D I R E C T I O N S D I R E C T I O N S II N N D E V E L O P M E N TT D E V E L O P M E N THE WORLD BANK Building Market Institutions in South Eastern Europe Comparative Prospects for Investment and Private Sector Development HARRY G. BROADMAN, JAMES ANDERSON, CONSTANTIJN A. CLAESSENS, RANDI RYTERMAN, STEFKA SLAVOVA, MARIA VAGLIASINDI, AND GALLINA A. VINCELETTE Building Market Institutions in South Eastern Europe Building Market Institutions in South Eastern Europe Comparative Prospects for Investment and Private Sector Development Harry G. Broadman, James Anderson, Constantijn A. Claessens, Randi Ryterman, Stefka Slavova, Maria Vagliasindi, and Gallina A. Vincelette THE WORLD BANK Washington, D.C. © 2004 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 Telephone 202-473-1000 Internet www.worldbank.org E-mail feedback@worldbank.org All rights reserved. 04 05 06 07 4 3 2 1 The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone 978-750-8400; fax 978-750-4470; www.copyright.com. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax 202-522-2422; e-mail pubrights@worldbank.org. ISBN 0-8213-5776-X Cover photos: Fish market photo used with permission of the Croatian National Tourist Board. All other photos provided by World Bank Country Offices. Library of Congress Cataloging-in-Publication Data has been applied for. Contents Foreword xv Acknowledgments xvii Building Market Institutions in South Eastern Europe-- An Overview xix Abbreviations xl 1. Institutional Aspects of the South Eastern European Economy: Introduction, Trends, and Scope of the Study 1 Background 1 Trends in the SEE8 Economies 2 Scope and Methodology of the Study 21 Structure of the Study 24 2. Institutional Reform Progress to Date and Remaining Challenges in South Eastern Europe 33 Aggregate Assessment of the Business Environment in SEE 33 Institutional Impediments to Investment and Growth 37 Conclusion: The Unresolved Institutional Problems in South Eastern Europe 82 3. Competition in South Eastern Europe 89 Development of the Private Sector and Prospects for Competition in SEE 91 Structural Conditions for Competition in SEE: Horizontal and Vertical Elements 95 Assessment of Entry and Exit Barriers 124 Business Performance and Competition 137 Policies to Enhance Competition in South Eastern Europe 148 Statistical Annex 156 v vi CONTENTS 4. Access to Regulated Infrastructure Utilities 163 Tariffs, Access, and Quality of Service across Countries 164 Infrastructure's Access and Quality across Different Enterprises' Characteristics 176 Private Sector Involvement and Independence of Rulemaking 182 Role of Infrastructure Development in Fostering Investment in the Real Sector and in Regional Integration 193 Policy Recommendations 213 5. Corporate Ownership, Financial Transparency, and Access to Finance 221 Introduction 221 Forms of Ownership 224 Transparency and Accountability in Firm Finances 230 Access to Finance 240 Financial Transparency, Investment, and Growth 249 Policy Recommendations 251 Annex: Additional Analyses 255 6. Resolving Business Disputes in South Eastern Europe: The Role of the Courts 279 Avoidance of Business Disputes 283 Contract Enforcement in Court 294 Firms' Use of the Courts 312 Perceptions of Court Performance by Court Users 321 Judicial Corruption 327 Policy Implications 330 Statistical Annex 342 Boxes 2.1 The European Charter for Small Enterprises 42 2.2 Challenges in Establishing a Working Bankruptcy Institution in Albania and Bosnia and Herzegovina 46 2.3 Energy Problems and Setbacks for Reform in FYR Macedonia 53 2.4 Implementation Problems in Moldova 55 2.5 Water Challenges in Albania 58 2.6 Institutional Hurdles to Privatization in Bosnia and Herzegovina 62 2.7 Combating Corruption in Bulgaria through Public-Private Partnerships 76 2.8 Land Reform in Romania: Identifying and Tackling the Problems 80 3.1 Is Ownership Change Enough? 96 CONTENTS vii 3.2 Variation in Number of Competitors 98 3.3 The "Home-Grown" Construction Sector in SEE 111 3.4 Market Dominance and Anticompetitive Pricing in SEE 113 3.5 Vertical Integration in the South Eastern European Food Processing and Retailing Sector 116 3.6 Weak Financial Discipline Delays the Exit of Loss-Makers and Distorts the Use of Capital 125 3.7 Brand Loyalty as a Barrier to Entry: The Case of Food Processing and Retailing 128 4.1 Uneven Playing Field in the Energy Sector 169 4.2 Utility Pricing 172 4.3 Electricity Crisis in Albania 175 4.4 Effect of Privatization on Infrastructure Business Users 184 4.5 Establishing a Competitive Mobile Market 195 4.6 Telecommunication Liberalization in the SEE8 202 4.7 Preshipment Inspection in Moldova 208 4.8 Regional Energy Market 210 4.9 Regional Cooperation in Water Management 212 4.10 How Does EU Enlargement Affect Telecommunication Industries? 215 5.1 The Mixing of Social and Private Goals: State Ownership in Bosnia and Herzegovina 225 5.2 Postprivatization Concentration in Bulgaria 226 5.3 The Perils of Partial Privatization for a Croatian Firm 230 5.4 The Link between Accounting and Inspectorate Reforms in Moldova 232 5.5 Firm Skepticism of Audits in Albania 237 5.6 The Pros and Cons of Barter in Croatia and Romania 243 5.7 Access to Formal Financing in Albania and FYR Macedonia 248 6.1 How Do Firms Avoid Business Disputes? 284 6.2 The Role of Business Associations in Resolving Commercial Disputes 287 6.3 Using Prepayment to Reduce Contractual Risk 289 6.4 Example of a Debt Collection Court Procedure 309 6.5 Which Firms Use the Courts? 314 6.6 How Are the Courts Perceived? 325 6.7 Disputes over Land Ownership 330 6.8 Resolving Payment Disputes with the Government 331 Figures 1.1 Progress in the Transition of the SEE8: Small-Scale Privatization, Large-Scale Privatization, and Private Sector Share in Output 5 1.2 Registered Unemployment in the SEE8, 1994­2001 10 viii CONTENTS 1.3 Direction of Trade in the SEE8 13 1.4 Inflows of Foreign Direct Investment in the SEE8, 1991­2003 18 1.5 Institutional Development of the Business Sector and Foreign Direct Investment in the SEE8 20 2.1 Aggregate Assessment of Institutional Barriers in the Business Environment in the SEE8, 1999 and 2002 34 2.2 Institutional Progress in the SEE8, 1999 and 2002 36 2.3 Changes in Average Employment by Enterprise Ownership, 1999­2002 38 2.4 Firms with Subsidies and Arrears in the SEE8 under BEEPS1 and BEEPS2 43 2.5 Assessment of Quality of Infrastructure 50 2.6 Largest Shareholder's Identity in Surveyed Firms, 2002 60 2.7 Financial Disclosure and Transparency 67 2.8 Financing as an Obstacle to Enterprise Development 69 2.9 Aggregate Effectiveness of the Judiciary 78 3.1 Number of Competitors by Ownership Type, 1999 and 2002 99 3.2 Number of Competitors by Country, 1999 and 2002 101 3.3 Sales to Governmental Entities by Ownership Type and by Country, 2002 109 3.4 Firms with Holdings or Operations outside Their Home Countries, 2002 110 3.5 Expected Sales Sensitivity after a 10 Percent Price Increase, by Firm Market Share, 2002 115 3.6 Expected Sales Sensitivity after a 10 Percent Price Increase, by Number of Competitors, 2002 115 3.7 Number of Material Input Suppliers by Country, 2002 118 3.8 Firms with More Than Three Material Input Suppliers, by Ownership Type and by Country, 2002 119 3.9 Tenure of Supply Relationships: Firms with at Least 20 percent of Material Inputs from Suppliers Maintained for at Least 3 Years, 2002 120 3.10 Reliance on Imported Inputs, 2002 122 3.11 Key Barriers to Entry in SEE, 2002 131 3.12 Average "Bribe Tax" Paid in SEE, by Firm Ownership, 2002 132 3.13 Government Subsidies by Firm Ownership Type, 2002 135 3.14 Government Subsidies by Sector, 2002 136 3.15 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Country, 1995­98 138 CONTENTS ix 3.16 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Country, 1998­2001 139 3.17 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Sector, 1995­98 140 3.18 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Sector, 1998­2001 141 3.19 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Ownership, 1995­98 141 3.20 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Ownership, 1998­2001 142 3.21 Distribution of Profit-to-Sales Ratio by Country, by Sector, and by Ownership Type 143 4.1 Infrastructure-Related Barriers by Sectors 166 4.2 Infrastructure-Related Arrears 167 4.3 Infrastructure-Related Arrears across Ownership Classes 168 4.4 Waiting Times for Infrastructure Services 173 4.5 Outages for Infrastructure Services 174 4.6 Unevenness of Waiting Times for Telecommunication Services 177 4.7 Unevenness in Outages for Telecommunication Services 178 4.8 Unevenness of Waiting Times for Power Services 179 4.9 Unevenness in Outages for Power Services 180 4.10 Unevenness in Outages for Water Services 181 4.11 Urban and Rural Access to Water Services 182 4.12 Effect of an Independent Regulator on Performance Indicators 190 4.13 Business Use of Telecommunication Services 194 4.14 Telecommunication Development 195 4.15 Brain Drain 199 4.16 Customs and Trade Regulation Barriers 204 4.17 Export-Related Delays 205 4.18 Import-Related Delays 206 4.19 Ratios of Revenue Collected per Staff Person 207 5.1 Financial Transparency, as Reported by Firms, and GDP Growth 223 5.2 Privatization, Enterprise Restructuring, and Governance 225 5.3 Firms Reporting Use of International Accounting Standards, 1999 and 2002 234 x CONTENTS 5.4 Firms Reporting Using IAS, by Size and Ownership Type, 2002 235 5.5 Firms Reporting Using External Audits of Financial Statements, 1999 and 2002 237 5.6 Firms Reporting Using External Audits, by Firm Size and Ownership Type 238 5.7 Prepaid and Credit Transactions 240 5.8 Barter, Bills of Exchange, and Debt Swaps as a Percentage of Sales 241 5.9 Percentage of Firms Using Barter, Bills of Exchange, or Debt Swaps 242 5.10 Factors Influencing the Use of Barter 244 5.11 Factors Influencing the Prevalence of Contract Violations by Customers 245 5.12 Percentage of Firms Using Bills of Exchange, Barter, or Debt Swaps, 1999 and 2002 246 5.13 Methods of Financing New Investment, 1999 and 2002 247 5.14 Financial Transparency and Firm Investment, 2002 250 5.15 Financial Transparency and Firm Sales Growth 251 6.1 Confidence in the Legal System: Average across All Interviewed Firms, 1999 and 2002 282 6.2 Duration of Debt Collection Court Cases: A Comparison of Transitional Economies 294 6.3 Lithuania: A Comparison of Available Procedures in Debt Collection 295 6.4 Procedural Steps in the SEE8 298 6.5 Procedural Steps in Transition Regions 299 6.6 Days to Enforce a Debt Contract 301 6.7 Costs of Procedure by Country 302 6.8 Costs of Procedure by Region 304 6.9 Index of Procedural Complexity 305 6.10 Index of Procedural Complexity in Transition Economies, Average by Region 305 6.11 Duration and Number of Procedural Steps in Serbia and Montenegro 311 6.12 Average Perceptions of Court Performance, 1999 and 2002 327 Tables 1.1 Output in the SEE8, 1998­2002 3 1.2 Foreign Direct Investment in the SEE8, 1989­2002 18 1.3 Enterprise-Level Case Studies 23 1.4 Characteristics of SEE8 Firms Participating in BEEPS2 25 1.5 Characteristics of SEE8 Firms Participating in BEEPS1 26 2.1 Business Entry 39 CONTENTS xi 2.2 Bankruptcy Indicators 45 2.3 Primary Methods of Privatization in SEE 59 2.4 Domestic Credit to Private Sector and Stock Market Capitalization, 1993­2001 71 2.5 Control of Corruption, Protection of Property Rights, Legal Effectiveness, and Legal Extensiveness in the SEE8 74 3.1 Private Sector Share of GDP in the SEE8 92 3.2 Origin of Private Sector Firms in the SEE8, 2002 93 3.3 Average Annual Sales Revenues of Privatized and De Novo Private Firms by Country, 2001 93 3.4 Origin of Private Sector Firms in the SEE8, by Sector, 2002 94 3.5 Number of Competitors by Sector, 2002 100 3.6 Market Share by Country and by Ownership Type, 2002 103 3.7 Market Share by Sector and by Country, 2002 105 3.8 Horizontal Integration: Number of Establishments under Single Firm Ownership, 2002 106 3.9 Horizontal Integration: Number of Establishments under Single Firm Ownership by Sector and by Country, 2002 107 3.10 Share of Revenue Earned from Sales to Customers of Different Size by Firms of Different Ownership Type, 2002 108 3.11 Export Intensity by Country, 2002 110 3.12 Export Intensity by Sector, 2002 111 3.13 Proportion of Firms Having New Export Destinations, 1998­2002 112 3.14 Expected Sales Change after a 10 Percent Price Increase, by Country, 2002 114 3.15 Expected Sales Change after a 10 Percent Price Increase, by Ownership Type, 2002 114 3.16 