enterprise, the Tajik aluminium smelter. If the growth of production and increased price of aluminium are deducted from the calculation then the annual economic growth in 2000 will have to be substantially revised down. The same refers to the rate of increase of industrial output, which amounted to 10.3 per cent in the year 2000. This increase is almost fully accounted for by the increased production of aluminium by 30.3 per cent as well as by the increase in the world price for aluminium, which averaged 12.4 per cent. No significant changes took place in the volume of output in any other sector. In agriculture the officially reported growth rate of agricultural output in 2000 (12.4 per cent) causes serious concerns. As already mentioned, the main agricultural product in Tajikistan is cotton. Officially, the real output of raw cotton increased only by 6.2 per cent in 2000. As for cereals, severe drought in 2000 reduced output by 46.3 per cent compared to the previous year. In other branches of agriculture (livestock breeding, forage production, tobacco, orchards produce, vineyards and vegetable production) there was no notable increase of production, while in some spheres output decreased. There thus exist serious caveats to the interpretation of the officially reported economic growth rate of Tajikistan. Changes in the Structure of Industry In 2000 the real volume of industrial output only reached 40.6 per cent of its level in 1990. The real volume of fuels sector production contracted by more than ten times during the same period, with the coal mining segment decreasing to 1.7 per cent of its 1990 level and oil production contracting by a third. The non-ferrous metallurgy output lost 40 per cent, machinery and metal processing shed more than 80 per cent, chemicals and petrochemicals output decreased ten times, construction materials decreased more than 30 times, and food and beverages output decreased five times.2 As already discussed, real industrial output declined more than 2.5 times in the period 1990 to 2000. This slump in industrial production was accompanied by changes in the structure of industry (Table 9.3). Only three branches of industry increased their shares in total industrial output: electricity, non-ferrous metallurgy, and flour and fodder. This

203

Tajik Statistical Committee.

100 4.2 0.2 8.0 3.6 6.7 1.6 0.4 3.8 49.2 15.7 5.7 0.9

All Industry Electricity Fuel Non-ferrous metals Chemicals and petrochemicals Machinery and metal processing Wood and paper Glass and china Construction materials Light industry Food Flour and fodder Other

Source:

1991 100 6.0 0.4 28.8 4.2 7.4 0.9 0.5 2.7 31.9 11.8 5.5 0.5

1992 100 8.4 0.6 21.9 3.0 5.9 0.9 0.7 3.7 33.3 11.5 9.5 0.6

1993

Changes in the structure of industry, 1991–2000

Years

Table 9.3

100 4.7 0.6 30.4 3.4 5.8 0.6 0.6 4.9 28.0 10.4 9.9 0.7

1994 100 19.6 0.4 36.7 4.8 3.5 0.2 0.4 2.5 18.0 6.5 7.2 0.2

1995 100 26.3 0.3 31.2 3.6 2.6 0.1 0.3 1.1 14.5 9.5 9.0 1.5

1996 100 11.2 0.3 41.0 3.2 1.8 0.1 0.3 1.0 16.9 13.4 10.2 0.6

1997 100 6.9 0.2 33.3 1.8 1.7 0.1 0.3 0.9 22.7 17.2 14.6 0.3

1998

100 8.7 0.2 49.5 1.6 1.1 0.4 0.3 1.2 13.2 16.1 7.6 0.5

1999

100 7.2 0.2 56.3 1.7 0.9 0.3 0.3 0.8 15.5 10.7 6.1 0.3

2000

204


increase in shares, however, happened against the background of the continuing decrease in the real volumes of production. Thus, electricity production fell from 17597 million Kilowatt hours to 14247 million Kwh during 1990–2000, a 19 per cent decline. Out of 11 non-ferrous metallurgy plants only two are continuing to function (the aluminium smelter and a goldmine). As already mentioned, economic growth during recent years owes much to increases in aluminium prices on the world market and the ensuing increase in aluminium production. The observed increase of the electricity sector’s share in industrial production is closely linked to this since more than 90 per cent of all electricity produced in the country is consumed by the Tajik aluminium smelter. Among those industrial branches severely hit by the economic recession in Tajikistan are construction materials and metal processing. Thus, the share of construction materials in industrial output plummeted from 3.8 per cent to 0.8 per cent during the ten years after transition. In general, the two key industrial components of Tajikistan’s tertiary sector, machinery and metal processing and construction materials, significantly decreased their contribution to the economy. Such a slump in output of the two sectors reflects two phenomena. First, due to the lack of investment funds by the government and the collapse of the Soviet Union, no new industrial enterprises were constructed during the first ten years of transition, although some construction of housing facilities was marginally going on. None of the plants producing concrete, wooden structures or housing construction facilities function any more. At the same time the state appears to put a high priority on enhancing the infrastructure, the most important projects including railway construction, a tunnel, the renovation of landing strips and construction of an international airport in the city of Kulyab. The economic justification of these projects, however, is opaque and most probably reflects political ambitions rather than economic rationale. Thus, the railway has never worked at its full capacity since being constructed and is making losses. The international airport only functions a few days a year during the Muslim hadj period. The collapse of the machines and metal-processing industry appears to be due to two factors. First, even given the large amount of output produced by the Tajik aluminium smelter, there is virtually no domestic market for the output of metal-processing plants that could use aluminium. Second, given the high extent of Tajikistan’s integration into the USSR economy, most of the Tajik machine-producing enterprises were largely dependent on input shipments from the other republics of the FSU. The collapse of the Soviet Union, leading to increases in input prices shipped from outside of Tajikistan along with the increases of railway transporta-


205

tion tariffs, made operation of most of these firms unprofitable, so that many of them were forced to shut down. Changes in GDP Structure After the collapse of the Soviet Union the Tajik economy underwent significant structural changes (Table 9.4). The data on the changes in Tajikistan’s economic structure suggest that the structural changes that occurred during the first ten years of independence were mostly caused by a general decline in material production. The latter’s share in the GDP declined by 19 percentage points, while the share of services gained 12 percentage points. That increase, however, is in no way a reflection of increases in the volume or quality of services in the Tajik economy. The increasing share of services is rather attributable to the substitution of the so-called ‘shuttle trade’ for the stagnating and often non-functioning domestic enterprises producing basic consumer goods. According to some estimates, the shuttle trade accounted for 80 per cent of both wholesale and retail trade activity for some years.

2.

MARKET AND INSTITUTIONAL REFORMS

Privatization The Tajik privatization programme started in 1991 in a political and economic climate that can be characterized by the following key elements: 1. 2. 3. 4. 5

the crisis of the state financial system caused by the collapse of the USSR; disruption of production links inherited from the Soviet period; no market infrastructure such as stock, currency and commercial exchanges, insurance companies and so on; absence of historical experience of a market economy, and lack of the corresponding mentality; buoyant asset-stripping.

The Tajik government formulated the following objectives of the privatization programme: 1. 2. 3.

increased production efficiency due to improved incentive structure; increased state budget revenues; deep restructuring of state-owned enterprises;

206 3.5

4.9

3.8

32.8 20.9 9.0 0.2 31.5

100 62.9

1993

18.5

27.5 19.1 10.4 0.2 42.4

100 57.2

1994

7.5

34.1 36.7 3.2 0.3 27.9

100 74.3

1995

14.6

25.7 36.0 2.6 0.9 27.7

100 65.2

1996

20.5

22.0 32.0 2.8 1.1 33.2

100 57.9

1997

22.1

20.1 25.1 3.8 1.0 42.7

100 50.0

1998

19.7

21.7 25.4 5.4 0.3 40.2

100 52.8

1999

18.3

23.9 27.0 3.4 0.3 37.4

100 54.6

2000

Osnovnyye pokazateli sistemy natsionalnyh schetov [The basic parameters of the national accounting system], Dushanbe (2001, pp. 40–41).

39.3 29.2 9.7 0.8 33.7

25.7 36.4 10.1 0.9 25.4

Source:

100 79.0

100 73.1

GDP Material sphere of which: Industry Agriculture Construction Other branches Services of which: Trade & Catering

1992

1991

Structure of GDP by sector (%)

Years

Table 9.4

207


4. 5.

de-monopolization of the economy; attraction of foreign direct investment.

The government envisioned two stages in the privatization process. The small-scale privatization was supposed to be the testing ground for the implementation of large-scale privatization. The government saw smallscale privatization as a source of funds with which it intended to finance the second stage. The civil war and ensuing destruction significantly slowed down the implementation of the first stage of privatization. Thus, in 1992, 631 state enterprises were privatized, while only 125 were in 1993, the period of escalation of the civil conflict. The maximum number of privatization deals was reached in 1999 at 1460 production units (see Table 9.5). Table 9.5 Small-scale privatization in Tajikistan (number of units per year) Years Privatized firms

1991

1992

1993

1994

1995

1996

1997

1998

1999

36

631

125

325

313

434

686

1175

1460


An important factor affecting the quality of implementation of the Tajik privatization process was the influence on the choice and evaluation of privatized firms exerted by the field commanders waging the civil war. After the truce was sealed in 1997, these commanders assumed high official positions in the new Tajik government and could exert control over the privatization of state property. Naturally, the most profitable enterprises were not privatized on a competitive basis. At the same time, these enterprises were granted generous tax exemptions, worsening the lack of state budget revenues already in place. By 2000 small-scale privatization was practically finished, and gave way to large-scale privatization, which is still in the process of completion. The process of large-scale privatization is facing more difficulties than smallscale privatization due to the following reasons: 1.

2.

the small-scale privatization did not result in increased incomes for the population and, as a consequence, did not increase the investment base; availability of investment credits did not improve;

208


Table 9.6 Privatization of medium- and large-scale enterprises (number of units) Years Medium-scale firms Large-scale firms

1991

1992

1993

1994

1995

1996

1997

1998

5

14

12

11

16

15

70

178

1

5

3

0

2

1

5

74


3. 4.

Tajikistan’s investment rating did not improve, restricting foreign investment inflows; the insufficient purchasing power of the Tajik population is a substantial obstacle to successful completion of the large-scale privatization programme. As evidenced in Table 9.6, progress with large-scale privatization was much more modest than with small-scale privatization.

The actual progress of the Tajikistan privatization process ten years after its launch is rather disappointing. As of 2001, 5835 enterprises had been privatized, constituting 75 per cent of the total state-owned firms eligible for privatization. The small-scale privatization was only completed in 1999. The bulk of the enterprises privatized at this stage consisted of trade, catering and household services firms. Thus, more than 90 per cent of trade and catering enterprises were privatized by 1999. In contrast, only 45 per cent of industrial firms, 19 per cent of firms in construction, 40 per cent in agriculture, and 32 per cent in transport and communications have become private in the course of small-scale privatization. In recent years the share of non-state-owned enterprises in the industrial sector visibly increased, which is illustrated by Table 9.7. Although by 2000 the share of non-state-owned enterprises is substantial in almost all industrial sectors, except for the glass and food branches, the level of labour productivity in the non-state-owned firms stays below that of the productivity levels in state-owned enterprises. That may be influenced by the fact that the Tajik government retained ownership of the most productive and profitable enterprises, while selecting the loss-makers for privatization. The ownership structure of agriculture has also been undergoing changes (Table 9.8). The process of privatization in agriculture usually starts within the state sector itself by conclusion of land and equipment rental contracts by private individuals. Given the adequate performance of a new semi-private farm, it may separate itself from the state farm. The

209


Table 9.7 The share of non-state-owned enterprises in industry in 2000 (%) Enterprises

Share of production units

Share of production volume

Share of employees

71.1 77.0

20.3 10.3

28.9 26.8

89.3 25.9 33.3 42.1

19.4 5.8 62.0 31.7

37.9 12.9 29.2 39.5

49.5 24.1 22.2 71.3

32.1 8.1 2.1 86.2

44.5 11.5 5.7 65.5

75.3 51.7 91.3

86.6 53.1 90.6

67.2 48.3 33.9

Total industry Machinery and metal processing Wood and products Construction materials Glass industry Light industry of which Textiles Sewing industry Leather and footwear Food and beverages of which Food Meat and milk products Flour Source:

Tajikistan Industry, Dushanbe (2000, pp. 21–2).

Table 9.8 The structure of the agricultural sector (%, in current prices of 1999) Years

1995

1996

1997

1998

1999

2000

a) All agriculture State sector Individual plots Farms

44.9 54.8 0.2

38.7 60.3 1.0

40.2 57.4 2.4

39.8 54.9 5.3

34.7 56.8 8.5

34.1 54.9 11.0

b) Plant sector State sector Individual plots Farms

44.3 54.6 1.1

44.3 54.7 1.0

46.9 45.7 7.4

47.5 45.6 6.9

38.8 47.4 13.8

39.8 47.2 13.0

19.0 81.0

13.7 85.2 1.1

11.0 88.5 0.5

9.3 89.9 0.8

7.6 90.9 1.5

c) Structure of livestock sector State sector 16.0 Individual plots 83.9 Farms 0.1

Sources: Statistical Yearbook of Tajikistan Republic, Dushanbe (2000); Socio-Economic Indicators of Tajikistan Republic, Dushanbe (2000, p. 162).

210


state provides land and legal protection for the new private agricultural entities, but in no way financial support. The share of the state sector decreased in the agricultural sector as well as in industry. The most noticeable decline of the state-owned sector in agricultural production is observed in the livestock sector. The increased role of the private sector in agriculture is to be attributed to two factors. First, the ongoing civil war disrupted many of the coordination mechanisms providing supplies for the former state-owned collective farms, resulting in a sharp decrease in the state sector’s agricultural output. Second, apparently realizing the benefits of decentralizing agricultural production in the face of the collapse of traditional supply links, the President of Tajikistan issued two decrees authorizing transfers of 100000 hectares of arable land to the private agricultural entities. That measure resulted in partial restoration of agricultural output levels, as well as in a significant increase of the private sector’s contribution to the country’s agricultural production. The share of privatized enterprises is highest in trade, compared to other sectors of the economy. By the beginning of 2000 the share of privatized firms in retail trade reached 40 per cent. In the first half of the 1990s the process of privatization in trade was going rather irregularly, while in the second half of the decade this process became not only irreversible, but also sustainable. By 1999 the number of privatized retail trade firms reached 2218. In 2000 and 2001 large trade facilities, wholesale warehouses and trading centres were privatized. Retail trade firms are expected to be fully privatized by the beginning of 2002. The private sector in retail trade is being formed not only through privatization of state property. Creation of new (de novo) firms and the growing number of shuttle traders are the other two important phenomena contributing to creation of the private sector. The shuttle traders engage in frequent trips to neighbouring countries and exploit arbitrage opportunities due to price differences. Such activities were allowed in 1996. The share of shuttle traders in total employment in the trade sector constituted 75 per cent in 1999. Shuttle trade activity is of utmost importance to the Tajik economy where the state enterprises are unable to meet the domestic demand in consumer goods. Most clothing, footwear and household items were brought in by shuttle traders from outside of the country during the 1990s. However, there are two major constraints to the ability of shuttle traders to substitute for state provision. Firstly, they have limited access to credit and face very high real interest rates. The second obstacle is the continuing decline in domestic demand due to deteriorating living standards. At present, according to official data, average income is only buying 55.6 per cent of the official minimal consumer basket.

211


Table 9.9

Retail commodity turnover (in prices of 1999, million roubles)

Years

1996

1997

1998

1999

2000

Overall volume Government sector Non-government sector of which: Commercial trade Cooperative trade Informal market

460.8 20.6 440.2

502.2 13.0 489.3

544.9 11.9 533.0

567.8 10.8 557.0

553.6 11.9 541.6

9.0 26.1 405.1

8.0 11.8 469.4

10.7 12.3 510.0

11.8 7.5 537.7

11.6 8.6 521.4

Source: Tajikistan Statistical Committee.

Judging by the data provided by Table 9.9, one can come to the conclusion that non-privatized state retail trade enterprises almost ceased to function. Table 9.9 suggests that the trade volume was on average growing. This growth, however, is likely to reflect the growing importance of imports and the diminishing role of domestic production. The share of state retail trade is very small and only reaches 2 per cent of the total, reflecting the state trade collapse that went along with the collapse of the Soviet Union. In the period 1996–2001, the number of state trade enterprises went down threefold. The Tajik privatization process faced numerous obstacles from its very start. First, credit availability was severely hindered by the fact that Tajikistan abandoned usage of the Russian rouble later than the other CIS countries, and linking the Tajik money supply to that of Russia caused cash shortages. After the introduction of a national currency in 1995, Tajikistan’s banks found it impossible to extend credits to the population due to the highly uncertain financial environment, high inflation rates and the ongoing civil conflict. Second, the lack of prior privatization expertise significantly delayed the creation of privatization institutions. Third, because Tajikistan’s population had never lived in a market economy environment, it had few incentives to acquire state property. Assessing the outcomes of the Tajik privatization process, it is worthwhile citing the assessment of the Russian privatization formulated by one of its organizers, the Russian economist Egor Gaidar: Initially our intention was to start privatizing firms after financial stabilization has been achieved and after the population had accumulated funds to acquire State enterprises with. However, pretty soon it became clear to us that we were nowhere close to achieving financial stabilization in the short run. The problem was, we had to implement the Law on Privatization ratified by the Supreme Soviet. As a result, the country ended up with the owners exerting unlimited

212


control over the acquired property but making little or no contribution to the country’s economic growth.

Foreign Trade Liberalization There exist at least two major factors that prevented Tajikistan from fully exploiting the gains due to liberalization of its foreign trade. First, the competitiveness of Tajik products is generally below world market standards. Second, the country’s landlocked position makes it difficult for Tajikistan to reach hard-currency markets. Table 9.10 illustrates the evolution of trade flows in Tajikistan in the period 1993–2000. Table 9.10 Years

Foreign trade of Republic of Tajikistan, million current US$ 1993

1994

1995

1996

1997

1998

1999

2000

Foreign trade 1206 1038.5 1558.5 1438.2 1496.0 1307.6 1351.8 1455.4 Export 546 491.6 748.6 770.1 745.7 596.6 688.7 779.1 Import 660 546.9 809.9 668.1 750.3 711.0 663.1 676.3 Source:

Annual Statistics in Republic of Tajikistan, Dushanbe (2001, p. 194).

Although Tajikistan does not appear to be experiencing a large trade deficit, we believe there is great potential for improving the trade balance, namely, by creating incentives for import substitution. For example, the majority of plants that were shut down due to financial hardships are technically operational, so that relatively minor maintenance investment is enough to restore these plants’ production activity. Without such investment, Tajikistan is foregoing a lot in terms of domestic output. Thus, to give just a few examples, the capacity utilization rate is 11 per cent in the mineral fertilizer, cement and construction sectors, 0.6 per cent in the meat processing and animal oil sectors, and 1.8 per cent in the dairy products sector.3 A more challenging task would be the reorientation of enterprises’ output flows away from the former Soviet bloc and towards the more lucrative hard-currency markets and the domestic market. For example, intermediate and consumer goods are the ones whose domestic production Tajikistan desperately lacks. Hard as it seems to accomplish the reorientation task, there are already examples of such reorientation. For example, the ELTO plant, which earlier specialized in production of piezo-technical items, has started production of TV sets. The Tajiktextilmash textile machinery plant has started


213

production of spare parts for water pumps for irrigation, and will begin production of pumps of various capacities. Export reorientation away from the FSU markets and towards world markets will be difficult to achieve in the short run. Such reorientation requires significant investments into modern technologies and equipment because most of the Tajik commodities are currently not competitive in world markets. The reorientation policy, however, could already be implemented with regard to the products that can be made marketable with minimal associated expenses incurred. These products are primarily cotton fibre, silk and cotton products and aluminium. Rehabilitation of production of cotton fibre requires investment in repairing the drainage network, decreasing the level of ground waters, prevention of secondary salinization of soil, and repairing hydro-technical facilities such as the irrigation canals. According to some estimates, the increased production of cotton fibre to the level of 900000–950000 tons would increase export proceeds (which are currently standing at US$270–280 million) by the order of three times. The same refers to exports of aluminium, because the Tajik aluminium smelter is in good technical condition, so that only basic maintenance investment is required to increase its current production volume. Thus, by repairing electrolyzes one would be able to achieve an increase of production and export of aluminium by 15–20 per cent compared to 2000, while export revenue would grow to US$500 million. Clearly, additional export revenue would result in an inflow of much-needed hard currency, increasing available investment funds. So far, aluminium, cotton fibre and electric energy are the dominating Tajik exports, while the key imported commodities are natural gas, oil products, wheat and flour. Exports of aluminium, however, have not increased due to the liberalization of foreign trade but are rather due to the renovation of one single enterprise, namely, the Tajik aluminium smelter. The reason is that the economic freedom the smelter acquired due to trade liberalization measures came tainted with the imposition of a host of bureaucratic restrictions. Thus, 11 permissions are required for cotton exports. Obtaining these documents takes between three and five months. These constraints drive transaction costs prohibitively high and increase the Tajik economy’s vulnerability to external demand shocks. For example, cotton farms in the Kulob zone spent five months obtaining licenses to export cotton fibre. During that period, the prices for cotton of mediumlength fibre at the Liverpool cotton exchange fell from US$1343 to US$940, rendering the exports unprofitable. The liberalization of imports did not proceed much differently. Outwardly, the customs and taxation procedures were liberalized, but in accordance with additional instructions, along with the 5 per cent customs duty,

214


the 20 per cent value added tax (VAT) is imposed at the customs clearance. For example, a tobacco factory in Dushanbe imported technological equipment from China for starting the production of high-quality cigarettes, but the factory management being unable to pay the VAT, the equipment was detained at the customs warehouses for more than 14 months. Price and Foreign Exchange Liberalization Tajikistan was among the first CIS countries to liberalize prices and foreign exchange in 1992. However, the creation of a market-based price system was jeopardized by the introduction of distortionary taxation rules. Thus, transportation of a significant number of food product groups across the border of a district within Tajikistan requires a specific permit issued by the local authorities. In addition to that there are numerous charges along the route. As a result, for a significant number of food product groups, such as potatoes, cabbage and carrots, shipment over distances beyond 200 km away from the place of origin renders their sale unprofitable. Despite the fact that numerous presidential decrees were issued in recent years in order to remove these transportation requirements, very few of them were implemented effectively. Price liberalization and the associated closure of enterprises in the beginning of transition led to a rapid growth in prices and to a state of shock in society. Consumer price inflation remained consistently high. Thus, in 1993 it was 2.236 per cent; in 1994, 340 per cent; in 1995, 543 per cent; in 1996, 370 per cent; in 1997, 172 per cent; in 1998, 143 per cent; and in 1999, 126 per cent. As one can see, the inflation rate is gradually decreasing, apparently as a result of measures taken by the government aimed at achieving economic and financial stability in the country, but it may also reflect the decline of the population’s purchasing power. General Progress of Institutional Reforms Inadequate economic growth in Tajikistan is to a great extent related to the insufficient development of market institutions. The privatization programme was flawed by the administrative authorities’ intervention into the process so that mostly loss-makers are privatized. Even if auctions are the dominant privatization method, the existing banks do not allow for credit acquisition based on the economic fundamentals. Credits are extended not on the basis of usual market criteria, but either by the principle of ‘taking the overheads’ (15 per cent of the amount of credit plus the commission of the intermediary) or by orders from above, or by demand of former field commanders who still preserve influence on the


215

economy and the state, or by request of friends and relatives of the bank management.

3. UNEMPLOYMENT AND MASS-MIGRATION OF HIGH-SKILLED LABOUR Downward Bias in the Official Unemployment Estimates Employment in industry underwent a significant contraction (Table 9.11). Employment only increased in non-ferrous metallurgy and electricity branches. The key reason why these branches performed relatively better compared to the other branches is the Tajik aluminium smelter and its exceptionally high levels of electricity consumption. The officially reported unemployment rate in Tajikistan is about 3 per cent. However, several unofficial estimates put the figure at as high as 33 per cent. Table 9.12 presents the official figures on the Tajik labour market. The above data suggest that the official estimates of the unemployment rate are biased downward. Indeed, unemployment rocketed during the period 1992–99 against the background of plummeting output. A lot of employees were put on forced ‘administrative leave’ and were not counted as unemployed. Besides, only those persons registered as unemployed are officially accounted for as such. The Russian-speaking population that comprised the bulk of the industrial production personnel searched for employment outside of the country for both economic and political reasons. In all sectors of the economy, employment is partial. In general, the official data on unemployment appear to fail to reflect the disguised unemployment, providing for a substantial downward bias. Mass Emigration of High-skilled Labour and Ruralization of the Tajik Economy After independence, there occurred a crowding out of high-skilled management by far less skilled persons, appointed to their positions for political reasons. Also, trading in management positions remains a widespread practice in Tajikistan. De-industrialization accelerated the process of ruralization of the Tajik economy. The share of urban population reached its peak in 1972 (38 per cent) when it started to decline. By 2000 the urban share only comprised 26.5 per cent. The crisis in Tajik industry along with the continuing migration of higher-skilled workers out of the country is resulting in the decrease of the total population. Tajikistan’s ruralization can be considered mainly

216

164.9 5.3 2.6 11.8 8.8 30.2 9.6 5.6 69.9 23.9 3.0

1992

Tajikistan Industrial Yearbook, Dushanbe (2001, p. 35).

188.2 5.0 2.7 10.5 8.8 36.4 11.5 8.1 82.8 24.3 3.4

Total industry Electricity Fuel Non-ferrous metallurgy Chemicals and petrochemicals Machinery and metal processing Construction materials Wood paper and wood products Light industry Food industry Flour

Source:

1991

Years 150.4 5.5 2.8 13.2 7.3 24.1 9.1 4.0 65.6 21.3 3.6

1993 140.5 5.8 2.7 13.8 6.8 21.3 8.5 3.4 61.5 19.8 3.0

1994 124.2 5.6 2.1 14.3 6.0 18.4 7.5 2.1 52.0 20.2 3.4

1995 93.3 5.2 1.3 12.3 4.3 17.6 4.8 1.2 34.7 14.9 2.8

1996

Table 9.11 Average annual employment by branches of industry (thousand persons)

85.6 5.2 1.5 14.4 3.2 12.0 3.6 1.0 31.5 12.9 1.6

1997

79.6 5.3 1.2 13.2 3.5 10.4 3.3 0.7 29.4 11.7 1.6

1998

77.5 5.6 1.2 14.8 2.9 9.6 3.4 0.6 29.5 11.0 1.7

1999

71.3 5.5 0.9 12.7 2.8 7.9 3.2 0.7 26.9 11.7 1.4

2000

217


Table 9.12

Tajikistan’s labour market, 1992–99 (thousand persons)

Years

1992

1995

1996

1997

1998

1999

Persons unemployed and seeking employment Including those with status of unemployed Applied to employment service during the year Provided with job during the year Provided with jobs out of total applied Unemployed per vacancy

30.3

64.4

82.9

67.8

66.4

61.4

6.8

37.5

45.7

51.1

54.9

49.7

40.2

39.2

79.6

46.7

47.5

33.2

13.0

14.1

15.4

15.1

15.5

16.2

32.3

35.3

19.3

32.3

32.6

48.6

38.7

10.6

10.7

9.0

9.9

8.4

Source:

Labour and Employment in Republic of Tajikistan, Dushanbe (2000, p. 45).

as a result of mass emigration of the Russian-speaking population, which was largely an urban population. As a result of the civil war going on and the consequent damage to the industrial enterprises (for example assetstripping), the cities started to rapidly lose their ‘industrial’ status, turning into rural areas again. In rural areas themselves, no civil construction was going on during the decade since independence, such as construction of electricity, sewage and gas supply. Two emigration waves that hit Tajikistan during the 1990s were the major factor behind changes in human capital that occurred in the republic. The first emigrants to leave the republic in 1990 were mostly the Russian-speaking population. Adoption of the laws on obligatory usage of the Tajik language in government bodies majorly contributed to the process. Given that the Russian speakers comprised the bulk of the urban areas and were highskilled, the damage inflicted on Tajikistan’s human capital was severe. Another factor contributing to the emigration of Russian speakers was the civil war unleashed by the Islamic fundamentalist groups envisioning the creation of an Islamic fundamentalist state in 1992. The second major outflow of emigrants began in the middle of the 1990s climaxing in the years 1999 and 2000. In contrast to the first emigration wave, this emigration was caused by increasing poverty. The emigrants of the second type mostly emigrate to Russia or Kazakhstan in search of (temporary) employment. The government does little to prevent it since emigration reduces the risk of social unrest by providing an additional source of income. In the absence of official data on this type of emigration most analysts agree that around 1.5 million Tajiks are temporarily employed outside

218


of the country, which is about 50 per cent of the Tajik labour force. A characteristic example would be the village of Sez in Roshtkalin district that consists of 57 households and where 97 villagers have found employment outside the country. Table 9.13 demonstrates that mass emigration of the Russian-speaking population was limited to the cities and not to the rural areas. The net migration is much less negative in the rural areas and remains continuously negative. Mass emigration of the Russian-speaking population was key to decreased utilization of production capacity in all sectors of the Tajik economy, resulting in tumbling production levels. The reason is again the high share of the Russian speakers in Tajikistan’s labour force. Thus, in sectors such as chemicals, petrochemicals, machinery, metal processing, mining and quarrying, construction materials and oil extraction, Russian speakers constituted about 90 per cent of the employees, this figure being 70 per cent in the civil aviation, light and food products industries. It is thus important to count emigration of the Russian speakers as an important factor behind the output fall in Tajikistan, along with the disruption of historical production links caused by the collapse of the Soviet Union. The negative impact of mass emigration of Russian speakers on Tajikistan’s educational potential was tremendous as well. Table 9.14 provides data on emigration by level of education. Among emigrants, 72 per cent had a higher education or a vocational training degree, while the share of Tajikistan’s population with these education levels only reached 39 per cent. Thus, in the course of the 1990s, Tajikistan was deprived of its most educated citizens. Mass emigration distorts the age and gender structure of the population since the bulk of the emigrants is comprised of young males aged between 20 and 40. Thus, a few sociological studies conducted in the Moscow, Novosibirsk, Tyumen and Ekaterinburg retail markets revealed that the overwhelming majority of Tajiks holding a scientific degree engage in doing the most menial work there. There are also accounts of mass female emigration for marriage because of the emigration-related shortage of males in the country. In general, both emigration waves dealt a hard blow to the Tajik economy, resulting in mass closures of industrial enterprises as well as the sharp decrease in productive efficiency of the ones that still function. Restoring the human capital level is thus among the Tajik government’s key policy priorities. However, implementation would put significant pressures on the state budget, which the country is not likely to be able to afford in the short run.

219

Source:

45708 62693 16985 24525 36032 11507 12.9 18.8 5.2 27.2 37.3 10.1 6.5 9.6 3.1

49258 97555 48 297

26816 38836 12020

14.4 25.8 11.4

29.4 58.3 28.9

7.4 10.7 3.3

5.0 8.9 3.9

18.8 66.8 48.0

9.1 26.2 17.1

19486 34785 15299

31255 111065 79810

50741 145850 95109

1992

1993

5.8 12.1 6.3

29.4 59.8 30.4

12.7 26.0 13.3

23344 48469 25125

47922 97477 49555

71266 145946 74680

Gender statistics of the Tajikistan Republic, Dushanbe (1999, pp. 81–2).

70233 98275 28492

1991

76074 136 391 60 137

1990

Tajikistan emigration flows

Total number of persons Inflow Outflow Net flow In the cities Inflow Outflow Net flow In the rural areas Inflow Outflow Net flow Per thousand persons Inflow Outflow Net migration In the cities Inflow Outflow Net migration In the rural areas Inflow Outflow Net migration

Years

Table 9.13

3.5 6.3 2.8

17.7 38.9 21.2

7.5 15.4 7.9

14559 25717 11158

28619 62964 34345

43178 88681 45503

1994

2.4 5.8 3.4

16.8 31.3 14.5

6.4 12.9 6.5

10012 24251 14239

27087 50549 23462

37099 74800 37701

1995

1.7 3.5 1.8

11.6 23.8 12.2

4.4 9.0 4.6

7282 15109 7827

18752 38430 19678

26034 53539 27505

1996

1.3 2.4 1.1

9.3 16.4 7.1

3.5 6.2 2.7

5715 10574 4859

15117 26584 11467

20832 37158 16326

1997

220 1991 100.0 32.00 3.19 35.99 13.59

In per cent of the total negative net migration: 1990

Cities, males, of which: higher education incomplete higher education vocational training high school

100.0 27.80 2.81 41.45 11.65

7493 2 398 239 2 697 1018 812 296 33 8323 2 422 265 3 746 420 714 725 31

16 021 4 454 450 6 641 1867 1 915 690 4 –18 881 4973 577 7 290 3 070 1523 1 425 23

Cities, males, of which: higher education incomplete higher education vocational training high school incomplete high school primary school no data on education Cities, females, of which: higher education incomplete higher education vocational training high school incomplete high school primary school no data on education

1991

Net migration by education level 1990

Years

Table 9.14

100.0 20.34 3.30 34.01 28.93

1992

28332 5 764 936 9 637 8196 2 936 777 86 33260 7164 1120 11453 8 321 3125 1 915 62

1992

100.0 27.20 3.07 32.90 20.14

1993

16671 4534 512 5 485 3 358 2023 719 40 23708 4 923 798 7784 5 915 2 395 1855 38

1993

100.0 21.05 1.87 31.63 32.54

1994

12205 2 569 228 3861 3 972 1 233 339 3 16245 3 364 391 5 377 4903 1280 930

1994

100.0 23.38 1.55 30.70 28.54

1995

8104 1895 126 2 488 2313 963 321 2 12211 2 566 226 3859 3 648 1147 765

1995

100.0 23.74 1.32 28.29 31.04

1996

6512 1 546 86 1842 2 021 805 210 2 10112 1964 187 3162 3428 861 510

1996

221

Source:

11.95 4.31 0.02 100.0 26.34 3.06 38.61 16.26 8.07 7.55 0.12

10.84 3.95 0.44 100.0 29.10 3.18 45.01 5.05 8.58 8.71 0.37

Gender Statistics in Tajikistan, Dushanbe (1999, pp. 96–7).

incomplete high school primary school no data on education Cities, females, of which: higher education incomplete higher education vocational training high school incomplete high school primary school no data on education

10.36 2.74 0.30 100.0 21.54 3.37 34.43 25.02 9.40 5.76 0.19

12.13 4.31 0.24 100.0 20.77 3.37 32.83 24.95 10.10 7.82 0.16

10.10 2.78 – 100.0 20.71 2.41 33.10 30.18 7.88 5.72 –

11.88 3.96 – 100.0 21.01 1.85 31.60 29.87 9.39 6.26 –

12.36 3.22 – 100.0 19.42 1.85 31.27 33.90 8.51 5.04 –

222


4. CONCLUSIONS AND POLICY RECOMMENDATIONS Along with the civil war, disruption of the production links between Tajikistan and the former Soviet republics was the key factor behind the initial collapse of output in the country. Although the conclusion of the Peace Agreement in 1997 gave a major boost to the recovery of output, the problem of disorganization has not been resolved so far, which shows up in the very low rates of capacity utilization of industrial enterprises. On the positive side, the recovery that apparently took off in 1997 was characterized by high growth rates of GDP reaching 8 per cent in 2000 and macroeconomic stabilization that was a direct effect of government policy. It is highly doubtful, however, if the ongoing economic recovery is a sustainable one. Indeed, the two best-performing industrial branches, namely non-ferrous metallurgy and electrical power, owe their success to a single enterprise, the gigantic Tajik aluminium smelter that consumes 90 per cent of the country’s electric power. The machine-building enterprises are still suffering from the absence of intermediate inputs since no replacement has been found for the supply routes that were cut with the collapse of the Soviet Union. Since no new industrial enterprises have been constructed since the start of transition and the existing ones are working far below their capacity or are simply shut down, the Tajik economy is rapidly de-industrializing itself. In terms of market reforms, privatization was almost exclusively limited to trade and catering, while in industry the most profitable enterprises were retained by the state with the loss-makers being prime candidates for private ownership. Price liberalization did not succeed in establishing the relative price system based on opportunity costs due to the numerous and distorting taxation rules, most of which drive transaction costs prohibitively high, even for otherwise profitable businesses. On the labour market side, mass emigration of the high-skilled Russianspeaking population remains a big problem for Tajikistan, along with the high proportion of Tajiks emigrating to neighbouring Russia and Kazakhstan in search of employment. While the emigration of both Russian speakers and Tajiks was significantly influenced by the deteriorating living standards, the adoption of the Law on Tajik Language added an additional spur to the outflow of the Russian speakers. Both types of emigration, being predominantly comprised of working-age higher-skilled males, undermine the quality of Tajikistan’s human capital. In light of these basic developments, we believe the following policy measures would be most relevant:


1.

2.

3.

223

A group of policy measures aimed at resolving the problem of disorganization: a) granting preferential taxation status to intermediate goods-producing enterprises; b) providing maintenance investment funds for technically apt firms. Policy measures for revising the market and institutional reforms: a) major revision of the existing taxation system, for example abolition of the within-Tajikistan, cross-regional taxes; b) facilitate the privatization process of large-scale, profitable enterprises; c) enable access to credit on market principles by revising the existing banking regulations, with a special focus on taxation. Revising the Law on Tajik Language: expanding the allowed areas of application of the Russian language would contribute to the restoration of Tajikistan’s human capital by providing incentives for the Russian-speaking, high-skilled population to return.

NOTES 1. Data from the State Committee for Statistics. 2. Tajikistan Industrial Yearbook, Dushanbe (2001, pp. 13–15). 3. Annual Statistics in Republic of Tajikistan, Dushanbe, p. 148.

10.

Economic growth in Kyrgyzstan Roman Mogilevsky and Rafkat Hasanov

To understand the history, current level and prospects of economic development of Kyrgyzstan it is worthwhile to consider its geographical location, relief, climate, the size and structure of the population as well as the political history and structure of the country. Kyrgyzstan is located in Central Asia; its area is 199.9 thousand km2. It is a landlocked country, so world markets are accessible only through territories of neighbouring countries; to the east on the Chinese border transport infrastructure is poorly developed, and to the south there are centres of political instability. This makes the Kyrgyz economy dependent on the transshipment policy of Kazakhstan and Uzbekistan. Mountains cover more than 90 per cent of the territory of the country, and arable land composes only about 7 per cent of the total area. A majority of the population and larger part of economic activity are concentrated in valleys; the most important among them are the Chui and Fergana valleys. There are two main economic regions in the country – the North and the South. Because of mountains, communications between different parts of the country are quite difficult, for example, railway communication between North and South requires crossing Kazakh and Uzbek territories. The climate is continental, hot and dry. Highly productive agriculture is possible only on irrigated land; for this reason water resources and irrigation have a strategic importance for the Kyrgyz economy. A cascade of hydroelectric stations on the Naryn River supplies a large part of Kyrgyzstan and some neighbouring countries with electricity and water. The population of Kyrgyzstan is 5.0 million people, of which 65 per cent live in rural areas and 35 per cent in towns. The population is rather young, composed of children 38 per cent, working age people 53 per cent and pensioners 9 per cent. The country is multinational – 65 per cent of the total population are Kyrgyz, and the two largest minority groups (Uzbeks and Russians) are about 13 per cent each. From the middle of the nineteenth century Kyrgyzstan was a part of the Russian empire. In 1924 under Soviet rule the first form of national autonomy was established, and in 1936 Kyrgyzstan was transformed into one of the Soviet Union’s republics. This was of great importance for Kyrgyzstan’s 224

Economic growth in Kyrgyzstan

225

economic development, because the attention of the USSR’s central authority to the republic’s needs increased. In 1991 Kyrgyzstan became independent.

1. SPECIFIC FEATURES OF KYRGYZSTAN’S DEVELOPMENT IN THE SOVIET PERIOD At the beginning of the twentieth century, the country was characterized by a very low level of economic and social development. The economy consisted mainly of subsistence agriculture. Adult illiteracy level was close to 100 per cent, and health care almost did not exist. The picture changed significantly during the Soviet period. Moscow’s policy of accelerated development of remote areas resulted in very big resource and financial transfers to these areas, including Kyrgyzstan. Even in 1990 the amount of transfers from the Soviet Union budget (a major, but not the only, source of financial support from the centre) was 10.9 per cent of Kyrgyz GDP. These monies went on the social as well as the economic development of the republic. Forced industrialization with an accent on labourconsuming, agricultural processing and military production enterprises was the prevailing economic policy of the Soviet leadership with respect to Kyrgyzstan. This policy was an attempt to utilize the specificity of Kyrgyzstan: labour abundance, natural conditions and agricultural specialization, and the remote geographical location of the republic (this made expedient the placement of military industrial enterprises in Kyrgyzstan, because the whole military industrial system of the USSR became less geographically concentrated and vulnerable). One of the means of the industrial development of the republic was a large inflow of skilled labour from other parts of the USSR. As a result, by 1990 industry, together with agriculture, had become the leading sectors of the national economy of Kyrgyzstan (Table 10.1).

2.