Downstream Integration by Country, by Sector, and by Ownership Type, 2002 117 3.17 Size Distribution of Downstream Sales by Country and Ownership Type, 2001­02 119 3.18 Tenure of Distribution and Sales Relationships, 2002 121 3.19 Expected Input Purchase Change after a 10 Percent Price Increase, by Country and Ownership, 2002 123 3.20 Turnover of Number of Registered Firms and of Full-Time Employees in South Eastern European Industry, 1999 and 2002 126 xii CONTENTS 3.21 Turnover of Number of Active Firms in South Eastern European Industry by Size, 1999 and 2002 127 3.22 Comparative Severity of Potential Barriers to the Operation and Growth of Businesses in the SEE8, 2002 129 3.23 Key Barriers to Entry in SEE, 2002 131 3.24 Incidence of the Burden of Business Licensing and Permitting in SEE, 2002 132 3.25 Extent of Plant Closure by Country, by Sector, and by Ownership Type, 1998­2002 134 3.26 Extent of Tax Arrears to Government by Country, by Sector, and by Ownership Type, 2002 137 3.27 Estimated Determinants of Profitability: Multivariate Ordinary Least Squares Regressions 147 3.28 Ranking Effectiveness of Competition Policy Implementation in SEE 150 A.3.1 Summary Statistics of BEEPS Data on the SEE8 156 A.3.2 Bivariate Correlations of BEEPS Data on the SEE8 157 4.1 Infrastructure Performance Indicators 165 4.2 Power Cash Collection and Commercial Losses, 2002 170 4.3 Power Tariffs in the SEE8, 2002 171 4.4 Telecommunication Privatization in the SEE8 185 4.5 Independent Regulators in the SEE8 189 4.6 Infrastructure Transition Indicators 190 5.1 Origin of Firms in the BEEPS2 Sample 227 5.2 Forms of Legal Organization, 2002 228 5.3 Firm Ownership, 2002 229 A.5.1 Forms of Legal Organization: Medium and Large Firms, 2002 256 A.5.2 Firm Ownership: Medium-Size and Large Firms, 2002 257 A.5.3 Factors Influencing the Use of International Accounting Standards, 2002 258 A.5.4 Factors Influencing the Use of External Audits, 2002 262 A.5.5 Factors Influencing the Use of Barter, 2002 265 A.5.6 Factors Influencing the Problem of Customers Not Paying Bills, 2002 267 A.5.7 Financial Transparency and Firm Investment, 2002 269 A.5.8 Financial Transparency and Firm Sales Growth, 2002 272 6.1 Firms Willing to Switch to a New Supplier When Current Supplier Raises Prices and Firms Fearing Loss of Customers If Prices Are Raised 285 6.2 Business Association Membership 286 6.3 Share of Sales 288 CONTENTS xiii 6.4 Statistical Tests for Differences in Firms' Losses Because of Theft, Robbery, Vandalism, or Arson and for Firms' Spending on Security and Protection Services 291 6.5 Statistical Tests for Differences in Firms' Access to Bureaucratic Recourse, Legal Information, and Assessments of the Predictability and Consistency of Legal Interpretations 292 6.6 Plaintiff's Costs of Contract Enforcement in a First-Instance Court 296 6.7 Complexity of Contract Enforcement: Standard Case of Debt Recovery 306 6.8 Firms Reporting Zero Payment Disputes Resolved in Court 313 6.9 Firms Reporting Zero Court Cases Filed between January 2000 and July 2002 315 6.10 Statistical Tests for Differences in Court Use between Small and Large Firms 318 6.11 Statistical Tests for Differences in Court Use between Private and State-Owned Firms 319 6.12 Statistical Tests for Differences in Court Use between New and Old Firms 320 6.13 Court Performance as Perceived by Court Users, by Country 322 6.14 Court Performance as Perceived by Court Users, by Region 324 6.15 Statistical Tests for Differences in Firms' Perceptions of the Courts 326 6.16 Statistical Tests for Differences in the Frequency of Bribe Payments to Court Officials and the Effect of Bribes Paid to Judges in Criminal and Commercial Lawsuits 329 A.6.1 Ordinary Least Squares Regression of Firms' Use of the Courts on Judicial Formalism 344 A.6.2 Ordinary Least Squares Regression of Firms' Use of the Courts on the Index of Other Statutory Interventions 345 A.6.3 Ordinary Least Squares Regression of Firms' Use of the Courts on Attorney Fees Payable at First Instance 346 A.6.4 Ordinary Least Squares Regression on Firms' Capture of Courts 347 A.6.5 Ordinary Least Squares Regression on Frequency of Bribe Payment 348 Foreword A decade and a half has now passed since the collapse of communism in Central and Eastern Europe. In that period, countries of the region have had to overcome the legacy of an inefficient socialist economy and to adopt market principles. The challenges have been enormous, especially in South Eastern Europe. Bosnia and Herzegovina, Croatia, the former Yugoslav Republic of Macedonia, and Serbia and Montenegro have had to deal with internal conflict, and all of the countries--including Albania, Bulgaria, Moldova, and Romania--have faced, to varying degrees, high rates of poverty, political uncertainty, and an infrastructure weakened by years of neglect. The struggle has been unique in each country. And considerable progress has been made. Bulgaria and Romania look forward to accession to the European Union in 2007, and the European Commission has recom- mended that the European Council open membership negotiations with Croatia. The other South Eastern European countries recognize the need for further economic reform and are poised to meet the challenge. This book--a collaborative effort between the World Bank and the European Bank for Reconstruction and Development--not only assesses how each South Eastern European country is faring, but also provides guidance regarding where they need to turn next in their efforts to build a market economy. The book points out that to restore and consolidate peace and stability in the region, the countries must raise their levels of domestic and foreign investment. A weak investment climate undermines the prospects for economic growth and poverty reduction and jeopardizes the stability of the region. But to create a climate that will attract investors, the coun- tries must first establish robust and enduring basic market institutions. The book takes an innovative empirical approach to examining the issue and integrates and analyzes data from three sources. The authors developed data from a set of 40 original, enterprise-level business case studies, which were carried out in the field in each of the eight countries of South Eastern Europe in 2002. Data and perceptions from two rounds of the European Bank for Reconstruction and Development­World Bank Business Environment and Enterprise Performance Survey, which was con- xv xvi BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE ducted in 1999 and 2002, are also used. The findings from the business case studies and the surveys are buttressed by official statistics. Working from this comprehensive set of data, the authors identify regionwide and country-specific trends, impediments, and successes. They then suggest policy reforms to solve the problems diagnosed. Solutions must differ from country to country. Yet each country can learn from its own experiences and from the experiences of others. Indeed, creating lasting stability and prosperity in the region will demand that the countries work together in building market institutions even as they compete to attract investment. Thus, in time, by proceeding with market reforms, the countries of South Eastern Europe can expect to com- plete their integration into the global economy. Pradeep Mitra Willem Buiter Chief Economist Chief Economist and Special Europe and Central Asia Region Counsellor to the President The World Bank European Bank for Reconstruction and Development Acknowledgments This book was prepared by a team led by Harry Broadman. The authors of the chapters are as follows: Overview--Harry Broadman and Gallina Vincelette; chapter 1--Gallina Vincelette and Harry Broadman (with extensive contributions from Maria Vagliasindi); chapter 2--Gallina Vincelette, Maria Vagliasindi, and Harry Broadman; chapter 3--Harry Broadman (with the statistical assistance of Gallina Vincelette); chapter 4--Maria Vagliasindi; chapter 5--James Anderson and Constantijn Claessens; and chapter 6--Stefka Slavova and Randi Ryterman. Harry Broadman integrated and edited the chapters. Sandra Craig assisted the team. The study is a collaborative effort between the World Bank and the European Bank for Reconstruction and Development (EBRD). From the outset, the team benefited from discussions with, exchanges of ideas with, and comments on the manuscript from colleagues from both institutions. We appreciate the assistance of these individuals at the World Bank: Jean- Luc Bernasconi, David Bernstein, Marcelo Bisogno, Oscar de Bruyn Kops, Henk Busz, Bruce Courtney, Mansour Farsad, Bernard Funck, Kathryn Funk, Cheryl Gray, Simon Gray, Daniela Gressani, Mohinder Gulati, Ardo Hansson, John Hegarty, Joel Hellman, Ronald Hood, Joseph Ingram, Erika Jorgensen, Daniel Kaufmann, David Kennedy, Pascale Kervyn, Ioannis Kessides, Iftikhar Khalil, Ali Mansoor, Massimo Mastruzzi, Katarina Mathernova, Pradeep Mitra, Alia Moubayed, Helga Muller, Kari Nyman, Gael Raballand,Anand Seth, Khaled Sherif, Martin Slough, Rory O'Sullivan, Kyle Peters, Rosalinda Quintanilla, Andrew Vorkink, Marina Wes, and Lubomira Zimanova Beardsley. We would like to express our gratitude to these individuals at the EBRD: Willem Buiter, Hsianmin Chen, Elisabetta Falcetti, Steven Fries, Michel Nussbaumer, Peter Sanfey, Anita Taci, Kamen Zahariev, and Alexei Zverev. In addition to data from the EBRD­World Bank Business Environment and Enterprise Performance Surveys (BEEPS) of 1999 and 2002, which cov- ered approximately 1,600 firms in South Eastern Europe, primary data for this study were gathered from 40 original firm-level business case studies developed during several missions in the spring, summer, and fall xvii xviii BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE of 2002 in the eight South Eastern European countries (SEE8). The busi- ness case studies were conducted in the field as follows: · Albania in September 2002 by Anita Taci (EBRD) and Gallina Vincelette (World Bank) · Bosnia and Herzegovina in July 2002 by Harry Broadman (World Bank) and Gallina Vincelette (World Bank) · Bulgaria in September 2002 by Harry Broadman (World Bank) and Gallina Vincelette (World Bank) · Croatia in June 2002 by Harry Broadman (World Bank) and Gallina Vincelette (World Bank) · Former Yugoslav Republic of Macedonia in May 2002 by Harry Broadman (World Bank) and Gallina Vincelette (World Bank) · Moldova in May 2002 by Maria Vagliasindi (EBRD) · Romania in September 2002 by Harry Broadman (World Bank), Elisabetta Falcetti (EBRD), and Gallina Vincelette (World Bank) · Serbia and Montenegro in July 2002 by Harry Broadman (World Bank) and Gallina Vincelette (World Bank). The missions would not have been possible without the excellent organization and help the team received from our colleagues in the local offices of the World Bank and EBRD. Special thanks go to Juela Haxhiymeri (Albania); Samra Bajramovic and Stevan Raonic (Bosnia and Herzegovina); Sanja Madzarevic-Sujster (Croatia); Stella Ilieva and Galia Kondova (Bulgaria); Evgenij Najdov (FYR Macedonia); Maya Sandu, Octavian Costas, and Marisa Manastirli (Moldova); Catalin Pauna, Raluca Banioti, Corina Anton, and Simona Bucurei (Romania); and Miroslav Frick (Serbia and Montenegro). Members of a workshop held in Budapest in June 2003--who came from the private sector, academia, and the government in each of the SEE8, as well as from the international donor community--commented on the preliminary findings of this study. Their insights were extreme- ly helpful in sharpening the analysis and "reality testing" the study's conclusions. The peer reviewers were Simeon Djankov, Orsalia Kalantzopoulos, Daniel Kaufmann, and Anand Seth. The team thanks them for their com- ments and suggestions. We would also like to thank the World Bank publications team for their help and professionalism in preparing this book for publication. Building Market Institutions in South Eastern Europe-- An Overview Albania, Bosnia and Herzegovina, Bulgaria, Croatia, the former Yugoslav Republic of Macedonia, Moldova, Romania, and Serbia and Montenegro have emerged from the communist era to face the social and political chal- lenges of making an economic transition, building market institutions, and enacting wide-ranging policy reforms to promote private sector development and investment. The eight countries of South Eastern Europe (SEE8) trail their Western European neighbors in income and in other measures of development, but the differences among the SEE8 are as striking as their similarities. Already a functioning market economy in the eyes of the European Union (EU), Bulgaria has made progress in overcoming the legacy of inef- ficient socialist economic practices and has avoided tumultuous political revolutions. Romania's record of economic reform is somewhat weaker but not far behind. Both countries aspire to join the European Union in 2007. From the relative prosperity of Josip Broz Tito's time, Yugoslavia's economy was severely undermined in the 1990s by civil wars that split the country and disintegrated its industries and infrastructure. Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro all bear the scars of war. Albania and Moldova, like most of the former Yugoslav republics, are challenged today by poor infrastructure, high rates of poverty, political fragility, and economic isolation--problems that also affect the rest of the SEE8 to varying degrees. Building Market Institutions in South Eastern Europe examines how the countries of the region are developing, how well the good intentions and policy reforms of their governments have been translated into results, and where the process can be effectively improved. The book assesses the progress under way and offers recommendations on how best to retool production and commerce while improving the capacity of institutions to regulate markets and deliver public services. xix xx BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE This study is based in reality, integrating and analyzing data and per- ceptions from a set of 40 original enterprise-level business case studies, which were carried out in each of the eight countries in 2002, and from the two rounds of the European Bank for Reconstruction and Development (EBRD)­World Bank Business Environment and Enterprise Performance Survey conducted in 1999 (BEEPS1) and 2002 (BEEPS2), which covered approximately 1,600 firms in South Eastern Europe (SEE). The surveys complement traditional, official data from SEE8 governments, providing a deeper, qualitative assessment of the characteristics, trends, and rela- tionships among economic and government institutions and the enter- prise sector. They also provide results that challenge the conventional wisdom and assumptions. This book starts from the premise that further development and reform of basic market institutions in SEE are the key to increasing domestic and foreign investment and, thus, to accelerating economic growth and reducing poverty. Although the economic recovery of the region has start- ed, it will stall unless greater progress is made in the institutional envi- ronment for investment. Improving the investment environment also is essential to the integration of the SEE8 into the European structures. These two mutually reinforcing objectives--accelerating growth and reducing poverty, on the one hand, and integrating with Europe, on the other--are critical to achieving long-lasting peace and prosperity for all people of the region. The objective of the study is to assess, empirically and in detail, the nature and extent of the institutional constraints to improving the envi- ronment for investment in the SEE8 and to develop policy recommenda- tions to ease those constraints. The book focuses on four policy areas: 1. Competition and economic barriers to business entry and exit 2. Access to regulated utilities and services 3. Corporate ownership, financial transparency, and access to finance 4. Commercial dispute resolution Institutional aspects of the South Eastern European economy and back- ground on the scope and methodology of the study are presented in chap- ter 1. Institutional reform to date and remaining challenges are the topics of chapter 2. Chapter 3 deals with interenterprise competition and the conditions that hamper or promote it. Chapter 4 covers access to regulat- ed infrastructure utilities and resources and their effect on enterprise development and better public service. Corporate ownership, financial transparency, and access to finance are the subjects of chapter 5, which also explores how those issues are linked to successful market develop- ment, investment, and business growth. Chapter 6 examines changes in BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxi courts and legal systems aimed at creating a healthy environment for effective business dispute resolution. Seizing a Historic Opportunity for Growth South Eastern Europe's dramatic transition from command economies to market structures is occurring alongside a similarly ambitious effort to restore peace and social stability in a region traumatized by ethnic strife. Success in both arenas depends on market institutions that encourage investment and growth by facilitating commerce, enhancing job creation and poverty reduction, and integrating the region's domestic markets with the world economy. The 1990s were characterized by dramatic collapses of output in SEE. Economic stability, when achieved, was backed by subsidies to the state- owned industrial sector or by extensive borrowing from abroad. By 2001, the region had reached only 74 percent of its pretransition (1989) level of economic activity. In comparison, the five most developed Central European transition economies (the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia) had increased their combined output to 115 percent of 1989 levels. South Eastern Europe has now recovered from the recession of the 1990s. The region as a whole grew by 4.2 percent in 2002--faster than the 2.5 per- cent growth rate of the world economy--and by 3.5 percent in 2003. The region's economic rebound has been fueled primarily by private activity, which by 2001 was generating more than half of total output across the SEE8. In most countries in the region, privatization of small and medium-size enterprises has been completed. At the same time, the role of foreign aid and loans has declined even in the western Balkan states, where it constituted 7 percent of the five countries' gross domestic product (GDP) in 2002. However, a quicker and more robust rebound of output and economic growth has been impeded by the slow pace of restructuring in industry, agriculture, and services--which is in turn caused in part by the absence of effective market-based institutions to protect property rights, fair com- petition, and financial discipline. In addition, low levels of domestic and foreign investment have hindered economic development in SEE. Abun- dant evidence--from anecdotal sources to more systematic diagnostic studies and surveys--suggested that the risks and costs of doing business in SEE were excessively high and, along with other problems common to state-run economies, were discouraging private investment. Recognizing this, the countries of SEE and their development partners began efforts to improve the investment framework in the region. Those efforts are urgent. The European Union has greatly expanded trade access to the single European market not only for the accession xxii BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE countries (Bulgaria and Romania), but also for the western Balkan states (Albania, Bosnia and Herzegovina, Croatia, the federal Yugoslav Repub- lic of Macedonia, and Serbia and Montenegro) and Moldova. Simultane- ously, intraregional trade liberalization has found new momentum with the signing of the SEE8 Memorandum of Understanding on Trade Liberalization and Facilitation. The opportunities created by those devel- opments will be realized only if investment increases substantially and counteracts the region's high unemployment, insufficient job creation, and stubborn poverty. Chapter 1 conveys the message that a favorable institutional frame- work for domestic and foreign investments is essential to sustainable growth and poverty alleviation in the region. The chapter also presents the scope, methodology, and approach for understanding the role of the institutional environment that affects enterprise development and growth in SEE. Institutional Reform in South Eastern Europe-- Achievements and Challenges The business environment in the SEE8 improved between 1999 and 2002, according to the BEEPS data and EBRD transition indicators, although progress across the region varied. Government reform policies have tar- geted some of the underlying institutional problems in each of the coun- tries, but major institutional challenges remain. To better explain those challenges, chapter 2 presents a disaggregated analysis of the impedi- ments to further institutional reform. Reform efforts in the SEE8 come up short in two important ways. First, the development of key market institutions has been partial and slow. Second, institutional reforms already undertaken have not been effec- tively implemented and enforced. Traditional ways of doing things must catch up to the reforms, from recognizing the validity of contracts to pay- ing for utilities, and from achieving financial transparency to establishing a credible judicial system. Chapter 2 highlights the deficiencies in the development of the four market institutions that are explored in the subsequent chapters: the insti- tutions governing competition, regulated infrastructure utilities, corpo- rate ownership and finance, and commercial dispute resolution. Still Weak Interenterprise Competition Most countries have adopted policies for removing administrative barri- ers, for example, by streamlining business licensing and registration pro- cedures. In many of these countries, however, failure to operationalize the improved registration or licensing requirements in a predictable manner BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxiii and inconsistent interpretation of laws and regulations lead to discrimi- nation between different types of investors--and thus to deficiencies and corruption. More important, few of the countries have strengthened the fundamental market institutions that protect firms from anticompeti- tive structures and conduct. Although some of the countries have sound competition laws, there is almost universal neglect of the use of these instruments to reduce economic barriers to entry. On the exit side, the restructuring or liquidation of large loss-making enterprises has not been facilitated sufficiently, in part because key legislation has not been implemented. Severe Infrastructure Bottlenecks The SEE8 are dealing with severe infrastructure bottlenecks caused by years of poor maintenance and, in some cases, conflict. The severity of the problem varies by country and by sector. But the development of pre- dictable and transparent regulatory frameworks to ensure users' access to competitively priced, high-quality services and to engender investment in the utility sectors is lagging in all countries. Indeed, the inefficient pricing and cross-subsidies embedded in many sectors stifle the incentives that otherwise would attract investors and improve quality and access of utility services. Insufficient Financial Transparency, Accountability, and Protection of Ownership Rights The governments of the SEE8 have shifted away from divesting state assets to insiders, instead relying increasingly on more transparent meth- ods of privatization. However, although some countries have adopted International Accounting Standards (IAS) and independent financial audits for enterprises, most are still in the process of doing so. Use of such instruments needs to be complemented by training managers to properly interpret and use the financial information for improving enterprise per- formance. At the same time, in most countries enforcement of commercial legislation is still ineffective in protecting minority shareholders and in imposing the needed discipline of financial disclosure and transactional transparency. As a result, there are weak checks and balances on manage- rial performance. Compromised Institutions for Resolution of Business Disputes Legal frameworks in all of the SEE8 protect property rights and the integrity of contracts. But the functioning of the associated institutions is limited by lengthy procedures, lack of qualified and independent judges, xxiv BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE and weak enforcement mechanisms. Alternative out-of-court administra- tive channels for dispute resolution--such as arbitration--are underde- veloped in all eight countries. In addition, inefficient land and property rights registration systems present another source of disputes and barri- ers to investment in most of the region. The