BASIC FEATURES OF THE TRANSITION PERIOD

Stages of Transformation and Macroeconomic Stabilization In 1992 in Kyrgyzstan, as in other parts of the former Soviet Union, the process of system transformation toward a market economy started, and as in all other republics the Kyrgyz economy experienced a big fall in production at the beginning of the transition. The economy of Kyrgyzstan was one of the most ‘open’ among the economies of Soviet republics. In 1991, trade (exports plus imports) of

226

Table 10.1


GDP dynamics and structure in Kyrgyzstan

Years

1990

1995

2000

In % to In % to In % to In % to In % to In % to 1990 level GDP 1990 level GDP 1990 level GDP Industry and construction Agriculture Market services Non-market services GDP

100.0 100.0 100.0 100.0 100.0

34.1 32.9 18.0 15.0 100.0

28.1 65.6 85.4 43.1 53.0

18.1 40.7 29.0 12.2 100.0

50.1 77.2 114.5 42.1 69.4

24.6 36.6 29.7 9.1 100.0

Source: National Statistical Committee (NSC).

Kyrgyzstan with other Soviet republics was equal to 90.7 per cent of the national income. Analysis of the input–output (IO) table for 1987 shows that imports exceeded domestic production for 56 of the 100 products identified in this table. Imports of another 11 products exceeded 50 per cent of production. Out of the remaining products, exports made up more than half of production. Only for 23 industrial products (less than a quarter of the total number) did the republic have sufficient capacities and market within the republic. Our analysis of sensitivity of 1991 GNP to a 10 per cent increase in all import prices, based on the IO table, demonstrates that such an increase in import prices would decrease output by 5.5 per cent. So, taking into account actual price changes in 1992, one would expect (based on this model) an economic decline of almost 50 per cent. While the linear IO model could not predict accurately the effects of such large shocks as those which influenced the Kyrgyz economy in 1992, this result points to the highly disruptive consequences of the increase in relative prices of import goods for the Kyrgyz economy.1 The real reason behind the growth in import prices was, of course, the end of the Soviet policy of subsidized prices for many goods and services, in particular, energy carriers and transportation. The drying up of other forms of transfers from the central budget of the USSR was another major factor behind the deep economic recession, which started after the initial transformation shock and took several years to overcome. Changes in accumulation of factors of production as well as improper economic management (see next sub-section and section 3) are also responsible for the decline. During the period 1992–95 production almost halved,2 and the living standards of the population went down. Prices for consumer goods jumped up more than 500 times. The


227

national currency, the som, which came into circulation in May 1993, depreciated almost threefold over this period. Different sectors of the economy were affected by the recession to different extents (Table 10.1). Production in the market services sector fell by a lesser extent, and the share of market services in GDP has grown. The same is true with respect to the share of agriculture; it became the main sector of the economy, even though production in agriculture declined substantially. Major losses were in manufacturing, whose production, employment and share in GDP decreased. These negative developments were stopped in 1996, when economic growth recommenced. In 1997 the GDP growth rate came close to 10 per cent, and the inflation rate was much lower (down to 14.8 per cent in 1997). The national currency became more stable. The current government budget deficit was significantly reduced, from 11.5 per cent of GDP in 1995 to 4.7 per cent of GDP in 1997. The balance of payments improved: the negative balance on current account in 1997 decreased by US$96.3 million in comparison to 1995 (exports increased by 14.7 per cent, and imports decreased by 17.4 per cent), and the volume of national reserves increased by US$100 million in the same period. Unfortunately, sources of macroeconomic instability still remained. The relative financial stability during these years was supported mainly by IMF credits, and the impressive growth of GDP and gross industrial product was ensured by the Kumtor gold mine. Besides, the orientation toward traditional markets (first of all, Russia) made Kyrgyzstan sensitive to the consequences of the worldwide financial crises in 1997–98. Procrastinating the realization of numerous reforms stimulated the rise of negative tendencies in the national economy, which, along with the consequences of the Russian crisis, led to the development of an internal crisis in the last quarter of 1998. The rate of economic growth in 1998 was only 2.1 per cent, and this was accompanied by a still high budget deficit. The major reason for devaluation of the som and the slowing down of the growth rate in 1998 was the large external trade deficit, which amounted to 21.5 per cent of GDP. After 1999 the basic macroeconomic indicators in Kyrgyzstan significantly improved. The country went through tough fiscal adjustment, reducing its general government budget deficit from 10–11 per cent in 1999–2000 to 5 per cent in 2001. This allowed for a very significant improvement in the current account balance (to a deficit of just 1.3 per cent of GDP in 2001), deceleration of inflation (the CPI growth rate was 3.7 per cent in 2001), and relatively good GDP growth rates of 5–5.3 per cent in 2000–2001. However, it is too early to believe that the economy has finally achieved a sustainable growth pattern; many problems still persist in the Kyrgyz economy.3

228


Institutional Changes It has been mentioned already that one of the problems the economy faced in the transition years was improper economic management. All government bodies responsible for that were not prepared for the transition to a market economy. Neither understanding of the economic policy tools suitable for market conditions, nor experience of managing an independent economy, existed in Kyrgyzstan in 1991. All necessary government bodies were established or rearranged quickly after gaining independence, including the National Bank, the tax service, customs and so on, but it took a much longer time for these bodies to learn what they should and should not do. One of the remarkable features of economic governance in the Kyrgyz Republic is the instability of the legal environment. This instability is one of the major impediments to economic development, because the rules of the game for economic agents in Kyrgyzstan change too often and do not allow them to establish any long-term vision. While there are other economic governance problems, legal instability could be considered as the one most transparently demonstrating the influence of the institutional environment on economic growth in Kyrgyzstan. Traditionally, expert estimates are used for assessment of various indicators of institutional development (including the legal environment). Obviously, the main feature and the shortcoming of the expert method is its subjectivity. Below, the authors present a method of estimating the stability of the legal system, which attempts to reduce the need to use expert estimates. The proposed approach is based on determining the number of amendments introduced into adopted laws, and the number of laws having become invalid. The ratio of this indicator to the total number of the adopted laws characterizes the stability of the legal environment, thus characterizing the quality of the legislation in force. The formula for the legal environment stability coefficient (LESC) is as follows: LESC

N 1 N2 N

where N1 is the number of amendments which were introduced into the law in the succeeding periods; N2 is the number of laws having become invalid; N is the number of adopted laws. Calculations were made for eight areas of economic legislation: (1) enterprises and business activity, (2) banks and securities, (3) tax system, (4) customs legislation, (5) budget legislation, (6) foreign economic relations, (7) trade and anti-monopoly legislation, (8) book-keeping and financial control. Analysis was carried on with regard to laws, Decrees of the

229


President and Resolutions of the Government of the Kyrgyz Republic. In the process of calculating a general indicator of legal environment stability, each specific coefficient was given the weight of 0.33, for the purposes of eliminating the influence of a large number of regulative documents adopted by the government. Legislation which directly affected the activity of enterprises and business has suffered the most frequent changes (Table 10.2). Actually, every second document was subject to amendments or additions. The same indicators show the situation in the tax legislation, customs legislation and legislation regulating foreign economic activity. One could notice a negative correlation between the legal environment stability index and GDP (Figure 10.1). Beginning from 1996, that is from the time when the critical mass of legislation suitable for the market economy went into force, a connection between improvement of the legal environment and economic growth became visible. Table 10.2 The coefficient of legal environment stability by type of legislation Enterprises and business activity Banks and securities Tax system Customs legislation Budget legislation Foreign economic relations Trade and antimonopoly legislation Book keeping and finance control

0.50 0.30 0.40 0.43 0.21 0.42 0.29 0.10

Total

0.37

Source: Authors’ calculations.

Foreign Trade and the Country’s Comparative Advantages The economy of Kyrgyzstan is small and inevitably open. This was a characteristic of the economy in Soviet times and it continues to be true. Interestingly, the foreign trade share in GDP almost did not change: it was 81 per cent in 1990 and 81.3 per cent in 2000. However, before independence almost all trade was oriented towards other Soviet republics (98 per cent of exports and 75 per cent of imports), whereas now the role of former Soviet republics has decreased (41 per cent of exports and 54 per cent of imports); that is, trade has been reoriented in large extent towards non-CIS countries. These changes are closely related to the changes in the commodity structure

230


0.6

1.2 Legal environment stability coefficient

1.0

0.5 GDP level

2000

1999

0

1998

0.1

1997

0.2

1996

0.2

1995

0.4

1994

0.3

1993

0.6

1992

0.4

1991

0.8

0

Source: National Statistical Committee (NSC), and authors’ calculations.

Figure 10.1

GDP and the coefficient of legal environment stability

of foreign trade. In 1990 manufactured products were a considerable part of total exports, but now the share of manufacturing has shrunk. When in 1992 production costs went up as a result of a rise in prices for energy products, raw materials and other inputs, and the quality of production remained the same (or worsened), these markets were lost almost immediately. Another reason is the economic decline in the CIS countries. One more factor behind the drop in exports of manufactured products is the protectionist policy in some neighbouring countries. At the same time, exports of gold and electricity have increased; these two products together now account for more than 60 per cent of total exports. Currently, Kyrgyz exports are concentrated in primary goods, and the country’s participation in the international division of labour has become more and more vertical. This statement may be validated by the recent dynamics of the Grubel-Lloyd intra-industry trade coefficient, which was equal to 64 per cent in 1995 and fell to 39 per cent in 2000; this means that intra-industry flows (characteristic mainly of the man-


231

ufacturing sector) became less intensive, and inter-industry trade became more important. The considerable openness of the domestic market resulted both from targeted policy (for example, Kyrgyzstan entered the WTO) and from imperfections in the state regulation system (big contraband trade). This openness obviously caused big changes in imports. The role of CIS countries has decreased; from these countries Kyrgyzstan now imports mostly energy products. Analysis of Kyrgyzstan’s comparative advantage in trade with its partners, using the revealed comparative advantage (RCA) index, shows the following. Firstly, the commodity structure of exports does not correspond to the country’s comparative advantages, which exist for less than a half of all export commodity groups. Secondly, in trade with CIS countries the number of commodity groups for which a revealed comparative advantages is observed, is declining. In trade with non-CIS countries this number is small, but increasing. This means that the export structure generally follows the country’s pre-existing specialization. Thirdly, the dynamics of the RCA index is negative for many export commodities, and this can lead to future reduction in exports of these commodities. Because of the small domestic market and prevalence of commodities with low price-weight ratio in Kyrgyz exports, regional markets are important for the Kyrgyz economy. However, development here goes in an unfavourable direction. During the period from 1996 to 2001 exports to neighbouring countries dropped by 60 per cent. Trade with neighbours is now concentrated almost exclusively on energy products; Kyrgyzstan exports electricity and imports oil, natural gas and coal. It is worth noting that such trade reorientation has taken place despite Kyrgyzstan’s participation in different regional trade agreements. Within all of these regional arrangements, things do not go beyond declarations about mutually beneficial cooperation. In an attempt to expand trade possibilities, in 1998 Kyrgyzstan became the first CIS country to join the WTO. So far, this has brought neither positive nor negative effects to the country. The lack of positive results is connected with two factors. Firstly, not all Kyrgyzstan’s neighbours and major trading partners are WTO members, and in relations with these countries nothing changed. Secondly, WTO membership can be advantageous with respect to trade in manufactured products, but the share of these goods in Kyrgyz exports is low. However, WTO membership did not damage the country (as is usually expected) through opening up the domestic market, because this market had already been opened up long before the moment of entry into the WTO. In the long-run outlook, WTO membership can be useful in attracting foreign direct investments aimed at Chinese, Russian

232


and Kazakh markets (especially after Russia and Kazakhstan enter the organization).

3. FACTORS OF LONG-RUN ECONOMIC GROWTH: ROLE, CURRENT SITUATION AND DEVELOPMENT PROSPECTS Natural Resources and Geographical Location Kyrgyzstan is not very rich in natural resources. The mining industry plays an important role in the country’s exports (about 50 per cent), but this is mostly due to gold from the Kumtor mine, which will be depleted in the medium term. The country produces and exports some non-ferrous metals (antimony, mercury, rare-earth). There are as yet undeveloped deposits of gold, tin, tungsten, and so on, but these deposits cannot achieve an importance for the economy comparable to Kumtor. Energy resources, especially hydropower, have a key importance for the Kyrgyz economy. Hydro energy production is a large source of export revenues (10–15 per cent of the country’s total exports) and plays a decisive role in the water supply of the southern part of the republic, as well as of Uzbekistan and Kazakhstan. Domestic production of mineral energy products is very limited, and covers only an insignificant part of domestic demand for oil products and coal. There are considerable deposits of coal and, possibly, oil in the country, but development of these deposits is hindered by lack of investment sources, because domestic savings are very small and for foreign investors the market scale is not very attractive. As a result, it is necessary to import energy products and this is a very heavy burden for the trade balance. There is good natural potential in the country for the development of agriculture and tourism. The large dependence of the Kyrgyz economy on foreign trade and its landlocked location make the problems of transshipment of goods through the territories of Kazakhstan and Uzbekistan very acute. Many official (tariff, non-tariff and administrative limitations on transit) and unofficial (bribes and extortions by local government officials) barriers exist for Kyrgyz cargo vehicles crossing these countries’ territories. By some estimates, transportation costs are as high as FOB prices of Kyrgyz goods; this undermines competitiveness of these goods in the markets of Russia and other countries of destination. However, geographical location may not only be a source of difficulties for the economy, but it contains also some growth potential. This potential is connected to plans for construction of Eurasian transport and telecom-


233

munication highways through the territory of Kyrgyzstan, which would connect Europe with China and other Asian countries. There are projects for the construction of railways, roads, and fibre-optic information highways crossing Kyrgyz territory. The most realistic project proposes constructing a railway from Uzbekistan to China through the south-eastern part of Kyrgyzstan. If this or similar projects were realized, the country could earn money from the transit of goods. Apart from that, the road would have to pass through a poorly developed part of the country, and this would create conditions for economic revival of the region. So far, realization of the project has not begun; financing sources are not finally determined; it is supposed that China would be the largest investor, and the Asian Development Bank (ADB) will make some contribution. The railway route is also not fully agreed. Construction of internal roads, which should improve communications and ease the movement of goods between different parts of the country, is also of large importance for the economy. The strategic Bishkek–Osh road is being rehabilitated with money from an ADB loan. The country’s energy independence would be strengthened and its trade balance improved, if it becomes possible to construct a road to the Kara–Keche coalmine in the east of Kyrgyzstan. The problem is that this road has only internal importance and apparently can be built only with domestic savings, which are insufficient. Physical Capital It is difficult to evaluate the dynamics of fixed production assets (FPA) in the transition period. The FPA dynamics, in contrast to nominal GDP, is stipulated not only by changes in prices, but also by the influence of reassessment of balance sheet value of assets. As a result, the nominal value of FPA does not correlate to nominal GDP. Moreover, the statistics in the Kyrgyz Republic and, apparently, in other transition economies, does not calculate investment deflators, which makes it impossible to even try to calculate directly the real growth rate for this indicator. The usual approach to resolving this problem is based on an assumption that the capital stock data for the transition period could be obtained using gross investment data and applying depreciation rates that are imputed from pre-transition period data. However, this methodology does not work well for Kyrgyzstan, because it ignores one important specific feature of capital stock dynamics, namely the outflow of physical capital abroad during the first years of transition. This fact explains the seemingly paradoxical growth of exports of machines and equipment in 1992–95, while during the same period the gross output of machine-building decreased sevenfold. Taking this outflow

234


1.2 Real capital stock

1.0

0.8

GDP real growth

0.6

0.4

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

0.2

Source: National Statistical Committee (NSC).

Figure 10.2

Real GDP and the capital stock

of physical capital into account one can notice a decrease in fixed capital value in 1992–95 (Figure 10.2). The crisis in the sphere of investments turned out to be a lot worse than even in production. Since the start of the transition period, the volume of capital investments decreased every year by more than a quarter till 1995, when it started growing. Public capital investments decreased at a much faster speed, by nearly half, also till 1995. It is worth considering the dynamics of public and private investments. Obviously, before 1991 almost exclusively only public investments were possible (with the exception of residential construction). These investments were financed mainly by special funds provided by the State Planning Committee of the USSR. With the USSR break-up, transfers from this fund had ended, and this explains the huge fall in public investments until 1999. Starting from this moment, however, public investments started to grow very quickly due to the Public Investment Programme (PIP) financed


235

by loans from the World Bank, the Asian Development Bank and some other international financial institutions. These investments are directed mostly to the construction of roads (the strategic road Bishkek–Osh, first of all), irrigation systems, electricity transmission lines and so on. In 2001–2002 public investments went down again, because of the necessity to reduce the PIP in the light of the very acute problem of high external public debt. Thus, the country has not yet found a sustainable way to finance urgently needed public investments in infrastructure. Private investments were very low at the beginning of transition, then started to grow (mainly as a result of progressing privatization). A very big increase (and then decrease) in private investments in 1995–97 was connected with investment in the Kumtor gold mine. After 1997 no large private investments took place. However, in 2001–2002 it is possible to observe some increase in private investments. This time the increase is not a result of just one large project, but many relatively small investments, which is probably a more sustainable path of fixed capital accumulation. Since the beginning of reforms, the government of the Kyrgyz Republic has made large efforts to attract foreign direct investment. However, apart from the Kumtor project almost no significant foreign investments were registered. The most important problems appear to be the small domestic market, limitations for exports to regional markets, the poorly developed infrastructure and, last but not least, the insufficiently favourable investment climate. The major problem behind all unsatisfactory developments in the investment sphere is the low level of domestic savings. In some years (for example, in 1998), savings were even negative. The low savings are a result of (1) the poverty widespread in the country, and (2) the traditional reliance on foreign aid decreasing the national propensity to save. This reliance on aid is especially characteristic of the government. The large role of foreign aid makes it a separate important factor in the economic and social development of the country. Foreign Aid One of the major factors of development of Kyrgyzstan during all the years of independence has been massive financial and technical assistance from the international community. It is worth noting that Kyrgyzstan traditionally depends on external transfers. The total amount of international aid received by Kyrgyzstan in 1992–2000 reached US$1695.7 million. In per capita terms this means about US$370 per Kyrgyzstan inhabitant. In 1995–99 this indicator was about US$50–60 per year, very high value by international standards. Figure 10.3 shows the shares of major donors in

236


Government of Japan, 15%

Government of Switzerland, 4% Government of Germany, 4%

European Union, 4% Other donors, 15%

EBRD, 5%

IMF, 15%

World Bank, 23% Asian Development Bank, 15% Source: Database at UNDP office in Kyrgyzstan.

Figure 10.3

Largest aid donors

total international aid to Kyrgyzstan: US$344.5 million, or 20.3 per cent, was provided as grants, and US$1351.1 million or 79.7 per cent as loans. Different components of international aid influence domestic demand and GDP in Kyrgyzstan in different ways. According to the mechanism of such influence, all international aid can be subdivided into the following types: 1) investment loans; 2) programme loans and grants to the government budget; 3) programme loans and grants to support the country’s balance of payments; 4) technical assistance. The first type of aid influences capital investment value, mainly within the PIP. Almost all programme assistance to the budget increases the government consumption and, to a lesser degree, private consumption (through budget transfers to the population). Programme aid supporting the balance of payments influences domestic demand indirectly and in different directions. From one side, it contributes to macroeconomic stabilization and in this way creates better terms for growth of all components of GDP. From the other side, this assistance contributes to appreciation of the national currency and makes

237


import goods cheaper; for this reason, a large part of this type of aid has been spent financing not domestic production, but imports of consumer goods into Kyrgyzstan. Technical assistance (TA) does not always go directly to the country or remain in it. By the authors’ estimates, only about 15 per cent of TA project expenditures contribute to the domestic demand of the country. Figure 10.4 shows the estimated share of Kyrgyz GDP financed by international aid programmes. These estimates are based on information from the National Statistics Committee on government consumption and public capital investments, structure of revenues, expenditures and budget deficit financing (including PIP), and also on an international aid database at the UNDP office in Kyrgyzstan. In 1995–2000 about 6.5 per cent of Kyrgyz GDP was financed by aid. This estimate seems to be conservative, because it does not take into account the multiplicative effect (that is, influence on the private sector) due to expansion of public expenditures financed by 8% 7% 6% 5% 4% 3% 2%


Figure 10.4

Contribution of foreign aid to Kyrgyz GDP

2000

1999

1998

1997

1996

0%

1995

1%

238


international aid. Besides, it does not take into consideration the growth of human and fixed capital (for example the production capacity of the country), which results from the implementation of programmes on production and social infrastructure development, and training local people. The multiplicative effect mentioned above is taken into account by the indicators in Table 10.3. These indicator values were calculated with the use of our own macroeconomic model of the Kyrgyz economy. Analysis shows a very big dependence of basic macroeconomic indicators on foreign financial aid flows. This is obviously a dangerous tendency, which can outweigh the positive long-run impact of aid. Table 10.3 Macroeconomic impact of a 10% reduction in foreign aid (programme and investment loans and grants) Years

1995

1996

1997

1998

1999

2000

GDP, % Private consumption, % Government consumption, % Investments into fixed assets, %

1.6 1.0 4.1 1.2

1.4 0.6 3.0 1.1

1.3 0.7 3.9 2.0

0.1 0.6 1.8 0.7

0.4 0.3 2.0 0.8

0.8 0.1 3.0 1.3

Note: Percentage deviation of simulation results from actual indicator values (in real terms). Source: Authors’ calculations.

It is worthwhile considering also the influence of aid on macroeconomic stability in the country. Most international aid, especially during the early years, was aimed at macroeconomic stabilization in the country and, as mentioned above, at first gave useful results. For several years these loans provided the resources necessary for financing the country’s large current account deficit (reaching 20 per cent of GDP in some years). At the same time, further large-scale international aid directed to the public sector stimulated maintenance of large budget deficits (about 10 per cent of GDP); this deficit is considered to be a main source of long-run macroeconomic instability in the country, and in recent years the budget deficit has been financed almost entirely by international aid. The budget deficit, in its turn, maintained considerable current account and trade deficits, created pressure towards exchange rate devaluation, and reproduced inflationary trends in the economy. Another big problem related to foreign aid is the very rapid growth of the country’s external debt. Independent Kyrgyzstan began with zero external debt. By the end of 2001 the total external debt came to US$1677.7 million,


239

or 110 per cent of the country’s GDP, including public debt of US$1262.2 million (83 per cent of GDP), debt of the National Bank to the IMF of US$179.3 million (12 per cent of GDP), and private sector debt of US$236.3 million (15 per cent of GDP). As a result of extensive government borrowing, in 2000–2001 public external debt servicing had become a serious problem and required a significant reduction in non-interest expenditures of the budget. In 2001 the country was on the edge of default on its foreign debt. In 2002 the Paris Club rescheduled the debt of Kyrgyzstan, requiring implementation of a fiscal adjustment programme in the framework of the IMF’s Poverty Reduction and Growth Facility (PRGF). This programme assumes a considerable reduction in public borrowing: in 2005 the government deficit should not exceed 3 per cent of GDP. Thus, aid is expected to become much more limited in size and better targeted. Labour Force The size and dynamics of labour are determined by a number of factors: 1. 2. 3.

demographic situation, which determines the total number of people of working age; participation of the adult population in the labour force; labour force utilization, that is, registered and hidden unemployment.

The actual number of working person-hours, L, may be expressed by the following formula: LN LR PR (lu) H PE where N is total population of the country, LR is share of the population of working age, PR is labour force participation rate, u is unemployment rate, H is annual fund of working time of one worker (in hours), PE is partial employment rate equal to a ratio of actual working hours to H. The PE coefficient characterizes the degree of utilization of employed workers, and is equal to one under full employment and is close to zero if formally employed workers in practice do almost no work. General trends in the dynamics of each of these variables are described below. Population growth rates in Kyrgyzstan generally are rather high, although the growth rates decreased, from 2.0 per cent in 1979–89 to 1.2 per cent in 1989–2001. The main factors behind the population growth deceleration are a decline in the birth rate, from 3.0 per cent in 1989 to 2.0 per cent in 2001, and emigration (net migration outflow in 1989–99 was

240


393.5 thousand persons or 8.6 per cent of the total population of the country). Large-scale emigration from Kyrgyzstan was caused by the desire of many representatives of national minorities (in Soviet times they composed up to 50 per cent of the total population of the republic) to reside in the countries where their ethnic groups compose a majority of the population. At the same time, economic reasons for emigration should not be underestimated, because living standards in Kyrgyzstan are much lower not only in comparison to any Western countries but also in comparison to Russia. Traditionally, society in Kyrgyzstan was young: the share of children was about 40 per cent, working-age people 50 per cent, and elderly people 10 per cent. During the last decade, the share of working-age people increased from 49.4 per cent in 1989 to 52.4 per cent in 1999, while shares of children and pensioners decreased because of the birth rate decline and emigration. For this reason, the growth rate of the working-age population decreased less than might be expected from the total population dynamics. In the transition years labour force participation has decreased significantly. The participation rate in 1989 was 84.7 per cent, while in 1999 it fell to 79.0 per cent. An important reason for this drop is the fact that in conditions of a sharp reduction in the possibility of finding a job, and of a deterioration in the provision of many social services (for example, preschool establishments), many people choose not to look for a job, but to concentrate on their household activities. Another form of working-age people outflow from the labour force is related to the increase in the number of universities and students attending them during the independence period. Apart from that, the decrease in the participation rate is connected also to external labour migration involving many Kyrgyz citizens (up to 10–15 per cent of population of Kyrgyzstan of working age), who are working or looking for jobs in neighbouring countries (mainly Russia and Kazakhstan). The unemployment rate in Kyrgyzstan in 1989 was 3.1 per cent. During the transition period unemployment has grown considerably and, according to the 1999 census data, the unemployment rate reached 14.4 per cent. Some workers, who have been counted as employed, in fact are only partially employed. The partial employment effect can be expressed by a coefficient equal to a ratio of the actual number of working hours of one worker during a year, to the annual working hours fund per worker. Calculations based on data for a representative sample of industrial enterprises of Kyrgyzstan for 1996–99 show that this coefficient is approximately equal to 85 per cent and is rather stable over time. This value of the PE coefficient can be used as an estimate of a degree of employed workers utilization in recent times. In the Soviet period it was close to unity.

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Table 10.4

Change in working hours, 1989–99

Years Population of the country (N), thousand persons Working-age population, thousand persons LR coefficient, % Labour force, thousand persons Participation rate (PR), % Unemployment rate (u), % Employment, thousand persons Number of working hours by legislation (H), hours per year Coefficient of partial employment (PE), % Actual number of working hours, million hours per year Sources:

1989

1999

1999 in % to 1989

4290.4

4850.7

113.1

2118.1 49.4

2541.4 52.4

120.0

1795.0 84.7 3.1 1738.6 2074.6

2006.9 79.0 14.4 1717.9 2066.4

107.5

100.0 3607.0

85.0 3017.4

98.8 99.6

83.7

National Statistical Committee (NSC) and authors’ calculations.

Thus, taking all the above into account it is possible to conclude (Table 10.4) that during the transition period the number of working hours in the economy decreased by almost one-sixth. Human Capital A high level of education of the population, in comparison to countries with similar GDP per capita, is characteristic for Kyrgyzstan. The adult literacy rate is 98 per cent, and 97 per cent of all school-age children attend secondary school. The educational population structure is presented in Figure 10.5. In the 1990s serious changes in the process of accumulation of human capital took place. First, this is connected to mass migration of people from or to the country, even more massive inter-sector mobility of the employed, and changes in the system of education. Among emigrants, the share of people with higher and professional secondary education is higher (16.0 per cent and 28.9 per cent in 1998) than the country averages; this means some losses of human capital from emigration. The inter-sector migration also causes some losses in human capital, because a proportion of previous professional skills of workers appears to

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Illiterate, 2.6% Primary education, 6.3%

Higher education, 12.0% Professional secondary education, 10.8%

Incomplete secondary education, 18.3%

General secondary education, 50.0% Source: National Statistical Committee (NSC).

Figure 10.5

Adult population by education level, 1999

be useless. This kind of labour force mobility can be characterized by a coefficient of sector mobility of employment: SMt0

1 2

n

(wit wi0)2 ·100% i1

where wit is the i-th sector share in total employment, n is the number of sectors, t and 0 are final and initial moments of time. It is clear that without any movement between sectors this coefficient would be equal to zero. The more intensive the flows of workers from one sector to another, the higher this coefficient; its maximum value is one. For the period 1989–99, SM6.8 per cent. For comparison, in 1999–2000 (with a rather stable sectoral structure of employment), SM0.1 per cent. It is important also that the general direction of labour force movement is from technologically more advanced and productive manufacturing to much less education-demanding agriculture and trade.


243

During the period of time under consideration the education system has changed significantly. First, the number of universities and of students has grown considerably. Second, education expenditures (in constant prices) per student have fallen sharply (more than three times) in comparison to the Soviet period and continue to fall. Third, outflow of teachers from schools takes place because of low salaries; this contributes to a declining quality of education. All these considerations provide a more sceptical perspective on the growth in the number of students, because the quality of education (measured by financing allocated to education) has decreased. It is interesting to consider the relationship between the income of workers and their level of education; to some extent it can be interpreted as a return to human capital. We estimated a regression of log of workers’ wages on their years of schooling using data from the LSMS household survey conducted in 1998 by the World Bank and NSC. It appeared that a one-year increase in schooling time increases a worker’s income by 12.1 per cent (the result is significant at the 1 per cent level). Institutions Markets of products, capital, labour, land The liberalization of prices in 1992 had a great impact on the functioning of product markets. Inflationary processes in the 1990s were accompanied by significant changes in relative prices. These changes mostly returned to prices the role of signals of real scarcity of resources. At the same time there are a number of markets where prices are still controlled by the government. These include electricity, public transportation, municipal services and excisable goods. The effectiveness of price control, however, is decreased by large-scale non-payments, especially with respect to electricity (the electricity monopoly Kyrgyzglavenergo estimates that at least 40 per cent of total electricity production is lost to so-called ‘commercial losses’, that is non-payments and theft) and smuggling. A large impediment to development of private entrepreneurship and free movement of goods is the intervention of the government, which takes the form of excessive licensing and certification requirements as well as a direct intervention of officials into production processes and ownership issues. A favourable climate for this kind of intervention is created by so-called indicative planning, which still remains in Kyrgyzstan’s economic system. In practice, this planning often takes the form of setting production plans for private enterprises with administrative sanctions for non-fulfilment of the plan. Obviously this generates distortions in the functioning of markets, and results in the production of goods which are impossible to sell. In 1996–2001 the component of GDP by use entitled ‘Change in material

244


working capital’, which includes changes in stocks of unsold production, was invariably positive. Even larger problems exist in the functioning of financial markets. The banking system of the country is very weak. In 2001 banking deposits accounted for only 3.5 per cent of GDP, and this led to a very low value of M2x multiplier, 1.53 at the end of 2001. The amount of credits to the nonfinancial sector is even less, 2.1 per cent of GDP, at interest rates of 30–40 per cent per annum for som credits and 20–30 per cent per annum for US dollar credits. Taking into account the inflation rate in 2001–2002 of less than 5 per cent, this means that real interest rates are close to 30 per cent per annum for som credits. Such high interest rates can be explained by general macroeconomic instability, high risks in entrepreneurship, and an imperfect judiciary system. The non-banking financial sector and securities market hardly exist, and serve a quite small segment of financial flows. The only component of the financial sector performing relatively well is the foreign aid supported system of soft credits for agricultural enterprises (through the Kyrgyz agricultural financial corporation) and numerous micro-finance programmes of different donor organizations. These financial facilities have shown good credit repayment rates (just slightly less than 100 per cent) and are popular among the rural population of the country. However, this system obviously covers only part of the demand for credits (short-term credits only). More importantly, the system is strongly dependent on foreign aid; in light of the above discussion on the shortcomings of the reliance on foreign aid, the sustainability of this segment of the financial sector is far from being guaranteed. The main factors determining the labour market functioning in the country are a big preponderance of labour supply over labour demand and a relatively small share of industry and non-market services in the economy. In general, the climate is quite favourable for employers. Because of large unemployment levels, the position of workers in relation to employers is rather weak. In 1997 a new Labour Code was adopted, which takes into account more realities of the market economy than the previous one. Unemployment insurance is almost absent; monthly unemployment benefit varies now from US$5 to US$10, and just one-tenth of all registered unemployed receive it.4 The country is mostly rural, so the problem of rural overpopulation persists; youth from rural areas is flowing to towns, and this increases the deficit of working places. All these circumstances keep wages low (the official average wage in Kyrgyzstan is only 27 per cent of that in Kazakhstan and 31 per cent of that in Russia) and make hiring and firing of workers easy for employers. Together with the relatively high level of education of workers this creates favourable preconditions for the growth of production.


245

Agrarian reform in Kyrgyzstan started together with other economic reforms. This reform led to the disintegration of almost all old large farms and the creation of many small farms. These farms have received agricultural land first under long-term leases, and after 1998 as private property. After some delay the land market in the country (including leasing and sales of land) is now in operation. The social sphere Sustainable long-run economic development of the country requires a corresponding level of social development, ensuring reasonable living standards and fair income distribution, good health of the population and proper functioning of the social security system. A conventional international measure of living standards in a country is the ‘United Nations’ human development index. For Kyrgyzstan the index values dropped in the beginning of the 1990s because of the sharp decline of PPP GDP per capita (from US$3430 in 1990 to US$1950 in 1995) and the visible reduction in life expectancy (from 68.3 to 65.8 years). When economic growth in the country resumed, the index values also began to increase, but now it is still far from the 1990 level. Income inequality has increased significantly, the Gini coefficient is equal now to 0.45. At the same time poverty became widespread; about 50 per cent of the population are considered now as poor. Poverty and income inequality create an unfavourable environment for economic growth, as low incomes of the population limit consumer demand and undermine development prospects for enterprises oriented towards the domestic market. The current social security system in Kyrgyzstan does not ensure proper conditions for labour force reproduction. The above example of unemployment insurance is quite eloquent. It can be added that the level of pensions is only about 50 per cent of the minimum consumer budget. From another point of view, the pension system (almost exclusively from the state Social Fund) does not fulfil its important function of savings accumulation. Total Factor Productivity Estimates of total factor productivity for the Kyrgyz economy in 1971–2000 are provided in Table 10.5. The Cobb–Douglas production function was used: YAK0.3L0.7 where Kphysical capital, Llabour, Youtput. Output values are based on 1991 data, because both national income (for the Soviet period) and

246


Table 10.5

Changes in total factor productivity

Period

Change in physical capital, %

Change in labour, %

Change in output, %

Change in total factor productivity, %

9.2 6.4 5.8 4.5 6.5 6.4

2.9 2.5 2.5 1.6 4.4 1.5

43.6 42.3 42.4 44.7 11.9 45.5

1.2 1.3 1.1 2.2 6.9 2.6

1971–75 1976–80 1981–85 1986–90 1991–95 1996–2000


GDP (for the independence period) data are available for this year. Values for other years were calculated on the basis of National Income/GDP real growth rates. Calculations show that in 1971–85 total factor productivity consistently declined. Somehow, surprisingly, it appeared that TFP grew in 1986–90. This fact is explained by the abnormally high growth rate (10.7 per cent) of national income in 1988. As one would expect, there was a considerable drop of TFP during 1991–95. Finally, in 1996–2000 TFP grew, although not very fast. This growth of TFP to a large extent is connected to the 1996 results, when GDP grew significantly in conditions of falling physical capital stock and stagnating employment. The main source of GDP growth in this year was agriculture, where a recovery started after several years of recession. If one excludes 1996 from the calculations, the total change of TFP during the last period would be close to zero; in other words, a visible growth of production efficiency has not yet been registered.

4.

CONCLUSIONS

There is a quite considerable specificity of the situation in Kyrgyzstan in comparison to many neighbouring countries. The sources of this specificity are: 1) the small size of the country and its unfavourable geographic location; 2) the lack of rich and easily tradable natural resources; 3) the strong dependence on external aid. Despite the diversity of sources and impediments for growth, some permanent factors influenced the development of Kyrgyzstan during the period under consideration:


1.

2.

3.

4.

5.

6.

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Human capital, whose accumulation is largely an achievement of the prior period of development and a major determinant of future development. Labour force abundance, predetermining the country’s specialization in labour-intensive economic sectors and facilitating geographical and sectoral labour mobility. Low domestic savings, creating permanent need for external financing of development programmes, which makes economic and social growth less sustainable in the long run. Imperfections of economic management by the government, which has created and continues to create problems for economic development of the country throughout its history. Small scale of the economy and its strong dependence on external exogenous factors, which often are of an uneconomic nature (the social and military policy of the USSR in Soviet times; the policy of international financial organizations and neighbouring countries now). These factors influence the country’s development in complex and different ways, in particular financial and fixed capital inflow since independence has been determined not so much by economic efficiency considerations, but mostly by the donors’ strategic planning. Geographical location, which was an additional determinant of external investments inflow in Soviet times (some remote areas received targeted support from Moscow) and is an impediment for the development of Kyrgyzstan now.

The authors of this chapter believe that to achieve sustainable economic growth in the interest of all people of Kyrgyzstan it is necessary to implement the following measures: 1.

2.

3. 4.

5.

sound macroeconomic policy (low budget deficit and inflation, first of all), which would maximally protect the economy against external shocks, lower risks, contribute to creation of a better investment climate, and prevent further growth of income inequality and poverty; foreign direct investments attraction and provision of an appropriate investment climate, permitting substitution of aid by direct foreign investment; openness and export orientation of the economy; drastic improvement of governance through considerable reduction in redistribution programmes, radical improvement in transparency of government activities, prevention of any intervention of government bodies or officials in enterprise activities; support for the education and health care systems, which provide the

248


reproduction of the country’s main productive force – its human capital.

NOTES 1. In reality in 1992 GDP fell by 13.9 per cent. 2. In 1995 GDP was just 55 per cent of its 1991 level. 3. As a matter of fact, the GDP growth rate in 2002 would probably be much lower than before, less than 2 per cent. 4. In its turn, registered unemployment is just one-quarter or one-fifth of the total number actually unemployed.

11. Natural resources and economic growth in Kazakhstan Yelena Kalyuzhnova, James Pemberton and Bulat Mukhamediyev The possession of rich natural capital (agricultural land, forests, fossil fuels and minerals) has the potential to play an important role in the economic performance of transition economies. There is some evidence from nontransitional economies which suggests that resource-rich economies have slower economic growth, for example because corruption and rent-seeking may be encouraged, or because there is reduced incentive to pursue soundly based macroeconomic policies (Auty, 2001; Dolinskaya, 2001). However, this question is quite debatable in the transition context. For example, Dolinskaya (2001, p. 21) argues that countries with rich resources do better in transition. Among the CIS countries, the best-endowed are Azerbaijan, Kazakhstan, Turkmenistan, Uzbekistan and, especially, Russia. Economic growth in Kazakhstan, Azerbaijan and Turkmenistan has been led by large exports of fossil fuel, namely oil and natural gas. Kyrgyzstan and Tajikistan export hydroelectricity. Pomfret (forthcoming) provides a good overview of the transition experience of all five Central Asian republics, focusing both on common features and on country-specific features. Outside Central Asia, economic growth in Poland, Armenia and Lithuania, for example, relies significantly on agricultural output. Although the existence of natural resources may be a temptation to governments to pursue bad policies, the sensible use of natural resources can generate benefits for the whole economy and contribute to a higher economic growth. However, policy has to be balanced. At the present time there is a real danger that excessive exporting of natural resources is leading to excessive dependency on this sector in some Central Asian republics. This can have serious consequences, partly because of its riskiness, through excessive exposure to a volatile world commodity market, and partly because industrial diversification may be stunted. In this situation it would be sensible for governments to attempt to use some of the state revenue generated from the booming resource sector to attempt to encourage development of other sectors of the economy, including investment in general human capital. 249

250


How to do this – and more generally, how best to manage natural resource wealth – is a key policy issue. There is some evidence worldwide to support the view noted earlier that oil wealth is a tempting target for governments of countries which are faced with difficult macroeconomic choices. For example, Easterly (2001, p. 129) reports that ‘the average growth in oil production is 6.6 percentage points higher in the heavily indebted poor countries (HIPCs) than in the non-HIPCs, which is a statistically significant difference’ and involves ‘a form of running down assets, since it leaves less oil in the ground for future generations’. In effect, this amounts to mortgaging the future: the present generation is enjoying unsustainable benefits at the expense of future generations. A standard inter-temporal macroeconomic perspective on the management of oil wealth would argue as follows. First, it is desirable that sustainable macroeconomic policies should be followed, where in this context, a ‘sustainable’ policy is one which is consistent with at least maintaining any currently chosen real per capita consumption level over all future generations. To identify this sustainable consumption level requires estimation of the permanent income equivalent of the present value of oil wealth (that is, the constant annuity value which, when appropriately discounted, equals current stock values). Then consumption should be adjusted into line with the estimated permanent income equivalent. Any higher consumption value is, by construction, unsustainable on a permanent basis. If the current production and sale value of oil exceeds the permanent income equivalent value, then the excess must be invested, not consumed. In principle, policies followed by any resource-rich country should be evaluated against this benchmark. In this chapter we first discuss the development of the Kazakhstani economy during the first decade of transition.1 We then look at the impact of hydrocarbon development on economic development to date, focusing on the management of hydrocarbon sector wealth.