following sections present summaries of the main findings of each of the four core topics of the book: competition, regulated infrastruc- ture utilities, corporate governance and finance, and commercial dispute resolution. Interenterprise Competition--The Key to Growth Chapter 3 investigates the incentives and constraints on competition in the SEE8 and recommends policies for reform, focusing on the funda- mental determinants of competition and on the power of competition to multiply the benefits of reforms. Deeper diagnosis of how basic market institutions affect interenterprise competition in SEE is essential for the design of enduring policy reforms. Noncompetitive Market Structures and Business Conduct After a decade of privatization and the establishment of new private firms, changes in enterprise ownership in SEE have yet to produce com- petitively structured markets and competitive business operations. Weak incentives in market institutions and policy frameworks in all of the SEE8 have produced little restructuring of large state-owned enterprises. Many firms with dominant sectoral positions continue to operate unchecked by a competitive market structure. Vertical Integration across Sectors, Ownership Forms, and Countries The degree of vertical integration of South Eastern European firms, upstream and downstream, varies significantly across sectors, ownership forms, and countries. In terms of downstream integration, the BEEPS data for the region show that an average of 11 percent of firms' output transactions actually occur internally or are made to related parties. This level of vertical integration is generally much lower than the level case studies indicate for upstream integration. About two-thirds of the sur- veyed SEE8 firms indicate that they have at least four suppliers for their "main material inputs." According to the BEEPS data and the enterprise- level case studies, proportionately more de novo firms than privatized or state-owned firms buy their inputs in markets populated with more suppliers, hence suggesting that new businesses are most able to benefit BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxv from upstream competition. Overall, the evidence suggests that, although privatized and private firms shop around for distributors and customers more than state-owned enterprises do, the converse is true for input purchases. Barriers to Business Entry and Exit In assessing the extent of entry and exit barriers to private sector devel- opment in the SEE8, this study distinguishes between two different types of barriers: those that are (a) economic in nature, principally determined by technology, and those that are (b) institutionally determined, policy driven, or administratively induced. The need for policy intervention to deal with economic barriers generally arises when such barriers are chronically high and in markets in which there is already significant horizontal or vertical dominance. Evidence from the business case studies and the BEEPS data suggests that generic economic policy uncertainty--understood to be unanticipat- ed or unilateral changes in the rules of the game--and macroeconomic instability are the most serious obstacles to new business formation in SEE, implying that governments can proactively carry out policy reforms to reduce barriers to entry in the region. Other important perceived entry barriers are high tax rates, high cost of credit, corruption, and anticom- petitive practices of other businesses. Interestingly, the data give less sup- port to what has become the conventional wisdom--that administrative barriers are the major impediments to business development in transition economies. For example, the surveyed SEE8 businesses do not perceive access to land, titling or leasing of land, business licensing and permits, and tax administration as major impediments. Exit barriers need to be low to make economic space for new entrants and to rechannel productive assets bottled up in inefficient firms to new ventures in which employment can be expanded and new products devel- oped. Creating such an environment calls for hard budget constraints to engender improved enterprise competitiveness from viable firms and to expose firms that are no longer commercially viable. The case studies suggest that in many of SEE8 economies budget constraints are soft and barriers to exit are in some cases appreciable. The BEEPS data show that, for the region, 11 percent of the firms closed at least one plant since 1998--a rather low share by international stan- dards, especially when taking into account that many SEE8 firms are not commercially viable. On a net basis, about 9 percent of the firms indicat- ed opening at least one plant. The infrastructure sector had the largest percentage of firms reporting plant closures and very few net new plant openings. State-owned enterprises reported both the greatest proportion of gross plant closures and the greatest proportion of closures on a net xxvi BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE basis. New firms had the smallest proportion of plant closures, and on a net basis they indicated the largest share of plant openings. The average surveyed SEE8 firm indicated that it received subsidies from national government entities amounting to 9.5 percent of sales rev- enues and received subsidies from regional and local governments amounting to 17.7 percent of sales revenues. State-owned enterprises receive the greatest amount of subsidies as a proportion of sales revenues, followed by privatized firms and then by new private firms (except for FYR Macedonia and Moldova, where privatized firms receive the largest share of subsidies as a percentage of sales revenues). The largest recipi- ents of subsidies are firms in the services and infrastructure sectors; firms in the trade, mining, and hotel and restaurant sectors are the smallest recipients of subsidies. With regard to tax forbearance, the regional aver- age of tax arrears is 12 percent of sales revenues, not an insignificant amount. Competition, Firm Growth, and Performance Changes in sales revenues, exports, employment, investment in fixed assets, and profit margins serve as measures of business performance of surveyed SEE8 firms over the period 1995­98 and 1998­2001. In recent years, there has been considerably less cross-country uniformity in all firm-level performance dimensions except profit margins. Employ- ment growth jumped in Albania and Moldova, whereas firms in Albania, Croatia, and Romania exhibited sizable spurts in sales revenues. Albania and Croatia also experienced above-average growth in investment in fixed assets. Compared with 1995­98, export growth diminished significantly in 1998­2001. On a sectoral basis, in 1995­98 growth in investment in fixed assets was particularly high in the services, transportation, and manufacturing sec- tors. In these same sectors firms generally indicated high growth rates of employment in the later period. Whereas firms in the service sector--and to a lesser extent power generation--registered significantly higher prof- it margins than those in other sectors in 1998, there was more uniformity in profit margins across sectors in 2001. The examination of performance across ownership types yields a striking variance: new private firms out- performed privatized and state-owned enterprises in all five dimensions measured in 1995­98. In 1998­2001, new private firms again generally outperformed the two other ownership types. The gap in employment growth rates between (a) new private firms and (b) privatized and state- owned firms considerably widened, whereas performance differences between privatized firms and state-owned enterprises narrowed consid- erably along all dimensions. BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxvii Times are tough for many South Eastern European businesses. Examin- ing data on the dispersion of firm profitability in 2001 shows that the great- est proportion of loss-makers is concentrated in Bosnia and Herzegovina (11 percent), Bulgaria (8 percent), and Croatia (4 percent). Moreover, a sub- stantial share of surveyed firms in all countries (except for Albania and Romania) indicated zero profits. Most of the surveyed firms indicated a profit-to-sales ratio in the 1 to 10 percent range. Across countries, the distri- bution of firms with profitability rates above 10 percent varies significantly. Across most sectors, there is more uniformity in the distribution of firm profitability--except for the mining and hotel and restaurant sectors. Across ownership types, loss-makers and those earning zero profits are most heavily represented in the state-owned enterprise category. Privatized firms have the next-largest proportion of firms in those two categories. Multivariate regressions on approximately 1,600 surveyed South East- ern European firms suggest that higher firm profitability is associated with increased market share, greater vertical integration, lower level of subsidies, absence of state ownership (now or in the past), and more intensive research and development spending (a measure of a barrier to entry). These findings are consistent with analyses of the determinants of business performance in other regions of the world, which show that profit differentials are likely driven by the structural competitiveness of markets. The econometric results also point to country-specific factors that explain the variance in firm profitability across SEE. Need for Proactive and Effective Competition Policies A proactive policy approach is needed that includes (a) economywide institutional and structural reforms, and (b) reforms in competition policy. Such a two-pronged approach will facilitate the entry of new businesses and will foster the horizontal and vertical restructuring of anticompetitive incumbent firms. Among the specific policy recommendations, the chap- ter outlines the following: · Make structurally dominant markets contestable for new entrants. Priority attention and resources should be directed at preventing fur- ther horizontal and vertical consolidation through mergers and acquisi- tions in markets in which concentration and structural dominance are already excessive. Explicit, well-defined, and transparent merger guide- lines should be developed that establish general policy parameters for distinguishing between procompetitive and anticompetitive mergers. · Foster proactive competitive restructuring or exit of value-subtracting incumbents by facilitating reorganization and bankruptcy--including, when necessary, liquidation of insolvent firms. xxviii BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE · Review the missions of SEE8 government current competition policy agencies with a view to strengthening their rules-based incentive struc- tures and to improving their implementation and enforcement capacities. · Promote market-oriented policies for developing small and medium- size enterprises (SMEs), such as nongovernmental support programs (sponsored by commercial banks or international donors) that include (a) providing equity participation in venture capital and investment funds, (b) funding of local banks that provide commercial-based credit to SMEs, and (c) cofinancing with local banks of SME projects. · Establish independent monitoring systems, based on widely publi- cized and anonymous feedback channels for enterprises to report vio- lations, as a check on reform implementation to oversee success. · Enhance "behind-the-border" competition to facilitate international trade and foreign direct investment (FDI) in SEE, and continue to bring policy regimes governing FDI in line with international best practice: (a) national treatment for foreign investors; (b) binding international arbitration for investor-state disputes; (c) substantial reduction in restrictions and limitations on FDI; (d) freedom for profit remittances; (e) expropriation for only a bona fide public purpose and with prompt, adequate compensation; and (f) absence of trade-related investment measures. · Establish mechanisms that give individual countries incentives to compete for reform progress in the region. To jumpstart competition in reform among South Eastern European countries, governments could propose appropriate measures to assess reform progress, together with a simple survey methodology. · Enhance public education efforts to foster a culture of competition in SEE by undertaking initiatives aimed at ensuring that consumers at large, as well as all