1. THE TRANSITION DECADE: DE-INDUSTRIALIZATION OR CHANGING A PATTERN? At the beginning of the 1990s, Kazakhstan dropped central planning in favour of a market economy. Since then, the Kazakhstani economy has had to cope with enormous challenges in conducting the essential reforms and restructuring needed to implement a new development track. The economic disintegration of the Soviet Union broke trading links not only between former republics but between production systems as well. In con-

251

Natural resources and economic growth in Kazakhstan

120%

100%

80% Real GDP/NMP

60% Real gross industrial output

40%

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

0

1980

20%

Note: NMP data for 1980–90 were chain-linked to GDP data from 1990. Country indices were aggregated with previous year PPP-based weights obtained from the European Comparison Programme for 1996. Source: UN/ECE Common database, derived from national and CIS statistics.

Figure 11.1 Real GDP/NMP and industrial output, 1980, 1986–99; 1989 100 per cent sequence, during the first half of the 1990s, GDP in Kazakhstan fell to little more than half its 1989 levels. Figure 11.1 summarizes movements in real GDP/NMP and industrial output from 1980–2001 for Kazakhstan. It can be seen that Kazakhstan’s GDP fell by some 40 per cent in the first four years of transition, 1991–95. Since then there has been no substantial upturn. Figure 11.1 indicates that the decline in industrial production was larger than that for aggregate output and that its subsequent recovery was more fragile. In 2001 Kazakhstan achieved only 65 per cent of its 1989 industrial output level. The composition of Kazakhstani industrial output also changed substantially during the years of transition, with a strong emphasis on the extraction of oil and gas sectors and the virtual disappearance of final

252


manufactured products. The industrial sector in Kazakhstan has become more oriented towards raw materials at the expense of manufactured goods (Kalyuzhnova, 1998; 2003). We undertook a growth accounting exercise for the first decade of transition, 1991–2001. Table 11.1 summarizes the results. The most noteworthy point is the sharp contrast between the first and second halves of the decade. The summary data for the first half simply confirm the massive drop in aggregate inputs and output in the early years of transition. The picture for the second half of the decade is completely different, with a rapid growth in total factor productivity (that is A/A) being the main source of rapid overall economic growth.2 Table 11.1

Growth accounting, 1991–2001

Year

Y/Y

K/K

L/L

A/A

1991–96 1996–2001

7.07 5.01

3.31 0.54

0.73 1.41

5.57 5.84

Notes: The data show annual rates of change. Calculations assume a Cobb-Douglas production function YAKaL1a where Y, K, L denote aggregate output, capital inputs and labour inputs respectively, A is a technical knowledge index, and a0.3. Data source: Statistical Yearbook of Kazakhstan (2002, Tables 30.3, 30.32 and 30.52). Output growth is calculated using the GDP deflator in Table 30.32. Labour inputs are defined as total employment plus total self-employment. Capital growth is calculated by assuming that aggregate capital stock was constant in 1991, implying that aggregate investment in Table 30.52 was just equal to capital depreciation. Assuming annual depreciation of 5 per cent in 1991 and in each subsequent year then allows capital growth to be computed from the annual investment data in Table 30.52.

Changes in the composition of GDP led to changes in employment patterns (Figure 11.2), with a substantial drop in industry and agriculture, and reallocation of labour resources to the services sector. Once transition started, open unemployment rapidly became a key feature of the Kazakhstani economy. Between 1993 and 1995 the number of unemployed people increased more than three times in Kazakhstan. One of the key features of the Kazakhstani economy before transition was its closed nature, with little international trade outside the Soviet Union borders. It might be argued that transition has simply revealed Kazakhstan’s area of comparative advantage (extraction of mineral resources). This poses the question of whether the collapse in manufacturing represents a downward spiral of de-industrialization, or is simply adjustment to a new pattern of comparative advantage. Advocates of the latter view argue that not only Kazakhstan, but also developed economies like Britain, experienced indus-

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120%

100% Total employment

80%

60%

Employment in industry

40%

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0

1989

20%

Source: UN/ECE Common Database, derived from national and CIS statistics.

Figure 11.2 Kazakhstan: aggregate and industrial employment, 1989 100% trial decline over the past two decades. But the analogy is not necessarily convincing. Kazakhstan is suffering transitional syndrome (shrinking of an already distorted economy) simultaneously with capital expansion in the hydrocarbon sector; Britain is undergoing a structural change from manufacturing towards service sector dominance. The ultimate solution for the Kazakhstani economy could be the development of a service sector and an infrastructural environment linked to the development of the oil and gas fields. During the 1990s the service sector grew significantly compared with the pre-1990s. However, the development of small and medium-sized business in Kazakhstan is still in an early stage. It will require a lot of effort, and systematic policy from the government. Inappropriate interventions could be counter-productive. For example, policy interventions which distort natural patterns of comparative advantage can have a negative impact on growth (Levine and Renelt, 1992). Thus,

254


interventions which attempt to prop up non-competitive industries in Kazakhstan could be an expensive mistake. Defining an appropriate industrial policy for the next decade is a key policy priority.

2. IMPACT OF ENERGY ON ECONOMIC DEVELOPMENT: FIRST RESULTS The notable structural changes which have taken place in the Kazakhstani economy since 1990 have had a significant impact on the pattern of industrial development. As noted in the previous section, the structure of the economy shifted towards raw materials, mainly the hydrocarbon sector. Figures 11.3 and 11.4 summarize trends in oil and gas production in Kazakhstan during the 1990s. The data indicate that over the decade Kazakhstani oil production rose by some 20 per cent. Simultaneously, its oil 40 35 30 25 20 15 10

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

5

Source: Kalyuzhnova (2002) and BP Statistical Review of World Energy (June 2002).

Figure 11.3

Oil production, 1991–2001, million tonnes


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consumption fell by nearly two-thirds. Kazakhstan was already a net oil exporter in 1989, exporting around 30 per cent of production, but by 1999 the effect of changes in both supply and demand meant that it was now exporting around 80 per cent of production. Changes in other parts of the energy sector had a smaller proportionate impact: in natural gas the economy swung from importing nearly half its domestic consumption, to being a small net exporter; in coal it remained a net exporter, but with sharply reduced levels of both domestic production and domestic consumption. The significant increase in net oil exports, and the smaller but still significant increase in net gas exports, are reflected in the overall pattern of Kazakhstani exports. Between 1996 and 1999 the share of oil and gas in total exports (measured in US dollars) rose by between 4 and 6 percentage points each year, from 20.0 per cent in 1996 to 34.1 per cent in 1999, representing a 63 per cent volume increase over the four-year period (IMF 2001, Table 29, p. 68). Data for 2001 suggest an acceleration of the trend, with 12

10

8

6

4

Source: BP, Statistical Review of World Energy (June 2002).

Figure 11.4

Natural gas production, 1989–2001, billion m3

2001

1999

1997

1995

1993

1991

0

1989

2

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the share of total exports of mineral resources rising to 58 per cent of total Kazakhstani export.3 Simultaneously the geographical pattern of exports was altering sharply. Between 1995 and 2000 the share of Kazakhstani exports going to CIS and Baltic countries fell from 58 to 27 per cent, the share to the rest of the world correspondingly rising from 42 to 73 per cent. The rapid expansion of Kazakhstani oil production, both in absolute terms and in proportion to GNP and total exports, was an outcome which was to an extent forced upon the Kazakhstani government by the collapse of the final manufacturing sector and by its need to establish at least one strongly growing sector within the economy. In this sense it cannot be viewed as a strategic policy decision. Kazakhstan has been fairly successful in attracting foreign direct investment (FDI). Cumulative inflows up to the end of 2000 amounted to US$8.5 billion. Kazakhstan has attracted around 75 per cent of all FDI into Central Asia and about 10 per cent of all FDI into the former communist bloc. FDI is proportionately more important as a percentage of GDP in Kazakhstan than in any other transition economy except for Azerbaijan; it is significantly more important than in even a very successful transition economy such as Poland, and hugely more important than in Russia, given the latter’s much greater size.4 In the present context, however, sectoral distribution, as well as the total amount, of FDI is also important. FDI remains concentrated in the oil and gas sector which has so far accounted for 67 per cent of the cumulative total of US$9.5 billion over the 1993–2000 period. Western Kazakhstan, the site of most of the oil and gas fields, has received the highest investment, followed by Central Kazakhstan which is rich in copper, iron ore, coal and manganese. The East Kazakhstan oblast with major gold and mineral deposits is third. Inflows of foreign capital are expected to remain high; according to government sources, Kazakhstan is expected to attract US$1.8 billion in FDI in 2003. In addition to improving the balance of payments position and the development of new export capabilities in various industrial sectors, there is some evidence that FDI has generated spillovers to the domestic economy. Therefore, FDI will continue to be a major source of economic growth in Kazakhstan. There is some temptation to view the trends in oil production and net exports and in the structure of FDI, and the sharp falls in output of many manufactured goods reported earlier, as consistent with a ‘Dutch disease’ interpretation of the Kazakhstani transition path. In the floating exchange rate context which is relevant to Kazakhstan post-1993, this implies that a rise in oil exports drives up the nominal exchange rate to the point at which the competitiveness of non-oil output is weakened just enough to reduce non-oil exports by an amount which offsets the increase in oil exports. Overall balance of payments equilibrium is thus restored at the expense of


257

weakened competitiveness and reduced output in the non-oil sector. On the other hand, there are some reasons to be cautious about the ‘Dutch disease’ interpretation. Note first that the sharp decline in manufacturing output in part pre-dated the large growth in oil production. This is not conclusive, because it is possible for ‘Dutch disease’ effects to reflect expected, rather than actually experienced, expansions of oil output. Better time series evidence than we currently have available would be needed to investigate more carefully the plausibility of a ‘Dutch disease’ interpretation of the output and exchange rate trends over the period from the adoption of the new national currency onwards. An alternative approach is to look at other evidence, for example on relative unit costs, but here the evidence is not yet clear-cut. IMF calculations suggest that movements in the real effective exchange rate vary markedly depending on which other currency is the comparator: between 1995 and 2000 the tenge appreciated significantly in real terms against the Russian rouble and the Deutschmark (even after allowing for the nominal tenge devaluation in 1999), but depreciated against the US dollar and the Chinese yuan. Ultimately, competitiveness depends on relative unit labour costs rather than on real exchange rates, and associated calculations for tradable goods suggest that in 1999 Kazakhstani unit costs were 42 per cent above Russian unit costs.5 There are also conceptual issues concerning the meaning of ‘Dutch disease’ in the context of a transition economy. Most studies of ‘Dutch disease’ have focused on established market-based countries with competitive exporting manufacturing sectors which are wholly or partly displaced by a newly emerging oil sector. By contrast Kazakhstan, as well as other countries of CIS, is a transition economy, which at the time of independence did not possess a large competitive manufacturing sector. Thus, traditional ‘Dutch disease’ arguments do not apply here: there was little established activity to be displaced by oil expansion. Table 11.2 provides background data on changes in the nominal exchange rate and import prices. Over the period 1997–2000 the import price index rose much more sharply than the nominal exchange rate, whereas traditional ‘Dutch disease’ problems normally imply the reverse. Table 11.2

Annual rates of change

Years

1997

1998

1999

2000

The nominal exchange rate, US$ Index of the prices of imported goods

75.4 121.0

78.3 263.0

119.6 116.5

142.1 140.8

Source: Socialno-economicheskoe polozhenie Respubliki Kazakhstan v 2000 gody.

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Table 11.3 reports the results of Granger causality tests for patterns of lagged causation between oil and non-oil products based on the following model structure: n1

m1

i1

j1

n2

m2

i1

j1

Yt 10 Xt 20

li Yti lj Xt j lt

(1)

2i Xti 2j Yt j 2t

(2)

Table 11.3 Granger causality tests between oil and other main tradable goods Null hypotheses Oil (OIL) and refined copper (RCOPPER) D(OIL) does not Granger cause D(RCOPPER) D(RCOPPER) does not Granger cause D(OIL) Oil (OIL) and grain (GRAINKZ) D(OIL) does not Granger cause D(GRAINKZ) D(GRAINKZ) does not Granger cause D(OIL) Oil (OIL) and rolled metals (ROMETAL) D(OIL) does not Granger cause D(ROMETAL) D(ROMETAL) does not Granger cause D(OIL) Oil (OIL) and gas (GAS) D(OIL) does not Granger cause D(GAS) D(GAS) does not Granger cause D(OIL) Oil (OIL) and iron ore (IRONORE) D(OIL) does not Granger cause D(IRONORE) D(IRONORE) does not Granger cause D(OIL) Rolled metal (ROMETAL) and chromite ore (CHROMORE) D(ROMETAL) does not Granger cause D(CHROMORE) D(CHROMORE) does not Granger cause D(ROMETAL) Oil (OIL) and coal (COAL) D(OIL) does not Granger cause D(COAL) D(COAL) does not Granger cause D(OIL) Iron ore (IRONORE) and coal (COAL) D(IRONORE) does not Granger cause D(COAL) D(COAL) does not Granger cause D(IRONORE) Source: Agency on statistics of the Republic of Kazakhstan.

F-statistics

Probability

15.7083 1.09209

0.05985 0.47799

2.59980 0.13939

0.28994 0.92809

1.03913 0.35674

0.52454 0.79419

7.35878 1.06331

0.12196 0.51813

2.92690 1.23109

0.26494 0.47751

120.082

0.00827

8.07968

0.11213

4.47712 0.71581

0.18797 0.62743

27.7955 0.58474

0.03493 0.68059


259

Here Xt, Yt denote annual production at time t of any pair of products (for example petroleum and grain production) whose pattern of causation, if any, we wish to establish. is the difference operator, ki, kj are regression coefficients to be estimated, and kt is an error term, k1, 2. The difference terms in the equations (1) and (2) are used to eliminate non-stationarity in the primary data. According to the Granger methodology the hypothesis ‘X influences Y’ means that the lagged values of X partly explain subsequent values of Y. The main Kazakhstan export goods are petroleum and also refined copper, rolled metals, grain and coal. For the econometric analysis of the direction of causality between volumes of production of oil and of various non-oil traded goods, we used data for 1988–2000. The result of the regressions, executed by using the program EVIEWS, are represented in Table 11.3, where D denotes a difference operator ∆. The results provide limited support for the existence of Granger causality: for example production of rolled metals ROMETAL influenced production of chromium ore CHROMORE at 1 per cent significance, and production of iron ore IRONORE influenced production of coal COAL at 5 per cent significance. In the present context, however, the key issue is the presence or absence of Granger causality between oil and non-oil products, and here the data indicate that petroleum production did not influence the production of refined copper, grain, rolled metals, gas, iron ore or coal at a 5 percent significance level. Whilst these results cast doubt on ‘Dutch disease’ type arguments, they do not mean that the sorts of problems with which ‘Dutch disease’ is associated cannot arise in future. Neither do they rule out the possibility that Kazakhstan might become a state-rentier economy, with consequent dangers for the systematic misallocation of resources according to political priorities rather than economic efficiency. Most Central Asian countries had almost non-existent internationally competitive manufacturing sectors at the time of independence. In the absence of natural resources these countries would have had strong incentives to try to develop competitive manufacturing niches, using their inherited human capital and perhaps some FDI and imported expertise. Instead, abundant natural resources provide an alternative sector for development and this is a tempting strategy because it is probably easier to implement. A booming oil sector can provide enough foreign exchange to pay for essential imports and balance trade without much need for manufacturing or services sectors. This is not a traditional ‘Dutch disease’ problem because it does not involve any reversal of established resource allocation patterns. Rather, a potential manufacturing and services sector is prevented from emerging. This, rather than the classic

260


‘Dutch disease’, appears to be a widespread problem for transition economies.

3. MANAGING THE HYDROCARBON SECTOR WEALTH In theory, hydrocarbon abundance in Kazakhstan in the form of oil and gas commodities could benefit the economy, facilitating increased diversification across the economy in new technologies, and human and physical capital, and thus giving a big ‘push’ to other industrial sectors. With the current world oil prices (US$26–30 per barrel in March 2003) Kazakhstan can produce significant revenue in the short term, subject to resolving problems created by administrative and regulatory processes. This oil revenue could help finance structural reforms. The development of oil resources can provide linkages to other industries including refining, petrochemical fertilizers and so on, taking advantage of Kazakhstan’s continuing high level of human capital embodied in a relatively stable and well-educated engineering workforce. On the other hand, it also threatens to make the economy overdependent on a few natural resources, with attendant risks such as international price volatility. One possible solution to price volatility risks is the creation of a national oil fund. This was initiated in 2000 with the sale of 5 per cent of the Tengiz oil field. The stated intention was to invest the proceeds in foreign currency assets and to use them for only two purposes: investment in strategic projects, and cushioning against future oil price fluctuations. The latter is more relevant in the present context. The implication is that the oil fund can match national spending to the permanent rather than the current income generated by national oil wealth, by running down the fund at times of low world oil prices, and building it up at times of high world prices. Similar action can be taken to offset any other source of fluctuation relative to the trend in oil revenues. To the extent that this is done it can ease or remove one potential problem of resource dependence – high risk exposure – and it also addresses the ‘Dutch disease’ issue to the extent that the exchange rate may be pushed down as the fund is accumulated. In order to reduce government cash flow uncertainties due to oil revenue fluctuations and minimize exchange rate concerns, an offshore price hedging mechanism is planned. A similar oil fund has been created in Azerbaijan. The provision of both funds is envisaged to be supported by taxes from the oil companies, oil royalties and signing bonuses. The Kazakhstani oil fund works as a stabilization and savings fund. The stabilization function seeks to reduce the impact of volatile revenue on the

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government and the economy. The saving function allows a government to create a store of wealth for future generations. It was planned that the fund would not be touched for the first five years of its existence. The fund is managed by the National Bank and overseen by a governing board chaired by the President of Kazakhstan. Information on the fund’s revenues, expenditures, and the audit results have to be published in the local press and the fund will be subject to an independent audit annually. The website of the fund was established on 22 May 2002 at http://www.nationalfund.kz. The Kazakhstani Oil Fund produced its first full report in February 2002. The Kazakh opposition demanded transparency – ‘We won’t allow to plunder the National Oil Fund’ (BBC Monitor, 8 March 2002) – they wrote in a letter to James Turley, chairman and CEO of Ernst & Young Global, the firm selected as an independent auditor. According to the conclusions by the independent auditors, the financial report in all principal aspects provides a fair view regarding the financial situation of the National Fund of the Republic of Kazakhstan on 31 December 2001 and its cash flows for the period from 23 August 2000 (the beginning of the National Fund’s functioning) to 31 December 2001, according to the International Financial Reporting (formerly International Accounting Standards). Table 11.4 shows the growth of the Fund’s assets; the Government of Kazakhstan estimates the revenues of the National Fund at 5 per cent of GDP. Table 11.4

Kazakh oil fund: assets and liabilities

Year

Total assets, mln US$

Liabilities, mln US$

2000 2001 2002*

n/a 1 240.4 1 919.4

n/a 51.2 (?) 14.6 (?)

Note: *Authors’ estimations. Source: Data from the National Bank of Kazakstan, Annual Report 2001, supplied by Grigorii Marchenko, Governor, National Bank.