enterprises, especially start-ups, are aware of the importance of the competitive process in practice and of the objectives and content of competition law. Access to Regulated Infrastructure Utilities Bottlenecks in telecommunications, transportation, electrical power, and water are particularly severe in SEE because of inadequate maintenance, which is aggravated, in many cases, by conflict. Some needed and obvi- ous changes include the following: · De-monopolizing and privatizing existing infrastructure networks, as well as introducing competitive forces where natural monopoly condi- tions no longer exist, will help create the appropriate incentives for innovation by service providers and business users. BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxix · Establishing appropriate regulatory rules will remove a significant obstacle to the development and expansion of business, as well as to regional trade and integration. · Developing predictable and transparent regulatory frameworks will ensure users' access to competitively priced, high-quality services and will engender investment in the infrastructure sectors. With the notable exception of FYR Macedonia, where progress appears to be limited, the SEE8 report a major improvement in infrastructure ser- vices. Chapter 4 disaggregates the perceptions of enterprises across each of the infrastructure sectors and presents cross-country and cross-sectoral variations. For the region as a whole, the power sector is perceived as the most severe infrastructure barrier to market entry and to expansion of real sector enterprises, followed by transportation and telecommunications. This finding is driven largely by the fact that businesses in Albania (togeth- er with those in Bulgaria and Romania) perceive access to electricity as a severe obstacle for entry and expansion. For Bosnia and Herzegovina, Croatia, FYR Macedonia, and Moldova, transportation is considered as the most relevant infrastructure-related barrier to entry. In most of those coun- tries, the road network has been broken by war and has been degraded by severe underinvestment. For Serbia and Montenegro, the telecommunica- tion sector represents the greatest barrier to entry and expansion (likely related to the highly politicized privatization of the Serbian telecommuni- cation operator in the Slobodan Milosevic era). Access to infrastructure is also an impediment to exit. There is strong evidence that privatized and state-owned enterprises are by far the great- est beneficiaries of soft budget constraints through nonpayment of utility services, confirming the presence of an uneven playing field tilted against the private sector. Thirteen percent of privatized and 20 percent of state-owned enter- prises are not paying infrastructure providers on time, compared with only 5 percent of new private enterprises. The disparities across different ownership categories emerge strongly from the case studies and from offi- cial data as well. Among the utilities, arrearages are the most recurrent problem in the energy sector. Energy cash collection (in terms of percent- age of total collections) averages only 67.5 percent, and commercial losses (defined as nonbilled consumption) are at 20 percent. Cash collection is particularly low for industrial consumers, blunting incentives for indus- trial restructuring. Nonpayment results in a variety of problems: propping up state- owned enterprises at the expense of private companies, discouraging private investment in utilities, and preventing essential improvements in technology and service. xxx BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Poor Quality of Infrastructure Services The quality of infrastructure service is poor. Across SEE, power outages of more than 11 days per year stand out as the major quality problem, followed by water cutoffs (9 days) and suspension of telecommunica- tion services (5 days). Telecommunication services are characterized by higher waiting times, but they are on average more reliable. The opposite holds for electricity. By understanding the relevance of broader regulatory reforms, includ- ing greater private sector involvement and more independent rulemak- ing, policymakers can effectively address these challenges in access and quality of infrastructure services. The very low payment discipline in the region is a powerful reason for accelerating private sector involvement-- especially through foreign investment. A private firm owned or managed by a foreign strategic investor will have strong incentives to enforce pay- ment discipline. It also will have the technical knowledge and finance required for essential remetering programs, computerization of billing, and other measures that can help improve payment and collection. Expe- rience to date suggests that, in cases in which the private sector has entered power distribution, collections have gone up. Yet to successfully enhance efficiency, privatization requires complementary institutional changes, including restructuring to create scope for competition and to enhance the commercial viability of the privatized utility. It also requires changing public attitudes about low-cost energy as an entitlement. The regulatory regime adopted for privatized network utilities is likely to encompass several dimensions, one being the establishment of an inde- pendent regulator--vital for settling market disputes and dealing with policy and other regulatory issues. Two key decisions for any newly established agency are the development of pricing rules and the choice of appropriate rate regulation. In South Eastern European countries with an independent regulator in the electricity sector, waiting times for service are a fraction of those in countries with no independent regulator. A sim- ilar pattern characterizes the telecommunication sector: countries with an independent regulator have very low waiting times (fewer than 2 days), compared with the waiting times in other countries (more than 7 days). But even if an independent regulator exists, the difficult challenge facing the national government is to endow that regulator with technically com- petent people and give them the authority and budget needed to imple- ment its mandate effectively. Improving Infrastructure Services Better infrastructure services could offer tremendous opportunities to reduce costs and to increase revenues in the real sector; conversely, BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxxi innovation downstream has been severely constrained by inadequate infrastructure upstream caused by poor regulation. Policy recommenda- tions to break the vicious cycle include the following: · Sequence infrastructure reforms appropriately, establishing sound reg- ulatory frameworks before privatizing utilities. · Promote further private sector involvement by commercializing, restructuring, and ultimately privatizing key utility sectors. Wherever possible, involve strategic investors to maximize privatization rev- enues, to secure finance for necessary investments, and to strengthen incentives for improved efficiency. · Establish an independent, transparent, and publicly accountable regu- latory oversight process and institutions. Strengthen the independence and financial viability of the newly created regulatory agencies. Balance independence against accountability and requirements for monitoring and assessing regulatory effects. · Coordinate the work of regulatory institutions. With the creation of independent sector regulatory agencies, competition authorities would no longer be responsible for tariff-setting processes and supervision, leaving technical and pricing regulation to specialized agencies. Competition authorities could thus play a more forceful role in deter- mining the appropriate scope of regulatory authority and the appro- priate market structure, as well as in controlling anticompetitive con- duct by dominant enterprises. · Create a more competitive environment for delivery of infrastructure services by establishing fair, transparent, and nondiscriminatory terms of access to regulated utilities. · Develop alternative institutional frameworks for improving perfor- mance of infrastructure services, including regional and cross-sectoral approaches to regulation. Corporate Ownership, Financial Transparency, and Access to Finance The private ownership of productive assets that characterizes capitalism relies on an institutional foundation not found in recent postcommunist systems. In particular, capitalist systems provide legal protections that allow the pooling of capital with controlled risk for investors, which encourages a potentially important new source of financing for productive entities. Building these systems, however, requires reforms much more profound than stroke-of-the-pen passage of laws. Investor confidence-- indeed, fundamental fairness--requires corporate transparency and accountability. In the West, systems that have existed for centuries have yet to be perfected, a fact made clear by the wave of governance and xxxii BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE accounting scandals of the past several years. The relative infancy of the systems in transition countries poses an even greater challenge. In this vein, chapter 5 focuses on the themes of corporate ownership, financial transparency, and access to finance in SEE. Forms of Ownership The BEEPS2 sample exhibits variation in forms of ownership: · Croatia and Romania have very few firms describing themselves as sole proprietorships, but large numbers that call themselves corporations. · Bosnia and Herzegovina and Bulgaria stand out for the large numbers of firms that said their shares were listed on the stock exchanges. Larger firms are, predictably, more likely to report a corporate form of organization and listing on stock exchanges. · Overall for the region, most of the surveyed firms are completely owned either by the state or by domestic or foreign owners exclusively. Mixed ownership, such as joint ventures, is less common. Among larger firms, however, mixed ownership is much more prevalent. The continuation of state involvement in partially privatized firms does not come without costs. Managers may continue to feel pressured to deliver on the programs of politicians, rather than to deliver profits to shareholders. Degrees of Financial Transparency The degree of transparency and accountability evident in the way the firms present their financial statements is also examined. Among medium- size and large firms (firms with at least 50 full-time employees) that took part in BEEPS2, the use of IAS is highest in Croatia and Moldova, both of which also reported the most widespread use of IAS in BEEPS1. For both countries, the survey suggests that IAS have become the norm and are used by some 90 percent of firms. At the lower end of the scale are FYR Macedonia, Romania, and Serbia and Montenegro; less than half of the medium-size and large firms in those countries report using IAS. The low levels of compliance are in part explained by simple adherence to rules placed on firms by authorities. Within the SEE8 there has been little change in the prevalence of IAS between the 1999 BEEPS and the 2002 BEEPS, except in Bulgaria, which showed a marked increase. The BEEPS data suggest that larger firms and foreign-owned firms are more likely than smaller firms and domestically owned firms to use IAS and external audits. However, variation in the observed use of IAS and BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxxiii external audits in the SEE8 is most significant across countries. Apparently, firms adopt IAS because external factors, such as requirements embodied in laws, force them to do so rather than because it is inherently a better business practice. Ownership concentration is important for explaining the use of external audits in FYR Macedonia and Moldova, and in both countries it is firms with smaller degrees of concentration that are more likely to use external audits, even after controlling for form of ownership. This finding is consistent with the use of external audits as a tool for dif- fuse ownership to check the performance of management. Terms and Modes of Sale, Purchase, and Finance Firms in countries with less-developed formal financial systems are less likely to transact business in any manner other than spot exchange. Within the region, both prepaid and credit sales are strongly negatively correlated with the EBRD indicator on banking reform and interest rate