A major managerial challenge is related to the supervision of the oil fund. The experiences of some other oil-rich countries have shown that ‘petrodollars enabled inefficient, corrupt and wasteful governments to cling to power long after they would have been seriously threatened, if not actually overthrown’ (Amuzegar, 1999, p. 207). Whether or not the Kazakhstani government can avoid such a path remains to be seen. However, current studies6 have demonstrated that Kazakhstan is on a dangerous route: at

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present there is a wide range of delays in the hydrocarbon sector from both bureaucratic procedures and institutional conflicts. Since the oil price has been stabilised after its 1999 decline, there are repeated indications that the Kazakhstani government is planning to change the established agreements with the oil investors. By this the government creates a risk of reducing investments in existing projects and in addition, losing new projects. ‘Bad government as well as bad luck can kill growth’ (Easterly, 2001, p. 217). In the Kazakhstani context, ‘bad government’ denotes the dangers posed by a state bureaucracy, living off the oil revenues and trying to allocate and redistribute the proceeds of oil wealth to itself. ‘Bad luck’ denotes the danger of a decline in world oil prices. Taking advantage of the current relatively favourable state of the international oil market, the government should establish a transparent mechanism for monitoring the activities of the National Oil Fund, and should create a comprehensive strategy for optimizing the size of the fund as well as for the redistribution of the fund’s resources. There are other longer-term issues in the management of hydrocarbon wealth. Large natural resource stocks are a mixed blessing. On the one hand, they potentially allow a higher material standard of living; but on the other hand, their non-renewable nature makes it important to guard against choosing development paths which are unsustainable once the resource is exhausted. In principle, the appropriate strategy is clear. An economy with a finite resource should not finance consumption equal to more than the permanent income equivalent of that resource out of the proceeds of revenue from extraction and sale of the resource stock. The permanent income equivalent is a constant value annuity whose present value is equal to the present value of the remaining stocks of the resource. If this amount of the resource is extracted and sold each year, and the revenue used to boost consumption, then the resulting extra consumption is sustainable indefinitely. There is no reason why the annual extraction rate should not exceed this permanent income equivalent, provided that the excess production is used to finance investment, rather than consumption. Then the resulting investment will generate new streams of output in future, sufficient to maintain consumption once the flow of revenue from the resource stock diminishes. This approach reflects a broad concept of sustainability: the assumption is that natural capital and man-made capital (including human capital) are substitutable, so that it does not matter if a natural resource stock is depleted, provided that it is replaced by an equivalent amount of new manmade capital. This assumption of substitutability is sometimes highly questionable: for example it is not obvious that the loss of natural capital (in the form of global atmospheric conditions) which is implicit in the problem of


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global warming and climate change can be compensated by any increase in man-made capital: there is no obvious margin of substitutability. In the context of stocks of oil, natural gas and coal, however – the most important natural resource reserves in most of the transitional economies – substitutability between natural and man-made capital is clearly possible, and the broad concept of sustainability is therefore an appropriate framework. In practice things are more complicated. For instance, there is uncertainty about the size of many resource stocks: for example between 1986 and 1990 proven world oil reserves increased by some 40 per cent (BP Statistical Review of World Energy, 2001, p. 5). This carries over into uncertainty about the permanent income annuity value of the stock. An annuity calculated on the basis of current proven reserves may turn out to be a serious underestimate if there are subsequent new discoveries. Conversely, attempting to predict such discoveries and build them into the current annuity calculation risks overestimating the sustainable consumption level. Thus, linking consumption to the permanent income value involves inescapable uncertainty. There is related uncertainty about future prices; spot crude oil prices fluctuate sharply over medium time frames, with prices more than halving between the early and mid-1980s and, more recently, more than doubling between 1998 and 2000. This has a potentially very important effect on these countries where production costs are relatively high, and for whom profit margins may be eroded, or disappear altogether, at the relatively low prices in the mid-1990s. Some of the transition countries are in this category. By contrast, production costs in the Persian Gulf are generally well below even the lowest price experienced over the past 25 years. The issue of sustainability is further complicated by questions of time preference, that is the relative weight given to the present and the future. There is no objectively correct or universally accepted view about this. If the future is discounted relatively heavily, then it may be justifiable to consume more than the permanent income equivalent of natural resource wealth. In this way, the latter’s benefits will accrue disproportionately to current rather than future generations, but this is consistent with a view which attaches relatively little weight to future generations’ welfare. Heavy discounting of the future may be easier to justify in the very uncertain context which applies to natural resource usage. As well as the possibility of discovering additional resource stocks in the future there is also uncertainty about future technology: for example future technical advances may allow much lower levels of resource inputs per unit of output, in which case once again, ex post current rates of usage could have been higher. In the face of all these complications it is difficult to formulate a universal rule for the rate of natural resource usage. The seemingly simple idea of linking current consumption to the current calculation of the permanent

264


income annuity turns out not to be simple at all, and certainly does not give an unambiguous answer as to what policy is ‘best’. For example, in one sense both Venezuela and Saudi Arabia are extremely oil-dependent. In Venezuela oil production accounts for around one-third of GDP, half of all government revenue, and three-quarters of exports (Energy Information Administration at www.eia.doe.gov). For Saudi Arabia the corresponding figures are, respectively, 35–40 per cent, 70 per cent and 90–95 per cent. Is either of these cases a cause for concern, and if so which is more serious? One cannot answer these questions without also taking account of the size of remaining stocks relative to current usage, that is the ‘R/P ratio’ which is the ratio of the stock of remaining proven reserves (R) to the current annual rate of production and extraction (P). The R/P ratios in 2000 were 66.4 for Venezuela and 81.1 for Saudi Arabia (BP Statistical Review of World Energy, 2001, p. 4). Thus, at current rates of usage oil stocks are projected to last for more than two generations in Venezuela and for three generations in Saudi Arabia. If the annual rate of time preference is 5 per cent (so that a unit of utility one year from now is worth only 95 per cent as much as a unit of utility now), then social welfare 66 years into the future is worth only 4 per cent as much as current social welfare; 81 years into the future it is worth only 2 per cent as much. In other words, for relatively moderate rates of time discounting, it may be unreasonable for either Venezuela or Saudi Arabia to worry very much about the current sustainability of their resource usage, or to seek to invest large amounts of oil revenue in investment rather than in current consumption. Does the same argument apply to Kazakhstan or to other transitional economies? By 2001 oil and gas together accounted for some 47 per cent of total Kazakhstani exports. Although this proportion is currently much lower than the corresponding figures for Venezuela or for Saudi Arabia, it has risen sharply in the past four years, and is virtually certain to rise considerably further in future if current trends continue. Kazakhstan’s R/P ratio for oil is 31.1, and for gas is 172.0. Proportionately, its gas reserves are a little more significant than its oil reserves in world terms (1.2 per cent of the world total as against 0.8 per cent). Thus, taking oil and gas together, Kazakhstan is in a similar position to that of Venezuela and Saudi Arabia: although hydrocarbons currently dominate, increasingly so, its economic activity, remaining proven reserves are so large relative to current usage that it is not clear that it would be sensible for the country to adhere very rigidly to the ‘permanent income’ rule. This argument goes against the grain of much current thinking about policy towards finite resources. It has deliberately been stated in a relatively uncompromising fashion, in order to emphasize the basic points, and there is obviously scope for much further discussion. We consider several counterarguments.


265

The Problem of Price Volatility As already discussed, excessive dependence on oil or gas, or any other commodity subject to large swings in relative prices, potentially exposes the country concerned to the risk of large fluctuations in real national income. There are two quite different policy responses, however. One involves greater diversification of production and exports; the other – the path now being followed by Kazakhstan – involves intertemporal stabilization through ‘oil funds’, or the equivalent, which save (dis-save) when the oil price is above (below) trend. If the latter approach is taken, the problem of price volatility can be countered without the need for diversification. Thus, even the most extreme reliance on oil or other resources with volatile prices need not expose a country to the consequences of large price swings. Consumption Smoothing The basic argument in favour of the permanent income rule is based on intertemporal consumption smoothing: if the rule is properly applied, then in principle the current level of consumption can be sustained indefinitely into the future. An obvious objection to a policy which involves ‘excessive’ current consumption out of finite resource wealth is the risk that at a future date, the consumption level will have to be sharply reduced. Just as individuals often seek to ‘smooth’ consumption over time, so it can be argued that society in aggregate should do the same. Granted that intertemporal consumption smoothing is a legitimate social objective, however, the foregoing arguments emphasize that the appropriate policy to achieve it is far from straightforward. Essentially there is both a downside, and an upside, risk. The downside risk is the familiar one that excessive current consumption eventually becomes unsustainable, forcing a large future cut in consumption. The upside risk is implicit in the earlier discussion about uncertainty over future resource stocks. In the event of a large future resource discovery, today’s calculated permanent income value will turn out to have been too low, and if today’s consumption is set equal to the permanent income annuity, it will likewise turn out to have been unnecessarily low. Thus the upside risk is of a future increase in sustainable consumption, implying that the current generation consumes at an unnecessarily low level. As noted above, even moderate rates of annual time preference lead to rapidly reducing weights on future welfare. The upside risk is that today’s citizens end up consuming at a much lower level than future generations, despite the fact that, viewed from today’s perspective, the reverse pattern is more desirable.

266


It follows that in the presence of uncertainty, there is no way of guaranteeing a smooth intertemporal consumption path. Setting current consumption equal to currently calculated permanent income is merely the best current estimate of the strategy which will achieve a smooth path. Society has to decide whether it is more worried by upside or downside risks in choosing a path. Political Economy Arguments There is a well-established argument that large natural resource endowments tend to encourage bad government policy-making. To the extent that this is true, it should be taken into account when trying to identify appropriate policies. Yet again, however, no unambiguous conclusions follow. For example, use of an oil fund to counteract price fluctuations is open to the objection that the government may seek to divert the fund’s accumulated savings into other uses, for example ‘prestige’ projects, or other spending which benefits the government sector but not the wider community. On the other hand, attempting to counteract fluctuations by diversification runs the risk that the government may seek to influence the pattern of diversification in unhelpful ways, again perhaps with an emphasis on unproductive ‘prestige’ projects. Ultimately, no policy can be effectively ring-fenced against a sufficiently determined government. Commitment Another aspect of the political economy argument concerns the problem of committing a future government to a particular course of action. If the decision is taken to consume at more than the permanent income value of a resource stock, then by implication, and barring future new resource discoveries, a future government will need to make the decision to reduce consumption levels to what will then be sustainable. Unfortunately, whilst it is relatively painless for today’s government to make this commitment on behalf of a future government, it may be much more difficult for the future government to act on the commitment when the moment arrives. It will itself face a temptation to postpone the awkward decision to yet a further future point; and when the latter is reached, the same difficulty will occur all over again. This is similar to the arguments of Laibson (1997) and others about ‘hyperbolic discounting’, and the resulting need to make current commitments to which one is then locked in. Hyperbolic discounting does present a plausible argument in favour of consuming at, or near, to the current permanent income value, simply because it imposes a discipline which may otherwise be difficult to introduce at any future date.


267

Summarizing, the appropriate policy for Kazakhstan, or any other resource-rich country, to follow is not easily established. There is no unique ‘right’ policy, and there are perfectly respectable arguments in favour of consuming well above the current sustainable level, and postponing adjustment for later. The strongest argument against this is perhaps that based on commitment and hyperbolic discounting.

4.

CONCLUSIONS

A decade of transition has eliminated much of the industrial base and left the Kazakhstani economy dependent upon raw materials – especially oil and gas. Far from diversifying, therefore, the economy has become more dependent upon a few raw material sectors. Its risk exposure has thus increased, because its terms of trade are more vulnerable to price fluctuations in global oil and raw material markets. In short, a decade of transition has left Kazakhstan with many of the features of a resource-dependent economy. Whilst this is in some ways undesirable – especially because of the temptation it provides to follow bad policies – there are also counterargments. In particular, the establishment of the oil fund may help to mitigate price risks; and the sheer size of the country’s proven reserves relative to its current GDP, combined with the inescapable uncertainty surrounding all such intertemporal calculations, means that it is not necessarily undesirable for the country to remain primarily oil-dependent for some time to come.

NOTES 1. Data are from the database on Kazakhstani enterprise development since 1994 at the Centre for Euro-Asian Studies at the University of Reading. 2. The calculations in Table 11.1 are at best an approximate indicator. For example, the assumptions necessary to compute the change in aggregate capital inputs are relatively crude. However, the difference between the two halves of the decade is relatively robust with respect to plausible changes in assumptions. 3. Statistical Yearbook of Kazakhstan (2002), Agency on Statistics of the Republic of Kazakhstan, Almaty. 4. Since the Russian crisis of 1998 Kazakhstani FDI has also exceeded Russian FDI in terms of absolute totals, despite a tenfold difference in population size. 5. International Monetary Fund 2001 country report for Kazakhstan (Republic of Kazakhstan: Selected Issues and Statistical Appendix). 6. FIAS (2001) and interviews conducted by Yelena Kalyuzhnova ‘with Foreign Oil Investors in Kazakhstan’ (unpublished transcripts available from the centre for EuroAsian Studies at the University of Reading).

12.

Conclusions Gur Ofer and Richard Pomfret

The country case studies in this book offer a richness and subtlety that cannot readily be captured in cross-country growth analysis.1 They portray a rich and colourful patchwork made from the complex interaction between a common heritage, yet varied initial conditions and a variety of policy menus, implemented with different degrees of success. Despite the common historical background in the Soviet era, initial conditions in the CIS countries in 1991 varied substantially due to geography, resource endowment, the economic impact of the break-up of the Soviet Union, initial income levels and industrial structure. There were also differences in institutional capital, but here the imprints of the ancien régime as a major obstacle to change were more uniform. The studies of Kyrgyzstan, of Tajikistan and of Armenia emphasize the serious economic disadvantages arising from small size, landlockedness, isolation and inhospitable terrain. Moldova’s economic prospects are strongly shaped by its location and the lack of access to European markets for key agricultural crops (wine and tobacco). In Kazakhstan and Turkmenistan, and to a somewhat lesser extent in Russia and Uzbekistan, natural resources played an overwhelming role in the growth history of the first decade after independence; for these countries, good natural resource management has been, and continues to be, crucial for economic success. Belarus, Armenia and to a significant extent also Ukraine are energy (and other natural resource) importers, in which the political position of the industrialists (that is, managers of large state enterprises and their allies in the public administration) was powerful. Armenia, Azerbaijan, Georgia, Moldova and Tajikstan suffered from internal and external military conflicts, and these are only extreme cases of the social and political tensions existing in various degrees in all of the CIS countries.

1.

INITIAL CONDITIONS

The studies have generally tried to get behind the decline in total factor productivity which dominated the early and mid-1990s. The proximate cause 268

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of low and falling productivity, during the final decades of the old regime, emphasized in the chapter on Russia, is the long-term failure to replace old capital. The explanation is linked to Young and Krugman’s view of the similarity of East Asian and Soviet economic growth; both were based on factor accumulation, but the difference is that while upgrading and modernization of the capital stock occurred in East Asia it was absent from the USSR. In consequence the new independent states inherited a capital stock that was not worth much.2 This is not inconsistent with deeper views of initial conditions, emphasizing the lack of traditions of democracy, civil society, property rights and rule of law (and respect for the law), that is, the institutional infrastructure that was analysed in the Introduction. The need to mostly import and transplant quite alien but essential formal legal structure and institutions on the one hand, and the inherited informal rules that contradicted these formal institutions in content and in approach on the other hand, together created an environment hostile to reform and to institutional changes. These are difficult to pin down, but appear crucial to explaining the disappointing growth record in the CIS since 1991. Indeed, the main thrust of the country chapters is on weaknesses of the institutional-governmental infrastructure as the main barriers to economic growth. These weaknesses were further reinforced in Moldova, Tajikistan, Ukraine and Belarus by the lack of clear view of their national destiny and/or an internal conflict on its direction. In Russia, the lost status of a big power and head of an empire, and the absence of external power to blame for the failure of communism, contributed to weakness of purpose and a lack of concerted social action. With an improvement of the institutional base, there would be local as well as external capital and technology as well as entrepreneurship, and domestic human capital, to foster growth.

2.

RESOURCES: CURSE OR BLESSING?

The distinction between rent-seeking (or spending as in Turkmenistan) and productive activity is also a recurring theme in differing contexts of both resource exporters and resource importers (Ukraine). The curse of oil can be seen in different contexts in the chapters on Russia, Kazakhstan and Turkmenistan.3 Specifically, the illusion of plenty of resources tolerated more lax fiscal and restructuring policies and the continuation of soft budgeting, and the export revenues appreciated the exchange rates, making restructuring more difficult for other industries. Russia, although somewhat more diversified, remained mostly a resource-rich economy, while Kazakhstan has become more completely dependent on a narrow economic

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base of exportable natural resources, and Turkmenistan has tried to use resource rents to diversify. In all three countries, the abundance of oil or gas and the paucity of other ready sources of hard currency earnings led to intense competition for rents at the expense of directly productive activities. The Ukraine study illustrates how a conservative rent-seeking leadership delayed reform first through distribution of residual energy rents, then by printing money, non-payment and barter, and still later by borrowing internationally in order to sustain a strategy of subsidizing large energy-using enterprises in existence. The strategy was unsustainable and collapsed in 1998, when reform had to be brought on to the agenda. There, as in the resource-rich economies, the importance of access to energy or other resources in determining political power in the early post-independence period had a feedback mechanism of distorting the political evolution of the new independent states. All four of these country studies – and to a lesser extent those of other countries – identify examples where the feedback mechanism led to adoption of policies inimical to soundly based economic growth. The availability of foreign assistance, whether from the international financial institutions (as in Kyrgyzstan, Moldova or Russia) or from a diaspora (as in Armenia) or in military aid (as in Tajikistan), may have played a similar role in relaxing reform efforts and encouraging rent-seeking and political corruption. This strategy too has been unsustainable. A striking feature, particularly among some of the poorer CIS countries, has been the rapid accumulation of external debt to the point that several were forced to seek relief from their creditors by the early 2000s.4

3.

THE EVOLVING POLICY FRAMEWORK

The studies of Russia, Ukraine and Belarus all discuss the evolution of policy, and in the last case the prospect of policy reversals. The Russia study utilizes the country’s size and geographical diversity to analyse the determinants of regional growth patterns in differing time periods. In the initial period (1992–95) only export potential matters significantly in differentiating regional performance, but in 1996–98 governance starts to matter, and from 1999 onwards the degree of liberalization finally becomes a significant determinant. Another dynamic element of the Russian case study is the optimistic conclusion that responsiveness to economic signals has increased. This was highlighted after the 1998 devaluation. Similar increased responsiveness by the end of the 1990s was visible in other countries (for example Ukraine and Kazakhstan). The opposite story is told in Belarus, due to reform reversals, and also in the Kyrgyz Republic, perhaps

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the most rapidly reforming CIS country in the early and mid-1990s, which put reforms on hold after the 1998 crisis. The general point is that transition has been a process with its internal dynamics and each country’s experience is poorly captured by a point estimate of the degree of liberalization. If the Russian pattern can be generalized, then trying to identify initial conditions or good governance or liberalization as the determinant of economic growth may be time-dependent. The most important determinant may mainly depend upon the stage of transition or, in cross-country regressions, on the time period chosen for study. Even those who see initial conditions as the key variable in cross-country growth regressions for the 1990s acknowledge that their significance diminishes as we move into the twentyfirst century (for example Falcetti, et al., 2000). As mentioned in the Introduction, liberalization and structural reform have taken a decade or more to bear fruit in settings such as Chile or Australia.5 Similar (or even larger) time lags are likely to obtain in the CIS, and be conditional on institutional reform. Thus, the move to a market-based economy may now begin to bear fruit in Russia and, less definitely, in Ukraine, but the benefits may be longer delayed in institutionally less-developed settings such as Moldova, Kyrgyzstan or Tajikistan. The evolving policy framework makes it difficult to generalize about the evidence on the policy debate over the pace of transition, that is, whether shock therapy or gradual reform was preferable. Over time and with some hindsight the debate narrowed into more or less general agreement that it was important to move relatively fast on price liberalization, openness to trade and macroeconomic stabilization, while privatization, restructuring and financial reform required more time and could be accomplished at a slower pace. Institutional reform is generally, but not in all respects, much slower, although critics of classical shock therapy mentioned the lack of an early start with institutional reform as a major barrier to early recovery. Within the CIS three states, Belarus, Turkmenistan and Uzbekistan, deviated in a significant way from the above by their general commitment to gradualism. While they did eventually liberalize most prices, opened up significantly for trade and tried to fight inflation, they also preserved some price controls and larger budgets in order to soften the income blow on the population. They imposed strict central rule to preserve the rule of law and discipline, and to minimize illegal activities, and also slowed down the processes of small and, especially, large-scale privatization and refrained from granting full ‘democratic’ rights. Uzbekistan paid for its more gradual and protective policy by a lingering higher rate of inflation throughout, and continuing to 2002 (see Table 1.4 in the Introduction), but per contra it enjoyed the smallest and (almost) shortest initial decline of output and by

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2002 was the only CIS state to have surpassed its 1989 level of GDP. Uzbekistan still maintains a relatively large budget especially among the central Asian States, but with no significant deficit (see Table 1.7 in the Introduction). The same could have been said about Belarus, except that there was a policy reversal around 1995 back to a conservative, pseudoplanning set of policies. The reversal brought back three-digit inflation for a while and in 2002 it was still at more than 40 per cent, by far the highest among the CIS states; but on the other hand GDP grew handsomely over the last seven years and by 2002 reached more than 90 per cent of its 1989 level. Turkmenistan has also followed a cautious transition strategy, retaining a pseudo planning set of policies throughout the transition. Turkmenistan’s economic performance has been less good than that of Uzbekistan or Belarus, although inflation rates have little meaning in the tightly regulated economy and the national accounts data are the most suspect in the CIS. At the other end of the range Kyrgyzstan, the most prompt and consistent follower of the Washington consensus, chose to put its strategy on hold after the 1998 crisis. In sum, while both Uzbekistan and Belarus receive among the lowest overall transition grades from the EBRD, at 2 and 2 respectively (Turkmenistan gets 1, see Table 1.7 in the Introduction), one is left with the question of to what extent these two republics managed to do it in a better way or whether they only succeeded in postponing some of the pains of transition to a later date. The chapter on Belarus seems to support the postponement hypothesis, while the chapter on Uzbekistan clearly supports the gradual transition as a better option. In any case the people of Uzbekistan did travel so far via a less threatening desert. The CIS countries’ large initial gap in both formal and informal institutions, discussed in the Introduction, may provide a rationale for the gradual route. Russia’s experience before and after the 1998 crisis provides a clear example of two different outcomes under the same set of initial conditions and even (intended) policies – but with different institutional backing. True, the growth achievements since 1999 are partly an outcome of the devaluation brought by the crisis and the rise in energy prices, but it is no doubt also a result of the marked decline in disorganization achieved by the shift from the Yeltsin to the Putin government. The institutional gaps in Russia are still enormous, but the experience of the last few years underlines the great potential of even modest institutional improvements. It also demonstrates how the interaction of similar policies in different institutional environments can shift the outcome from one that leads to a crisis to one that promotes growth.