liberalization. In addition, the BEEPS data show that alternative means of transacting business, such as barter, bills of exchange, and debt swaps, are common in most of the SEE8. Firms in the former Yugoslav republics that participated in the BEEPS were especially likely to report the use of barter; the business case studies present a similar story. After firms switch from bartering to monetary payments, both sellers and buyers achieve better pricing and value. For both working capital and investment purposes, firms throughout the region continue to use primarily their own retained earnings. In Croatia and FYR Macedonia, firms were significantly more likely to bring in new equity as a means of financing operations, and in FYR Macedonia firms were also the most likely to make use of informal credit sources. Croatian firms were the most likely to use formal credit arrangements, consistent with the more developed level of banking in that country. Albania and Serbia and Montenegro demonstrated the highest levels of financing through retained earnings. The BEEPS data suggest also that the use of new equity for financing investment has increased in Bosnia and Herzegovina and in FYR Macedonia, whereas use of informal credit has expanded in Bulgaria and Romania. Financial Transparency, Investment, and Growth At a national level, countries with deeper penetration of IAS and exter- nal audits tended to grow faster in 2002. Nevertheless, building true financial transparency will continue to be a formidable challenge, and the case studies have already suggested that problems with formal finance are pushing firms to look elsewhere for the funds needed to invest and grow. xxxiv BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE In simple regressions, firm reports of adopting IAS and external audit- ing are correlated with firm-level investment. However, much of this relationship derives from the fact that countries with deeper penetration of IAS and external audits also had higher levels of investment, on aver- age, among firms in the survey. After controlling for country effects, both IAS and external audits cease to be important for explaining investment. This finding is consistent with the idea that financial transparency has an important external effect: when firms are generally more transparent, the atmosphere of trust that is so essential for arm's-length investing is strengthened, and all firms benefit. Ease of access to finance is important for explaining investment intensity across surveyed firms, even after controlling for cross-country and other differences. Surveyed firms with more competition and larger firms tended to report lower levels of investment, but the relationships were generally not significant at con- ventional levels. Firms that said they adopted IAS had much higher average sales growth than firms that did not, a finding that remains even after control- ling for country effect. However, when access to finance, size, competi- tion, and other factors are accounted for, the link between IAS and firm sales growth weakens considerably. It is notable that access to finance, itself determined in part by financial transparency, remains significant at a very high level. Higher Standards and Fuller Disclosure Analysis of the survey data and case studies suggest the following policy directions: · Deepen the separation between politicians and firms. Policy measures to achieve this separation range from promoting further privatization in countries where significant portions of the productive economy remain partially or fully state owned, to establishing clear governance mechanisms that moderate conflicts of interests. Albania, Bosnia and Herzegovina, and Serbia and Montenegro all need to continue the pri- vatization work that was delayed by conflict. Several countries, includ- ing Bosnia and Herzegovina and Romania, have adopted legislation that would strictly control conflicts of interest by requiring directors to choose between their public office and their board seats. · Monitor public disclosure of financial statements. Vigilant monitoring is needed to ensure that firms required to disclose their financial state- ments in fact do so. For the many publicly traded firms that do not yet obtain external audits, public disclosure of financial statements should be the first step in reforms, with or without reforms in accounting systems. BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxxv · Push for widespread adoption of IAS and the use of independent exter- nal audits. Financial transparency builds trust in financial statements on the part of banks, investors, regulators, and others, but without a push most firms will not undertake the necessary reforms. · Train people to interpret financial statements prepared according to international standards. Many professionals in the public and private sectors must be able to read financial statements accurately if financial markets are to function efficiently. Maintaining training and education programs that produce qualified accountants will be essential to build- ing investors' confidence in the integrity of financial statements. · Set down clear rules on conflict of interest in the accounting profession. In building institutions of financial transparency from the ground up, the SEE8 can learn from the experience of others, including the United States, which was recently rocked by accounting scandals. Conflicts arise when auditors want to please their customers; when investment- banking firms are also investment advisers; when executive officers are also board members; and when regulatory authorities, such as stock exchanges, are governed by the firms they regulate. Some of these sit- uations are specific to each country, but the general point is that envi- sioning the ramifications of potential conflicts of interest when laws and regulations are being drafted can help prevent the erosion of investor confidence that has recently damaged industrial markets. Commercial Dispute Resolution, Contract Enforcement, and the Courts A fundamental aspect of commerce is trust: trust that products and services have the expected quality and integrity; that services and prod- ucts will be delivered and paid for; and that contracts, partnerships, cred- it arrangements, and other agreements will be adhered to. Although the history of commerce is built on trust, commerce is also subject to risks of all sorts. For that reason, business and commerce rely on enforce- able rules and contracts, agreed-upon ways of resolving disputes, and instruments of justice. Part of the legacy of the state-run economies of SEE is the debasement of trust, the lack of enforceable rules, and a court system without credibility. These problems are all in the process of correction. Chapter 6 analyzes the quality of the investment climate throughout SEE from the perspective of commercial dispute resolution. This subject includes a spectrum of institutions, as well as formal and informal mech- anisms, that promote the reliability of business activities and serve to enforce contracts, such as the courts, business associations, social net- works, private protection firms (legal and criminal), government inter- vention, and public channels. xxxvi BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Although contract enforcement can be mediated through a variety of means--relationships based on trust, self-enforcement through repeat transactions, third-party enforcement based on reputation, private enforcement, administrative (governmental) intervention, and court enforcement (litigation)--courts are the main institution enforcing con- tracts and resolving business disputes. Without efficient courts and the expectation that courts will uphold contractual rights and obligations, firms will be less willing to deal with new clients and suppliers, and fewer transactions will take place. Transitional Techniques for Enforcing Good Commercial Practices To avoid and resolve disputes in this period of transition from a system no one trusted to new institutions that must win credibility, firms in SEE follow several strategies. These strategies include refusing to extend cred- it to existing or new customers; requiring prepayment before releasing the objects of the contractual exchange; and relying on business associa- tions, the government, political parties, or private protection services. The BEEPS2 data reveal the varied effectiveness of these techniques. · To avoid disputes, the region's firms use bilateral mechanisms, such as prepayment and nonextension of credit, that significantly reduce the probability of running into payment disputes. · Business association membership and donations to political parties are not found to reduce the incidence of disputes; indeed they are cor- related with greater recourse to courts. In fact, 84 percent of surveyed firms indicate that the business association to which they belonged provided no value at all--or at best negligible value--in helping them resolve disputes with the same third parties. · Firms avoid disputes by forgoing trade with unknown suppliers, even when such trade would be on more beneficial terms than existing sup- pliers could offer, and by forging long-lasting relationships with sup- pliers and customers, even at a higher cost of doing business. This cost reflects lost opportunities to trade with alternative firms on better terms or to facilitate the entry of new firms into the market. The High Cost of Formal Dispute Resolution Court enforcement of commercial debt contracts in the SEE8 is slow and costly, especially in comparison with court enforcement in other transition economies. On the ease of resolving contractual disputes in court, the SEE8 show considerable differences. To resolve the same case before a first-instance court in the country's largest city, Serbia and Montenegro imposes the most procedural steps (40), followed by BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxxvii Albania and Moldova (35), and Croatia (20). Moving that case through the court takes longest in Serbia and Montenegro (more than 1,000 days). There are significant differences in the cost of court proceedings. Albania has the highest costs of legal procedure before the first-instance courts--1.5 times the claim amount. Clearly, if fees exceed the claim amount, firms will not take cases to court. Court procedures are also expensive in Bosnia and Herzegovina, FYR Macedonia, and Serbia and Montenegro, with total attorneys' and court fees ranging from 40 to 80 percent of the claim value. The least costly of the SEE8 jurisdictions are Bulgaria and Croatia, where total costs come to approximately 13 percent of the claim value. Overall, chapter 6 emphasizes that firms tend to use the court system when it is less formal, less expensive, and faster in resolving disputes, and that those firms that regularly use the courts to enforce contracts are the ones that perform better. But what types of firms do go to court to resolve their business disputes? Three findings emerge: · Small firms use courts the least. · State-owned firms file more cases and have a higher proportion of pay- ment disputes resolved in court than do private firms. · New firms file significantly fewer cases with the courts and report a significantly lower proportion of payment disputes resolved by court proceedings than do older firms. In addition, several key observations arise from assessing firms' per- ceptions about the performance of the court system. First, respondents seldom rate the judicial system of their jurisdiction as performing well. Second, court delays are seen as a major symptom of court inefficiency. And third, despite their generally low assessments of the courts, firms tend to register somewhat higher scores when asked about their confi- dence in the legal system. Although old firms have a more favorable perception of the speed of court justice than do new firms, the differences are not statistically signif- icant. However, large and state-owned firms tend to believe that the courts are faster than do small and private firms. Naturally, firms that are larger generally have the resources to absorb longer legal procedures than smaller firms. Judicial corruption remains a significant problem. New firms, small firms, and private firms pay bribes to court officials and judges more fre- quently than do old firms, large firms, and state-owned firms. Frequent bribe payments raise the costs of "judicial capture" to the firm. Small and medium-size firms suffer higher costs of judicial capture; firm age also affects costs of capture positively and significantly. Interestingly, judicial formalism is found to significantly raise the frequency with which firms xxxviii BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE pay bribes to the courts, when other factors are controlled for. This find- ing lends support to the argument that higher procedural formalism and complexity create opportunities for corruption. The Burden of Judicial Complexity There is significant cross-country variance in judicial complexity. Only FYR Macedonia makes the use of lawyers for legal representation manda- tory in debt collection before a first-instance court, although in practice many plaintiffs in the other countries do hire lawyers at this stage. Also, all SEE8 jurisdictions impose written requirements for filing, service of process, judgment, and enforcement; three countries require that the defendant's opposition be in written form; and two insist that all evidence be in written form and that final arguments be submitted in writing. These requirements present an additional hurdle for businesses, because they have to seek legal advice before filing a complaint. The regulation of evidence delays contract enforcement. While six of the SEE8 have statutory regulations on out-of-court statements and the record- ing of evidence, none has regulations on the admissibility of irrelevant evi- dence or requires that oral interrogation be conducted exclusively by the judge. In each of the eight jurisdictions, enforcement is suspended if an appeal is filed, and the suspension lasts until the appeal is resolved. Fur- thermore, all jurisdictions allow comprehensive review on appeal and most, apart from Croatia and Moldova, allow appeal during trial. Thus, a debtor who wants to delay execution can file appeals, even if no reasonable chance of a successful appeal outcome is expected. Advancing Judicial Reform Contract enforcement mechanisms, both formal and informal, are essen- tial for the smooth functioning of commercial contracts. Therefore, any policy aimed at strengthening the enforceability of commercial contracts and the resolution of commercial disputes needs to address judicial reform together with mechanisms for informal enforcement. Policymak- ers could pursue several types of reform that have been found to improve the enforcement of commercial contracts in various jurisdictions world- wide. These measures include concrete policy recommendations, which are outlined below: · Establish information-sharing institutions. Create enforcement mecha- nisms such as credit bureaus, the media, nongovernmental organiza- tions, and intermediaries such as accountants and auditors. Such insti- tutions perform important functions in ensuring that contracts are enforced and that obligations between business partners are met. BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xxxix · Improve judicial statistics to identify bottlenecks in court performance and signal to policymakers the direction of future reforms. Collecting judicial statistics is a necessary step in improving court administration and case management systems, which are in need of modernization and reform in all of the SEE8. · Remove nondispute cases from the courts and transfer noncontentious matters such as company or property registration to relevant adminis- trative agencies to improve court efficiency and free resources. · Make judicial processes less burdensome and simpler for the parties in order to improve the speed and transparency of litigation. This mea- sure could involve (a) moving away from written to oral procedures to prevent interruptions and delays, (b) limiting the need for legal justifi- cation in straightforward commercial cases, (c) changing procedural laws to allow more discretion on the part of the judge in admitting evi- dence and using it to ease the judicial process, (d) improving the enforceability of the first-instance judgment and limiting the scope for appeals without due cause, and (e) improving the system of court noti- fications of parties and witnesses to reduce the burden of procedural notifications. · Establish specialized courts such as small claims courts and specialized commercial courts to reduce procedural complexity, to speed disposi- tion, and to reduce legal costs. · Strengthen existing or introduce alternative dispute resolution mecha- nisms such as mediation and commercial arbitration, especially in overburdened courts with significant case backlogs. · Increase court resources to enhance training of judges and judicial sup- port staff; improve the poor state of judicial buildings and office equip- ment; and improve the case assignment, case filing, and case tracking systems. Conclusion South Eastern Europe has made considerable progress in establishing an environment for the formation and operation of private enterprises. However, substantial challenges remain to be tackled everywhere in the region. This study emphasizes the importance of developing key market institutions to further the growth of a vibrant enterprise sector in the region. Boosting domestic and foreign investment in the SEE8--thereby accelerating growth, reducing poverty, and tightening the region's inte- gration with its European neighbors--depends on raising competition, reducing economic barriers to entry and exit, improving firms' access to regulated utilities and services, restructuring corporate ownership, increasing financial transparency, widening access to finance, and strengthening and streamlining commercial dispute resolution. Abbreviations ADR Alternative dispute resolution ANRC Romanian Communication Regulatory Authority (Autoritatea Nationala de Reglementare in Comunicatii) ATP Autonomous Trade Preference BEEPS Business Environment and Enterprise Performance Survey BSE Bucharest Stock Exchange BTC Bulgarian Telecommunications Company CEE5 The Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia CEFTA Central European Free Trade Agreement CEO Chief executive officer CIDA Canadian International Development Agency CIS Commonwealth of Independent States CMS Corruption Monitoring System CRC Communications Regulation Commission (Bulgaria) DSL Digital subscriber line EBRD European Bank for Reconstruction and Development ESM Elektrostopanstvo na Makedonija EU European Union FDI Foreign direct investment FESAL II Second Financial and Enterprise Sector Adjustment Program FIAS Foreign Investment Advisory Service FIC Foreign investors' council FTA Free trade agreement GDP Gross domestic product GNI Gross national income GSM Global System for Mobile Communications HEP Hrvatska Elektroprivreda IAS International Accounting Standards IFI International financial institution INA Industrija Nafte ISP Internet service provider xl BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE xli IT Information technology KESH Korporata Elektro-energjetike Shqiptare KfW Kreditanstalt für Wiederaufbau LLU Local loop unbundling LRMC Long-run marginal cost MEBO Management-employee buyout OECD Organisation for Economic Co-operation and Development R&D Research and development ROSC Report on the Observance of Standards and Codes SAA Stabilization and association agreement SEE South Eastern Europe SEE8 Albania, Bosnia and Herzegovina, Bulgaria, Croatia, the for- mer Yugoslav Republic of Macedonia, Moldova, Romania, and Serbia and Montenegro SEEPAD South Eastern European Partnership on Accountancy Development SMEs Small and medium-size enterprises SOEs State-owned enterprises USAID U.S. Agency for International Development VAT Value added tax WTO World Trade Organization 1 Institutional Aspects of the South Eastern European Economy: Introduction, Trends, and Scope of the Study Background Accelerating growth and reducing poverty through the establishment of a stable, transparent, and uniform investment framework are key to restor- ing and consolidating peace and stability in South Eastern Europe (SEE). Low levels of domestic and foreign investment have constrained eco- nomic development in the region. Evidence from enterprise surveys and diagnostic studies, as well as from many anecdotal sources, shows that the cost of doing business in SEE is too high and discourages private investment. South Eastern European countries and their development partners have recognized explicitly the importance of improving the investment framework in the region. All of the beneficiary members of the Stability Pact--which is a political declaration of commitment and a framework agreement on international cooperation among more than 40 partner countries and organizations--have committed to developing a shared strategy for stability and growth in SEE.1 As part of the Stability Pact, the countries of SEE intend to implement the Investment Compact, which includes important legislative and administrative commitments for advancing the region's economic and business environment.2 Improving the investment framework in SEE not only is important; it also is urgent for two reasons. First, the European Union (EU) has greatly expanded trade access to the single European market, both for the accession coun- tries (Bulgaria and Romania) and for the five western Balkan states (Albania, Bosnia and Herzegovina, Croatia, the former Yugoslav Republic of Macedonia, and Serbia and Montenegro) and Moldova. Simultaneously, liberalization of intraregional trade has gained new momentum with the 1 2 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE signing of the Memorandum of Understanding on Trade Liberalization and Facilitation by Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Serbia and Montenegro, and Romania. Only if investment increases substantially will it be possible to seize the oppor- tunities created by these developments. The second reason for urgency is the close association of high unem- ployment rates and insufficient job creation with high rates of persistent poverty throughout the region, which endangers social stability and could thus undermine the prospects for growth. In the study that is the focus of this book, we analyze eight countries (the SEE8): Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Romania, and Serbia and Montenegro.3 We cover the institutional impediments to investment and private sector develop- ment in the SEE8 and suggest policy reforms to ease these constraints. The premise of the study is that an institutional framework that is favor- able for domestic and foreign investments is essential to achieve sustain- able growth and alleviate poverty in the region. In this chapter, we describe the recent economic trends in the SEE8 and their prospects for international and intraregional integration. We present our understanding of the role of the institutions and economic environ- ment that affect enterprise development and growth in the SEE8 and describe the objectives, scope, and organization of the study. Trends in the SEE8 Economies Dynamics of Output by Sector The recent progress in privatization and structural reforms in South Eastern Europe indicates that the region has recovered from the deep and lengthy recession of the 1990s. Most of the economies of the region have experienced relatively sustained growth, although in some cases that growth is still somewhat fragile, especially since the end of the Kosovo conflict in 1999 (see table 1.1). Most of the 1990s were characterized by dramatic collapses of output. The occasional periods of economic stability were backed by subsidies to the state-owned industrial sector, which increased fiscal and current account deficits, or by extensive borrowing from abroad. In 2001, the SEE8 had reached only 74 percent of its pretransition (1989) level of eco- nomic activity.4 In comparison, in 2001 the five most developed Eastern European transition economies (the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia) had recovered and grown to a com- bined output of 115 percent of 1989 levels. Despite the slow and erratic 2002 32.4 22.7 12.8 44.9 -- -- -- -- 13.3 28.9 17.9 57.8 -- -- -- -- page.) GDP) following of 2001 34.2 23.4 13.2 42.4 14.3 29.6 -- 56.1 13.9 29.0 17.8 57.1 9.7 34.2 24.3 56.1 the (% on sector 2000 35.9 22.7 13.2 41.4 1.71 24.9 15.1 63.4 14.2 29.7 18.1 56.1 9.9 34.1 24.1 56.0 by continues able added (T 1999 37.2 22.3 13.5 40.5 13.3 24.4 14.9 62.3 16.6 28.6 17.2 54.8 9.8 33.4 22.6 56.8 alueV 1998 54.5 24.5 1.91 21.1 14.8 26.0 16.2 59.2 19.1 31.0 19.4 49.9 9.8 33.1 22.2 57.0 2002 4.7 3.0 5.5 6.0 7.4 3.9 -- -- -- -- 4.3 1.1 3.1 -- 4.9 5.2 -- -- -- -- 6.5 1.4 (%) 2001 10.7 6.5 13.6 4.5 -- -- -- -- 4.0 0.5 4.2 -- 4.2 3.8 0.7 4.3 6.0 4.8 sector by 7.8 4.0 2000 1.41 5.0 13.3 5.6 8.3 5.7 7.2 9.4 5.4 10.3 10.6 19.5 6.7 2.9 1.3 1.5 4.1 5.0 owth gr GDP 7.3 3.7 1999 10.8 6.4 13.0 9.6 3.4 9.0 0.5 14.1 2.3 5.5 6.3 5.9 5.3 0.9 2.0 0.1 4.1 0.3 1998­2002 Real SEE8, 7.9 5.0 1998 12.1 4.1 1.21 15.6 0.1 16.7 7.5 10.2 4.0 1.2 7.9 6.5 0.6 2.5 5.6 4.7 5.3 2.1 the in owth owth owth owth gr gr gr gr Output e e e e GDP Herzegovina GDP GDP GDP 1.1 and ableT Annual Agricultur Industry Manufacturing Services Annual Agricultur Industry Manufacturing Services Annual Agricultur Industry Manufacturing Services oatia Annual Agricultur Industry Manufacturing Services Albania Bosnia Bulgaria Cr 3 2002 12.1 29.7 18.6 58.2 25.1 24.2 18.2 50.7 14.8 35.6 25.7 49.6 -- -- -- -- GDP) of 2001 1.71 32.1 20.3 56.1 26.0 24.1 18.2 49.8 15.0 34.6 -- 50.4 -- -- -- (% sector 2000 12.0 33.7 20.7 54.3 29.0 21.7 16.3 49.2 12.5 34.1 -- 53.4 17.6 37.6 44.8 by added 1999 12.9 32.6 20.5 54.5 27.9 22.7 14.7 49.4 15.2 33.9 -- 51.0 10.1 43.1 46.8 alueV 1998 13.2 33.8 20.9 53.0 30.5 23.5 16.5 46.1 16.2 35.4 -- 48.4 -- -- -------- -- 2002 0.3 2.1 5.6 5.4 3.6 7.2 2.0 6.0 6.0 4.4 4.3 3.0 7.0 8.0 -- 4.0 -- -- -- -- 4.5 (%) 2001 10.8 6.4 3.9 1.6 6.1 4.3 17.5 17.8 0.5 5.3 21.2 7.4 -- -- 5.5 -- -- -- -- sector by 4.5 1.0 8.0 9.4 2.3 2.1 2.3 6.6 2000 15.9 3.8 0.6 18.2 6.2 6.2 6.8 5.0 20.0 10.9 -- -- owth gr authorities. GDP oduct. 