Conclusions

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273

CONCLUSIONS AND FUTURE PROSPECTS

An overarching theme of this volume is the importance of institutions, both as inherited initial conditions and as something that has evolved since independence. Institutions clearly influence growth, but the interesting question is why do institutions differ across countries. All of the evidence points to a divide between Eastern Europe and the CIS, whatever the explanation – whether due to Eastern Europe’s shorter period under communism or to some peculiarly Russian cause present through both the Tsarist and Soviet regimes. The studies in this book raise the question of whether a second divide distinguishes Russia (and perhaps Belarus or Ukraine) visà-vis the less institutionally developed CIS countries such as Moldova or the Caucasus or the Central Asian countries. The answer to this question could be crucial to assessment of the CIS countries’ future prospects insofar as it may be plausible that the institutionally more developed countries such as Russia and perhaps Ukraine have turned a corner in transition, while the long-term prospects may be less positive elsewhere in the CIS if long-lasting institution building is a necessary precondition for sustained growth. Another issue which will influence long-term growth prospects is the CIS countries’ success in taking advantage of opportunities in the world market. As mentioned in the Introduction, all but Turkmenistan are members of or seeking accession to the WTO, but in the experience of Kyrgyzstan or Moldova WTO accession has been far from a sufficient condition for successful integration into world markets. The process of trade reorientation and of integration into world markets has been much slower for the CIS countries than for Eastern European countries, and pre-exising trade patterns have been much more durable than many would have expected. All of the CIS economies were closely linked to Russia, and dependence on Russia remained important in the early years of independence, even though the common currency disappeared and the CIS never became a regional trading arrangement. By the late 1990s, however, a divide had emerged between the countries which have accepted continuing relations, symbolized by the Eurasian Union involving Russia, Belarus, Kazakhstan, Kyrgyzstan and Tajikistan, while the GUUAM grouping (Georgia, Ukraine, Uzbekistan, Azerbaijan and Moldova) has as its main glue suspicion of and resistance to Russian designs. In the early years of the twentyfirst century, international economic relations remain fluid as uncertainty still surrounds construction of key pipelines and as the political situation in southern neighbours of the Islamic states is unsettled. What are the long-term growth prospects of the CIS states? What did we learn from the first decade that can shed light on it? If we have to reach

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a judgement on this on the basis of the chapters of this volume, then the answer will be that much depends on the speed of movement along the learning curve of how to assemble together correctly and efficiently the main elements responsible for growth, rather than on how to collect enough basic inputs that produce it. The old regime concentrated mostly on mobilizing inputs, and failed to shift gear from extensive to intensive growth, despite endless reforms. The new regime is struggling to learn how to get the most out of a given amount of inputs or out of potential inputs that will not be realized unless the right infrastructure is created. Total factor productivity (TFP) was borrowed from the study of real production functions of specific products to the broad production arena of entire economies. In the Western literature the term ‘productivity’ was used mostly to describe technological innovations, enterprise-like organizational improvement and the like. For economies in transition it means a process of building a new institutional system. This, in combination with the stock of human capital, will help to build the new capital stock. We have seen why building new institutions for the market and for democracy are much more difficult for CIS states than for their Western neighbours. The ability of the Baltic states to jump over and join the more successful group underlines the past dependency of this process, the inferior initial conditions and the interaction between these and the choice of policies and their effectiveness. We have also seen that the policies implemented had varied results, and that in some cases a better balance between freedom and strong government can improve matters in either direction. The most important lesson learned is that the old debate between gradualism and the fast track was rather simplistic and that building new institutions (formal, informal and enforcement), and making them work together, is a long process, much beyond one decade. This calls for immediate action on some fronts without waiting for institutional change. Other actions, if implemented prematurely, may backfire. In the longer run institutional improvements and policy choices merge to the same thing. Those among the CIS states that will meet the institutional challenge more readily will find higher and more sustainable growth, and the global economy will move in to magnify the results by providing capital and know-how. There is no doubt that further institutional building will be left for the third decade. As everywhere, long-term growth prospects depend mostly on the rate of TFP growth, but transition economies, and especially the CIS countries, are different in that TFP depends heavily on institutional developments.

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NOTES 1. The conclusions in this chapter are based on the long versions of the papers, available electronically at www.eerc.ru, as well as the material in the country chapters of this book. 2. The Soviet extensive growth model is analysed in the first section of the Introduction of this book. The growth accounting exercises on East Asia are in Young (1994; 1995) and were publicized by Krugman (1994). 3. It would also have been interesting to compare the outcomes in Azerbaijan, but during the early and mid-1990s Azerbaijan’s economic performance was dominated by war and recovery as much as by oil. 4. Under an agreement by which Russia assumed the external assets and liabilities of the Soviet Union, all the other CIS countries started with zero foreign debts. By the end of 2000 the combined debt of Armenia, Georgia, Kyrgyzstan, Moldova and Tajikistan was US$5.9 billion, or US$252 per capita, and on average 73.5 per cent of GDP. The data are from a joint IMF/World Bank report on ‘Poverty Reduction, Growth and Debt Sustainability in Low-Income CIS Countries’ dated 4 February 2002 and available with other material on these countries at http://www.cis 7.org. 5. Chile entered its ‘golden age’ some ten to 15 years after the initial economic reforms. Australia enjoyed the highest growth in the OECD during the 1990s, although initial responses to the reforms of the early 1980s had been disappointing.

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Index Acemoglu, D. 194 agriculture 23 Armenia 27, 133, 144–6 Belarus 58, 63 Kazakhstan 249 Kyrgyzstan 224, 225, 227, 245–6 Moldova 3, 26–7, 102, 108–16, 124–5 Russia 41, 42, 53 Tajikistan 200–202, 208–10 Turkmenistan 28, 156, 157, 162–6, 167, 168, 170–1, 172 Ukraine 26, 80, 96, 99, 100 Uzbekistan 177–8, 180, 182–3, 187, 188–9, 195–6 aid 136, 235–9, 244 aluminium (Tajikistan) 202–3, 213, 222 Amuzegar, J. 261 anti-monopoly legislation 91, 228 antitrust legislation 199 Armenia 19, 22 –Azerbaijan conflict 10–11, 27, 133, 136, 138 basic facts 128–30 institutional policy 152–3 long-run growth trends 130–36 natural resources 268, 270 transformational recession 136–52 Armenian dram (AMD) 129, 134, 136 arms see military sector ASA 111 Ashgabat plant 168 Asian Development Bank 180, 192, 233, 235, 236 Aslund, A. 42, 45, 66 asset-stripping 112, 117, 135, 171, 178, 205 Association Agreement 69 Atkinson, A. 2 autocracy (Turkmenistan) 28, 154–76

Auty, R. 249 Avanesyan, V. 140 Azerbaijan 10–11, 19, 27, 133, 136, Bakanova, M. 59, 67, 69, 70 banking sector 22, 30 Armenia 134 Belarus 64 Kyrgyzstan 244 Russia 51 Tajikistan 214 Turkmenistan 169 Ukraine 78 Uzbekistan 191 see also central banks Barro, R.J. 187, 191 barter Belarus 63, 65 Russia 49–51 Turkmenistan 161, 169, 171 Ukraine 26, 49, 80, 87, 95, 270 Bektemirov, K. 180, 189 Belarus 9, 25, 268 country-specific growth 67–9 future prospects 273 growth patterns 60–66, 72 initial conditions 57–60, 72, 269 microeconomic aspects 69–72 policy evolution 72–3, 270, 271–2 Belarus Policy Matrix 57, 62, 63–5, 66 Belarusian rouble (BRB) 60, 62 Berg, A. 32, 41, 45, 155 Berglof, E. 4, 32, 33 Berkowitz, D. 34 Big Bang strategies 15–16, 23, 28, 179 Bishkek–Osh road 233, 235 Blanchard, O. 44, 59, 156 Bolton, P. 4, 32, 33 Bosworth, B.P. 2 Brezhnev, L. 178 bribery 7, 22, 118, 194 289

290


budget deficits 15, 16, 19, 22 Armenia 137 Belarus 62, 64 Kyrgyzstan 227, 237, 238, 247 Moldova 107 Russia 36 Ukraine 88, 89, 98 Uzbekistan 190–91, 272 Bunce, V. 38–9 Campos, N.F. 32, 41, 138 capacity utilization 70–72, 200, 212 capital 6, 269 Armenia 130–31, 132, 133, 144 investment see investment market (Kyrgyzstan) 243–4 capital flight 29, 45, 63, 178 capital goods 6 Carlin, W. 49, 51 Castanheira, M. 33, 37, 184, 190 central banks Belarus 62 Russia 9, 85, 179 Turkmenistan 169, 171 Uzbekistan 191, 194 Central Intelligence Agency (CIA) 42 central planning 4, 5–6, 11, 36, 58 Charter 77 38 Chepel’, S.W. 182, 183, 184 Chernobyl nuclear accident 25, 60, 72 China 17, 23, 36, 38, 162, 163 civil war Armenia–Azerbaijan 10–11, 27, 133, 136, 138 Georgia 268 Moldova 102, 103, 105, 122, 124, 268 Tajikistan 28, 162, 199–200, 207, 210, 211, 217, 222, 268 coal industry 80, 202 COMEX 169 Commonwealth of Independent States economic growth in 23–30 economic reform 10–23 future prospects 273–4 Soviet background 1–10 communism/Communist Party 4, 5, 6, 8 Russia 24, 33, 36, 38, 39, 40, 44 Soviet Union 7, 10, 38, 39, 85

Ukraine 85, 86 Uzbekistan 178 comparative advantage 23 Armenia 140 Kazakhstan 252, 253 Kyrgyzstan 229–32 Ukraine 97 competition policy (Ukraine) 78 computable general equilibrium (CGE) model 69 Constitutional Court (Moldova) 112 construction sector Armenia 144–6 Russia 53 Tajikistan 201 Turkmenistan 156, 157, 166 consumer price index (CPI) 14, 68, 227 consumption smoothing 265–6 contracts 7, 9, 92 Coricelli, F. 32, 41, 138 corruption 5, 25, 270 bribery 7, 22, 118, 194 control of 21, 22 Kazakhstan 249, 261 Moldova 27, 117, 119, 121, 123, 125 Russia 34, 40, 44, 46, 48 smuggling 117, 243 Tajikistan 199 tax evasion 117, 122 Ukraine 81, 84, 85, 91, 99 Uzbekistan 190, 194 cotton production Tajikistan 202, 213 Turkmenistan 162–3, 165, 167–8, 170, 171 Uzbekistan 178, 179, 180, 188–9, 196 Council of Europe 102 Council of State Creditors 102 creative destruction 83, 92, 93 credit 102, 210, 211, 244 Czechoslovakia 38, 39 Dabrowski, M. 106 de-industrialization Kazakhstan 250–54 Moldova 109 Tajikistan 198, 215–21 De Broeck, M. 101, 104–5, 186 debt 270

Index Armenia 130, 137, 147, 150 Kyrgyzstan 235, 238–9 Moldova 27, 102–7, 117, 124–5, 126 Russia 19, 45 Ukraine 92, 94, 95 Uzbekistan 193 demand 147–8 shocks 141, 142, 166, 167 De Melo, M. 41, 42, 58, 138, 184, 185 democracy/democratization 9, 22, 26 Moldova 122–3 Russia 33, 37–8, 40, 44, 47, 52–3 Uzbekistan 178 Denizer, C. 41 de Souza, V. 69 disorganization process Belarus 59, 65, 66 Russia 44, 46, 47, 49, 50, 272 Turkmenistan 156, 158 Djankov, S. 70 Dolinskaya, I. 249 Dushanbe 206, 209, 212, 214, 216–17, 219–21 Dutch disease 3, 84, 88, 116, 256–7, 259–60 Easterley, W. 131, 262 Economic Commission for Europe (ECE) 251, 253 economic freedom 78, 79, 128 economic growth 23–30 Armenia 128–53 Belarus 57–72 Kazakhstan 249–67 Kyrgyzstan 224–48 Russia 32–56 Tajikistan 198–223 Turkmenistan 154–76 Uzbekistan 181–4 economic performance Turkmenistan 154–76 Ukraine 81–90 economic reform (in CIS) 10–23 Economist Intelligence Unit 177 education 2, 3, 6–7 Armenia 27, 128, 129, 132, 1135, 140, 149, 150–52 Kyrgyzstan 225, 241–3, 247–8 Moldova 106 Russia 44, 46, 47

291

Tajikistan 218, 220–21 Uzbekistan 187, 189, 192 electricity industry (Tajikistan) 204 elites 7, 85–6, 97–8 ELTO plant 212 emigration Armenia 137, 143, 150 Kyrgyzstan 239–40, 241 Moldova 106, 123, 126 Tajikistan 28, 215–21, 222 Ukraine 85–6 employment in agriculture (Moldova) 113, 114 in agriculture (Uzbekistan) 188 Armenia 132, 133 Tajikistan 215–21 see also full employment; unemployment energy sector Armenia 27, 133, 134 Belarus 25 Kazakhstan 29, 254–67 Kyrgyzstan 231, 232 Moldova 26, 108, 116–17 Russia 24, 38, 272 Ukraine 25, 26, 76, 77, 82–4, 86–90, 94–6, 99, 270 Uzbekistan 185 enforcement see law enforcement enterprise reform (Ukraine) 78 Enterprise Survey 50, 118, 120, 121 Ergashev, B. 180, 188 Eurasian Union 273 Eurobonds 88 European Bank for Reconstruction and Development (EBRD) 191, 192, 236 Enterprise Survey 50, 118, 120, 121 transition indexes 19–20, 22, 60, 62, 66, 102 Transition Report 12, 14, 20, 78 European Comparison Programme 251 European Union 24, 33, 40–42, 67–9, 73, 97, 101–2, 103, 122, 191, 236 exchange rate 269 Armenia 129, 134, 137, 140, 141 Belarus 59, 62, 63 Kazakhstan 256, 257, 260 Kyrgyzstan 238 Moldova 107

292


Russia 35, 45, 49, 51 Turkmenistan 169, 172 Ukraine 95 Uzbekistan 194 expectation hypothesis 34–5, 41 exports Armenia 130, 139, 141 Belarus 60, 63, 67–9, 70–71 Kazakhstan 249, 255–6, 259, 264 Kyrgyzstan 226, 227, 231, 232, 247 Moldova 108, 111 Russia 44, 46, 47, 49, 51–2, 270 Tajikistan 212, 213 Turkmenistan 158–60, 161–2, 166, 169, 270 Ukraine 88, 95 Uzbekistan 185, 195 extensive growth model 6, 104 factors of production 4 Belarus 67 Kyrgyzstan 226 Moldova 103 Uzbekistan 182 Falcetti, E. 271 Filer, R. 125, 181 financial institutions 22, 29 financial markets (Kyrgyzstan) 244 financial shock (Armenia) 141 fiscal policy 269 Armenia 136 Belarus 62, 64 Moldova 106–7, 124 Fischer, S. 29, 32, 45, 101, 102, 131 fixed production assets (FPAs) 233 Fokin, V. (Ukrainian PM) 86 foreign aid 136, 235–9, 244 foreign direct investment (FDI) 19 Armenia 137, 147, 149–50 Belarus 62, 65, 73 Kazakhstan 256, 259 Kyrgyzstan 231–2, 235, 247 Moldova 125 Russia 25, 35, 45, 54 Tajikistan 207, 208 Turkmenistan 167 Ukraine 81, 88 Uzbekistan 194 Foreign Exchange Reserve Fund 171–2

foreign trade see exports; imports; trade formal institutions 7–8 Frienkman, L. 140 Frye, T. 81 full employment 154, 239 Gaddy, C. 49 Gaidar, E. 211–12 Garibaldi, P. 45 gas industry Belarus 65 Kazakhstan 29, 249, 254–5, 256, 258, 260–67 Russia 117, 160 Turkmenistan 27–8, 154, 158–62, 166, 167, 170–71, 173, 175 Ukraine 92 Gazprom 117, 160 Gelb, A. 41 Georgia 11, 22, 273 Gorbachev, M. 10, 24, 35, 38, 39, 178 Goskomimushestvo 190 Goskomstat 2, 43, 47–8, 54 government effectiveness (indicators) 21–2, 41 grabbing hand 18, 76, 117 Russia (collapse) 35–42 state capture 9, 26, 27, 81, 85, 117, 119 Turkmenistan 168–74 Ukraine (state interference) 91–2 Uzbekistan (size) 189–92 Government Short-Term Bonds (GKOs) 50, 64, 190 ‘grabbing hand’ 18, 76, 117 gradualism/gradual reform 15–16, 274 Belarus 271 Moldova 124 Turkmenistan 271 Uzbekistan 178, 271 gross domestic product (GDP) 3, 12, 15 Armenia 128–9, 136, 138–41, 143–9 Belarus 58–9, 61, 62, 66–7, 72, 272 Kazakhstan 251–2, 267 Kyrgyzstan 225–6, 227, 229, 230, 233–4, 236–7, 243–4 Moldova 26, 102, 107–9, 110–11, 117, 121

Index Tajikistan 198–9, 202, 205, 206, 222 Turkmenistan 154, 161, 166, 172 Ukraine 82, 87, 88–9, 96, 98 Uzbekistan 181–4, 189–90 gross industrial product 227 gross national income (Moldova) 111 gross regional product 43–4, 45, 47–8 gross value added (Armenia) 146 Grubel–Lloyd intra-industry trade coefficient 230 Guriev, S. 50–51, 70 Gutman, P. 143 GUUAM grouping 273 Gylfason, T. 84 Haizhou, H. 51 Hanousek, J. 181 hard budget constraints 17, 18, 23 Ukraine 89, 90, 95, 100 health care 6–7, 187, 189–90, 225, 247 heavy industry 6 Hellman, J. 81, 117, 118, 119, 120–21 Heritage Foundation 79 Heybey, B. 185 hidden economy (Armenia) 142–3 highly-indebted poor countries 250 historical hypothesis 33–4, 41 Hoekman, B. 70 human capital 7, 29, 274 Armenia 27, 128–53 Kazakhstan 249, 260, 262 Kyrgyzstan 241–3, 247 Moldova 104, 106, 116, 121, 126 Russia 38, 39, 41 Tajikistan 215–21, 222 Ukraine 26, 83, 86, 98, 99, 100 Human Development Index 6, 126, 128, 129, 187, 245 Human Development Reports 129, 130 hydrocarbon sector 250, 253–4, 260–67 hydropower (Kyrgyzstan) 232 hyperbolic discounting 266–7 hyperinflation 11, 16 Armenia 133, 136 Moldova 106, 108 Ukraine 76, 86–7 Ickes, B. 49, 51, 70 imitation-experimentation paradigm 33–4

293

import-substituting policies 28, 63, 77, 155, 194, 196, 212 imports Armenia 130, 139 Belarus 60, 63, 67–8 Kazakhstan 257, 259 Kyrgyzstan 226 Tajikistan 212, 213–14 Turkmenistan 169 Ukraine 77, 88, 89 Uzbekistan 194, 196 incentives (Moldova) 116–24 income levels 1, 2, 13, 19, 245 Armenia 128–9, 137 Belarus 25, 58 Russia 25 Tajikistan 28 Uzbekistan 186–7 incremental capital-output ratio 193 indicative planning 243 industrial sector Armenia 144–7 Belarus 58–60, 67–8 Kazakhstan 251–2 Kyrgyzstan 225, 226 Russia 44, 45, 46, 51, 53 Tajikistan 200–205, 215, 216 Turkmenistan 156–62, 166–7 Ukraine 76–7 Uzbekistan 179–80, 182, 184 industrial structure 3, 6 Belarus 25 Russia 24, 42–4 Tajikistan 202–5 Ukraine 77, 82–3 industrialization 3, 6 Kyrgyzstan 225 Moldova 103, 105, 109 Uzbekistan 177, 178, 194 see also de-industrialization; overindustrialization inequality, poverty and 18–19, 247 inflation 7, 10, 11, 14, 16, 22, 23 Armenia 129, 133, 134, 136, 143 Belarus 60, 62–3, 66, 67–8, 272 Kyrgyzstan 227, 238, 244, 247 Moldova 102, 106, 208 Russia 36, 45, 50 Tajikistan 200, 211, 214 Turkmenistan 169, 172, 272

294


Ukraine 76, 77, 86–7 Uzbekistan 179, 181, 191, 271 see also hyperinflation informal institutions 7–8 infrastructure 5, 6, 17 Armenia 133 Kyrgyzstan 235, 238 Moldova 104 Turkmenistan 155 Uzbekistan 196 initial conditions 1, 2–4, 23, 268–9 Armenia 138–40 Belarus 57, 58–60, 72, 269 Moldova 101, 269 Russia 35, 42–54, 269 Tajikistan 269 Ukraine 76–7, 269 inputs 6, 10, 164–5, 226 institutional capital 28, 177 institutional environment (Ukraine) 81, 97–9 institutional failure (Moldova) 116–24 institutional memory (Ukraine) 83–4 institutional policy (Armenia) 152–3 institutional reforms (Tajikistan) 205–15 institutions financial 22, 29 formal/informal 7–8, 120–23 Kyrgyzstan 228, 243–5 Inter-American Development Bank 77 interest rates Kyrgyzstan 244 Tajikistan 210 Ukraine 94 Uzbekistan 193 International Finance Corporation Survey 87 international financial organizations (IFOs) 86, 97, 136, 247, 270 International Monetary Fund 102, 136, 255, 257 Country Reports 105, 155, 158, 172 International Financial Statistics 105, 107 Kyrgyzstan 227, 236, 239 Poverty Reduction and Growth Facility (PRGF) 239 staff estimates 170, 172

Uzbekistan and 177, 183, 185–6, 192, 193 World Economic Outlook 41 investment 6 Armenia 132, 144, 147, 149 Belarus 62, 66, 73 Kazakhstan 256 Kyrgyzstan 234–5, 236, 237 Moldova 103, 104 Russia 35, 52–4 Tajikistan 200, 212–13 Turkmenistan 154, 167, 169, 171, 173–4, 175 Uzbekistan 177, 190, 192–4, 195–6 see also foreign direct investment invisible hand 18 Islamov, B. 178, 179 ITERA 161 job creation (Ukraine) 93–4 job destruction (Ukraine) 93–4 joint-stock companies 102, 112, 124, 179 joint ventures 70, 71–2, 184, 194 Kalyuzhnova, Y. 252, 254 Kara-Keche coalmine 233 Kara-Kum Canal 162, 164 Karimov, I. (Uzbek President) 178, 179 Kaufmann, D. 22, 35, 41, 123 Kazakhstan 9, 10, 11, 29, 249, 268–70 development (first decade) 250–54 future prospects 273 hydrocarbon sector wealth 260–67 impact of energy 254–60 policy evolution 270 Kazakhstani Oil Fund 260–61, 262 Khrushchev, N. 178 Kinakh, A. 91, 96 Knack, S. 122, 123 Koen, V. 101, 106, 186 Kolesnikova, I. 70 kolhoz 112, 115, 124 Kornai, J. 81 Kravchuk, L. (Ukraine President) 86 Kremer, M. 44, 59 Krugman, P. 269 Kuchma, L. (Ukraine President) 91, 92 Kulyab airport 204 Kumtor gold mine 227, 232, 235 Kushnirsky, F. 138

Index Kyrgyzstan 16, 28–9, 224, 268 development in Soviet period 225 future prospects 273 long-run economic growth 232–46 natural resources 270 policy evolution 270–71, 272 transition period 225–32 Kyrgyzglavenergo 243 labour 6 Armenia 130–31, 132, 133 Belarus 70–71 Kyrgyzstan 239–41, 242, 244, 247 Tajikistan 215–21, 222 Uzbekistan 182–3 see also human capital labour market Kyrgyzstan 244 Tajikistan 215–21, 222 Ukraine 93–4 Laibson, D. 266 land Armenia 136 Kyrgyzstan 245 Moldova 108–16, 124, 125, 126 Turkmenistan 170 Ukraine 99 law enforcement 7 Moldova 120–23, 124, 125–6 Russia 34, 40 Ukraine 92 legal environment stability coefficient (LESC) 228, 229, 230 legal transition (Russia) 35–42 legislation Kyrgyzstan 228–30 Moldova 120–23, 124 Russia 40 Tajikistan 199 Ukraine 78, 89–90, 91, 95 Uzbekistan 178 see also law enforcement; rule of law Levine, R. 253 liberalization 15, 16, 23 Armenia 136 Belarus 60, 69, 72, 73 Moldova 101, 106, 118 Russia 24–5, 35–6, 41–2, 44, 46, 48, 52–4, 270–71 Uzbekistan 179, 185–6

life expectancy 2, 3, 129, 187, 245 light industry 70, 167 liquidity crunch 50 living standards 6 Belarus 58 Kyrgyzstan 240, 243, 245 Moldova 104 Tajikistan 198, 210, 212 Ukraine 93–4 Uzbekistan 178 LSMS household survey (1998) 243 Lunina, I. 87 McGuire, M.C. 173, 174 macro rents 84, 88, 89, 99, 100 macroeconomic policies Kyrgyzstan 247 Russia 42–54 macroeconomic stabilization 271 Armenia 138 Kyrgyzstan 225–7, 236, 238 Tajikistan 199–200, 222 Maddison, A. 13 mahallah system 189 Manaenkov, D. 54 manufacturing sector 2, 3, 23 Armenia 27 Belarus 25 Kazakhstan 256, 257, 259 Kyrgyzstan 230, 231 Turkmenistan 28 Ukraine 99 Marchenko, G. 261 Marin, D. 49 market 9, 17–18 Armenia 138–40 Belarus 62 Kyrgyzstan 243–5 Russia 40 Tajikistan 205–15 Markosyan, V. 134 Martin, R. 181 Masol, V. 86 Michalopoulos, C. 58 Micklewright, J. 2 micro rents (in Ukraine) 84, 88–90 migrant labour (Tajikistan) 215–21 Milanovic, B. 18 military sector 6, 7 Armenia 27, 133

295

296


Kyrgyzstan 225 Russia 40, 42 Turkmenistan 156 Ukraine 77, 82 Mill, J.S. 123 Moldova 9, 11, 16, 22, 26–7, 268 future prospects 273 incentives and weak state 116–24 initial conditions 101, 269 Land Code 112 natural resources 270 output collapse 103–7 policy evolution 271 reform failures 101–3 terms-of-trade shock 108–16 monetary policy 11, 23 Armenia 136, 143 Belarus 62, 63, 72–3 Moldova 108, 124 Russia 49, 50 Uzbekistan 179 Mongolia 16 Mukand, S. 33, 38 Murrell, P. 179, 185 Nagorno-Karabakh conflict 10–11, 27, 133, 136, 138 National Bank of Kazakhstan 261 National Bank of Kyrgyzstan 228, 239 National Bank of Moldova 102 National Bank of Ukraine 85 national identity 9–11, 122, 123 national income 2, 3–4 Armenia 131, 136, 138 Kyrgyzstan 246 Uzbekistan 186 National Oil Fund (Kazakhstan) 260–61, 262, 265 natural resources 19 Armenia 268, 270 Kazakhstan 3, 29, 249–67, 268–70 Kyrgyzstan 232–3 Moldova 270 Russia 3, 35, 38, 41, 42, 45, 49, 52, 268, 269, 270 Tajikistan 270 Turkmenistan 3, 154, 172–6, 268, 269, 270 Ukraine 26, 84, 268, 269, 270 Uzbekistan 3, 268

see also gas industry; oil industry; water resources Nelson, R. 81 net material product 2 Armenia 130, 132–3 Belarus 59 Kazakhstan 251 Niyazov, S. (Turkmen President) 154, 162, 173, 174, 175–6 nomenklatura 26, 76, 85, 99 non-state-owned firms (Tajikistan) 28, 208, 209 North, D.C. 5, 7, 8, 9, 81, 101 North Atlantic Treaty Organization (NATO) 10, 24, 101 Nuti, D.M. 59 Ofer, G. 2, 5, 22, 101 oil industry Belarus 65 Kazakhstan 29, 249–50, 254–67 Russia 52 Turkmenistan 27–8, 154, 167, 170–71 Olson, M. 122, 123, 173, 174 Organization for Economic Cooperation and Development (OECD) 101 organized crime 45, 46, 48, 178 Orlowski, L. 59 output Armenia 130–31, 132–3, 136 Belarus 57, 60–61, 63, 66, 69 Kazakhstan 251–2, 257 Kyrgyzstan 226, 245–6 Moldova 103–7, 109–10 Russia 51 Tajikistan 198–205, 222 Turkmenistan 154–65, 166, 174–5 Ukraine 88 over-industrialization 6 Moldova 105 Ukraine 76, 77, 82–3 Uzbekistan 185 Paris Club 29, 239 Partnership and Cooperation Agreement 102 paternalism (Ukraine) 85–6, 87 Peace Agreement (Tajikistan) 222

Index perestroika 35–6, 178 permanent income rule 264, 265, 266 Petrov, N. 44, 52 physical capital Kazakhstan 260 Kyrgyzstan 233–5, 245–6 Moldova 104, 106 physical economy 4 Pisani–Ferry, J. 59 Pistor, K. 40, 41 Pivdenmash Missile Plant 82, 91 Poland 17, 23, 25, 38, 256 policy evolving framework 270–72 see also fiscal policy; macroeconomic policies; monetary policy political instability/violence 21–2 political leadership 10, 11 political transition (Russia) 35–42 politicians (in Russia) 38–9, 54 Polterovich, V. 34 Pomfret, R. 172, 179, 249 Popov, V. 15, 32, 33, 37, 43, 45, 50, 140, 184, 185–6, 190 population 6 Armenia 129, 149 Belarus 61 Kyrgyzstan 224, 239–40 republics of USSR 2, 3, 6 Tajikistan 198 Turkmenistan 154 Uzbekistan 188 Portes, R. 156 poverty 2, 18–19 Armenia 137 Kyrgyzstan 239, 245, 247 Tajikistan 217 Poverty Reduction and Growth Facility (PRGF) 239 price 6, 11, 16 Belarus 58–9, 60, 61 consumer price index 14, 68, 227 relative 22–3 signals 5, 15 Turkmenistan 169, 170, 171, 175–6 Uzbekistan 180 volatility (Kazakhstan) 265 price liberalization 17, 271 Armenia 136

297

Belarus 60 Kyrgyzstan 243 Moldova 101, 108 Russia 35, 36 Tajikistan 214, 222 Ukraine 78, 95 Uzbekistan 179, 185 prisoners’ dilemma (incentives) 117 privatization 9, 15, 16–17, 271 Armenia 134, 136, 147 Belarus 19, 25, 60, 62, 69–71, 72 Kyrgyzstan 235 Moldova 19, 102, 106, 112, 125, 126 Russia 35, 36, 54 Tajikistan 200, 205, 207–12, 214, 222 Turkmenistan 19, 169–70 Ukraine 78, 80, 95, 96, 97, 100 Uzbekistan 19, 179, 190, 196 procurement prices 170, 171, 180 producer price index (PPI) 43 product markets (Kyrgyzstan) 243–4 production chains 11 disorganization process see disorganization process –sharing agreements (PSAs) 160, 167 see also factors of production productivity (definitions) 274 profitable enterprises 200, 201 property/property rights 8, 9, 17 Moldova 119–20 Russia 33, 36, 45 Turkmenistan 154 Ukraine 81, 90 Uzbekistan 194 Public Investment Programme (PIP) 234–5, 236, 237 purchasing power parity (PPP) 13, 19, 58, 128–9, 245 Putin, V. 24, 54, 272 Rahimov, E. 189 RECEP (Russia) 54 recession 10, 11 transformational (Armenia) 136–52 regulatory quality/burden 21, 22 Renelt, D. 253 rents/rent-seeking 8, 9, 269 Belarus 63 Kazakhstan 29, 249

298


macro 84, 88, 89, 99, 100 micro 84, 88–90 Moldova 27, 106, 112, 116, 119, 125 Russia 33, 36, 37, 41 Turkmenistan 28, 173 Ukraine 26, 77, 81–4, 86–90, 94, 98–9, 270 research and development 5, 80, 152 resource-oriented policy (Ukraine) 83, 89, 90, 97–8 resource allocation 11, 15, 16, 36 Kazakhstan 259 Moldova 104 Turkmenistan 173 Ukraine 82 resources see natural resources retail sector (Tajikistan) 205, 210–11, 218 Rodrik, D. 33, 38 Roland, G. 10, 33, 34, 59, 156, 179, 185 rouble 24, 51, 140, 141, 211 Belarusian (BRB) 60, 62 Tajik 200 rouble zone 11, 106, 179 rule of law 21, 22, 24, 271 Moldova 125 Russia 33, 34, 37, 38, 40 Uzbekistan 186 ruralization (Tajik economy) 215–21 Russia 24–5 future prospects 273 growth determinants 32–5 initial conditions 35, 42–54, 269 natural resources 3, 35, 38, 41–2, 45, 49, 52, 268, 269, 270 policy evolution 270, 271, 272 political transition 35–42 Russian Soviet Federation Socialist Republic 39, 69, 86, 173, 198 Ryzhkov, N. 44 Sabluk, P. 96 Sachs, J. 84 Sahay, R. 32, 45, 101 savings Armenia 133, 144, 147 Belarus 73 Kazakhstan 260–61 Kyrgyzstan 235, 247 Uzbekistan 192, 196

Schankermann, M. 81, 117–21 secessionist movements 10–11 Selowsky, M. 181 services sector Armenia 144–6, 153 Belarus 58 Kazakhstan 253, 259 Kyrgyzstan 226, 227 Tajikistan 201, 205 Uzbekistan 182 shadow economy 45, 46, 121, 190 Shcherbytsky, V. 85 Shleifer, A. 35, 38, 45, 81, 84 Shmelev, N. 140 shock therapy 16, 36, 39, 271, 274 Armenia 133, 140–44, 153 shuttle trade 28, 191, 194, 205, 210 Shygayeva, T. 96 Sirazhiddinov, N. 180, 188 SISI 122 smuggling 117, 243 social contract (Ukraine) 81 social services 7, 16 soft budget constraints 15, 269 Belarus 64–5, 72 Moldova 102, 117 Ukraine 81, 84, 86, 88–9, 92–3, 95 Solidarity 38 Solow model 135 som (Kyrgyzstan currency) 227, 236–7 Sonin, K. 33 soum (Uzbek currency) 179, 194, 196 Soviet Union 178, 225 republics of (background data) 1–10 Spechler, M.C. 179 Spitak earthquake 138 stabilization 15, 23 Armenia 136, 138, 143, 153 Belarus 67 Kazakhstan 260–61 Moldova 104, 106–7 see also macroeconomic stabilization Stalin, J. 7, 85 start-ups 69, 72, 100, 118, 125 state-owned enterprises Belarus 25, 62, 64–5, 66–9, 70–73 Ukraine 77, 91 state capture 9, 26–7, 81, 85, 117, 119 State Planning Committee (USSR) 234 State Property Administration 190

Index Steinberg, D. 42 Stock Exchange (Moldova) 102 structural reforms Armenia 136, 138, 152 Belarus 62, 64–5, 67 Kazakhstan 29 Moldova 112 Russia 271 Tajikistan 198–205 Ukraine 78–80, 81 subsidies 3–4, 11, 25, 154, 177, 179 supply shock (Turkmenistan) 166 Suvankulov, F.S. 191 TACIS programme 51, 52, 191 Tajik roubles 200 Tajikistan 28, 162, 163, 268 future prospects 273 initial conditions 269 market/institutional reform 205–15 natural resources 270 output 198–205 policies 222–3, 271 unemployment and migration 215–21 Tajiktextilmash 212–13 Tarr, D. 2, 58, 59 taxation 22–3 Armenia 143, 144–5 evasion 117, 122 Moldova 121–2 Russia 44–5, 46, 47, 54 Tajikistan 213–14 Turkmenistan 171, 172 Ukraine 81, 91, 92, 95 Uzbekistan 191–2 VAT 91–2, 146, 171, 191, 192, 214 technical assistance 136, 237 technology 5, 6, 133, 134, 152 telecommunications 179, 232–3 tenge (Kazakhstan currency) 257 Tengiz oil field 260 terms of trade 2, 3 Armenia 140 Belarus 25, 59 Kazakhstan 267 Moldova 26, 102, 108–16 Ukraine 88 textile sector 162, 163, 165, 167–8 total factor productivity 268–9, 274

299

Armenia 27, 131–5, 136 Kazakhstan 252 Kyrgyzstan 245–6 Moldova 105–6 Uzbekistan 183 trade Armenia 133, 136–9, 140–41, 144–6 Belarus 58–9, 62–6, 67–9 Kyrgyzstan 229–32 Moldova 104, 125 subsidies 3–4, 11, 25 Tajikistan 201, 205, 210–14, 218 Uzbekistan 194–5 see also exports; imports; shuttle trade; terms of trade transaction costs 5, 8, 165, 213, 222 TransCaspian pipeline 160–61, 162 Transnistria 101, 103, 122, 125 transplant effect 34 transport Armenia 138–9, 144–6 costs 49, 138–9, 165, 194, 232–3 Kyrgyzstan 232–3, 235 Tajikistan 201, 204 Turkmenistan 156, 157, 165–6 Ukraine 80 Uzbekistan 194 Treasury Bills (T-bills) 88, 94 Treisman, D. 45 Turkmenistan 10, 16, 27–8 economic performance 154–65 economic recovery 166–8 future prospects 273 government controls 168–74 natural resources 3, 154, 172–6, 268, 269, 270 policies 174–6, 271, 272 Turley, J. 261 Tymoshenko, Y. 96 Ukraine 4, 9, 11, 16, 25 crisis (1998) 94–7 future prospects 273 growth potential 97–9 identification of problems 81–90 initial conditions 76–7, 269 natural resources 26, 84, 268–70 policies 270, 271 reforms (summary) 78–81 transition patterns 90–94

300


Ukrainian League of Industrialists and Entrepreneurs (ULIE) 91, 96 Ukrspetsfin 92–3 unemployment Armenia 137, 143 Belarus 61 Kazakhstan 29, 252 Kyrgyzstan 239, 240, 244, 245 Tajikistan 215–21 Ukraine 92–3, 99 Uzbekistan 187, 188 United Energy Systems 92 United Gas Supply System 159 United Nations 6, 126, 128–9, 187, 236, 237, 245, 251, 253 urbanization 6, 104 Uzbekistan 10, 23, 28, 177 agriculture 188–9 capital investment 192–4 comparative analysis 184–7 fiscal development 189–92 foreign trade policy 194–5 future prospects 273 growth record 181–4 legacy of Soviet period 178 natural resources 3, 268 policies 178–80, 271–2 VAT 91–2, 146, 171, 191–2, 214 Verdier, T. 10, 33–4, 59, 156, 194 vertical integration 156 Vincetz, V. 87 virtual economy theory 49 Vishny, R. 35, 38 Volga-Don Canal 165

wages 6, 7 Belarus 61, 62 Kyrgyzstan 244 Tajikistan 198 Turkmenistan 154, 168, 172 Ukraine 93–4 Uzbekistan 180, 186, 187 Warner, A. 84 Washington Consensus 15, 29, 177, 272 water resources Turkmenistan 154, 162, 164, 172, 174 Uzbekistan 188, 196 Wegerich, K. 180 wheat production 170, 171, 180 wholesale sector 205, 210 Winter, S. 81 Woodruff, D. 50 working hours (Kyrgyzstan) 239–41 World Bank 2, 18, 21–2, 81, 83, 102, 136, 139–42, 180, 184–8, 192, 194, 235, 236, 243 World Development Indicators 130 World Trade Organization 16–17, 97, 231, 273 Yeltsin, B. 24, 36, 38–9, 44, 272 Young, A. 269 Yushchenko, V. 26, 80, 92, 94–5, 96 Zak, P. 122, 123 Zettlemeyer, J. 32, 185 Zhuravskaya, E. 37

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