4.3 0.9 3.3 2.4 6.3 3.4 3.9 3.5 6.1 5.9 1.2 3.3 1.7 7.1 3.4 1999 15.7 1.2 22.5 -- -- pr Real statistical domestic 3.4 3.3 2.6 0.5 3.6 6.5 6.2 1998 15.2 16.4 0.6 4.8 10.4 8.7 5.3 0.5 1.9 -- 3.6 -- -- oss national gr and GDP o owth owth owth owth (2003c) gr gr gr gr (continued) e e e e Bank available; FYR GDP GDP GDP Montenegr GDP orld not 1.1 and W -- ces: ableT Annual Agricultur Industry Manufacturing Services Annual Agricultur Industry Manufacturing Services Annual Agricultur Industry Manufacturing Services Annual Agricultur Industry Manufacturing Services Macedonia, Moldova Romania Serbia Sour Note: 4 SOUTH EASTERN EUROPEAN ECONOMY 5 recovery in output since the fall of the socialist regime, by the end of the 1990s, growth rates in the SEE8 had been restored. In 2002, the region grew 4.2 percent, on average--faster than the 2.5 percent growth rate of the world economy. For 2003, the average regional growth for the SEE8 also was positive, at 3.5 percent (EBRD 2003). The economic rebound of the SEE8 has been fueled primarily by pri- vate means as resources have moved from the state to the private sector. In 2002, the private sector generated at least one-half of the output across the region, except in Bosnia and Herzegovina and Serbia and Montenegro (see figure 1.1). The privatization of large-scale enterprises advanced slowly for most of the 1990s, which suggests that the emerging private sector and the small and medium-size enterprises (SMEs) were the vehicles of recent growth in the SEE8. Although SME privatization has been com- pleted in most of the countries in the region, in Bosnia and Herzegovina, Moldova, and Serbia and Montenegro, ownership divestiture programs are still under way (EBRD 2002). At the same time, the role of foreign aid and loans has declined even in the western Balkans, where it constituted a Figure 1.1 Progress in the Transition of the SEE8: Small-Scale Privatization, Large-Scale Privatization, and Private Sector Share in Output 4.5 80 4.0 70 3.5 60 index 3.0 50 2.5 40 GDP 2.0 of % privatization 30 1.5 20 EBRD 1.0 0.5 10 0 0 and and FYR Albania Bulgaria Croatia Moldova Romania Bosnia Macedonia, Serbia Herzegovina Montenegro small-scale privatization (left scale) large-scale privatization (left scale) private sector share in GDP, 2002 (right scale) Source: EBRD (2002). 6 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE small share (7 percent) of the five countries' gross domestic product (GDP) in 2002 (European Commission 2003b, p. 10). INDUSTRY Despite progress with initial reforms such as small-scale privatization, price liberalization, and foreign exchange and trade liberalization, indus- trial output in the SEE8 has recovered on average only 45 percent of its 1989 level, except in Bosnia and Herzegovina, which registered only 12 percent recovery of its 1989 output level (UNECE 2002). Before the fall of the socialist regime, the industrial sector generated most of the output in these countries. However, traditional industrial sectors, such as base metals, textiles, footwear, and food processing, declined in many of the SEE8, partly because of the market transformation and the lack of compet- itiveness of many export sectors, and partly because of the war and regional conflicts of the Yugoslav succession. The failure to attract domestic and for- eign investment has left large-scale manufacturing, especially the heavy industries such as metallurgy, heavy-machine building, and mining, with outdated equipment and technology. This lack of up-to-date technology has hampered the competitiveness of the region's industrial products. Although the recovery of the industrial sector in the SEE8 has been ane- mic, in the past decade small-scale manufacturing has remained a major component of output. The recent industrial recovery throughout the region was led primarily by the export-oriented light industries for con- sumer goods such as food and beverages, textiles and clothing, leather goods and footwear, light machinery and equipment, chemical products, wood products, and electrical appliances. The construction industry also grew in parts of the region. In the 1990s, it became one of the most dynamic sectors of the economies of Albania and Bosnia and Herzegovina. However, because it was funded primarily by remittances and foreign aid for rebuilding the countries that suffered from regional conflicts, the sector became heavily dependent on foreign projects. Construction financed by the domestic private sector in Bosnia and Herzegovina, for example, has been negligible since the war there ended in 1995 (EIU 2002). In the rest of the region, the construction indus- try was hit by the transitional recession but mostly recovered and grew in the late 1990s. The acute need in the SEE8 for improvements in physical infrastruc- ture, housing, and tourism suggests the potential for further develop- ment of the industrial sector, but growth in the region will require a favorable investment climate. AGRICULTURE Agricultural output also shrank during the first decade of market trans- formation in the SEE8. On average, the agricultural sector made up less SOUTH EASTERN EUROPEAN ECONOMY 7 than 18 percent of GDP in 2001. Albania and Moldova were the only countries among the eight where agriculture represented a larger share of output in 2002: in Albania close to 33 percent of GDP, and in Moldova 25 percent of GDP (see table 1.1). The high level of agricultural output in both countries is due not only to their large rural populations, but also to the slower progress in the development of the services sector and indus- try restructuring. With the notable exception of Albania, agricultural labor productivity also declined substantially in the region since 1990.5 Although agricultural prices were liberalized early in most of the SEE8, the agricultural sector throughout the region suffered from a reform policy stalemate and from neglect. The decomposition of agro- industrial cooperatives and the restitution of land were often disrupted by political controversy regarding divestiture strategies and the pace of the process. Only in Bulgaria and part of Romania was restitution--the return of farmland to precommunist owners--used as a privatization strategy. In Albania, Moldova, and the remainder of Romania, a distribu- tion strategy allocated farmland to either collective farm workers or the whole population.6 In the countries that emerged from the former Yugoslavia, privatization of land was not required because farmland was privately owned before 1990 (EBRD 2002, pp. 76­78). A vibrant land market in the SEE8 has yet to evolve because disputes, lengthy procedures, and corruption have delayed the distribution of land titles. In addition, records held by the land registers and the cadastre are frequently inconsistent, and difficulties in identifying the real owners have jeopardized the upholding of property rights. For example, 70 per- cent of the issued land titles in Romania have ended up in litigation (FIAS 2001a). As a result, using land as collateral in business transactions in the SEE8 is rare. Serbia and Montenegro's central bank has assigned land value as zero in its accounting books (FIAS 2001b). The slow development of land reforms has impeded market exchanges and has hampered the growth of the agricultural sector. Across the region, the new owners of agricultural land have not yet achieved pre-1989 production capacity. For example, Romania, once a major agricultural producer, has experienced a steady decline in the livestock sector--the production of meat and crops--since 1989 (EIU 2001b). Although agricul- ture still accounts for over a quarter of GDP in Moldova, yields for vegetables have decreased by 64 percent (44 percent for sugar beets alone) since 1990 (data for 2000, EIU 2001a). The level of livestock production has also come down drastically in the past 10 years in Moldova.7 Similar trends exist in Bosnia and Herzegovina, FYR Macedonia, and Serbia and Montenegro. The liberalization of the agricultural markets in the SEE8 and the removal of protectionist prices exposed domestic agricultural products to the competitive pressure of imports. Many of the SEE8 are currently net 8 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE food importers, including Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, Romania, and Serbia and Montenegro, which further suggests the uncompetitive state of the domestic agricultural market. SERVICES With the decline of production in agriculture and industry, the services sectors became the leading generators of output in the transition economies of Eastern Europe. Transition trends from Eastern Europe indicate that, in general, services had grown to about half of GDP in these countries by the end of the 1990s. The composition of SEE8 output had similar dynamics; however, the high share of services in the SEE8 does not necessarily reflect a postindustrial structure to their economies. The high share of services in the GDP of these countries instead reflects qual- itative deficiencies in the economy: government services and utilities rep- resent a large share of those services. For most of the 1990s, regulated utilities were a vehicle for cross-subsidies and soft lending to nonrestruc- tured firms, and only recently have governments begun breaking up monopolies and privatizing those services.8 As a result of recent restructuring efforts in some services sectors, services such as communications and tourism have increased their eco- nomic significance in the region. For example, the liberalization of telecommunications in the region has resulted in investments in improved telecommunication networks. As a result, the number of fixed lines has increased, old analog networks have been replaced with digital networks, privatization of state-owned monopolies has begun, and the market for mobile services has expanded. The tourism industry has gained econom- ic significance for the region as well. For example, in Croatia 5.7 percent of total employment is concentrated in tourism, and the sector generates close to 5.1 percent of GDP (2002, constant market prices). The trade sector also has expanded. For the period 1990­2002, the share of GDP in wholesale and retail trade and repair of motor vehicles grew from 7.8 percent to 10.4 percent in Bulgaria, from 14.8 percent to 16.4 percent in Croatia, and from 5.2 percent (in 1993) to 8.1 percent in Romania in 2001.9 In fact, retail trade has emerged as one of the most attractive sectors for new private companies. For example, in Albania, 52 percent of the businesses operate in retail trade. Local and European retail chains such as Metro, Mercator, and Billa have spread throughout the region too. The financial sector plays an integral part in the evolution of the ser- vices sectors and of the overall economy by providing a payment mech- anism for the intermediation of resources. There is abundant evidence that the development of the financial sector provides a critical boost to economic growth (see, for example, Levine 1996). However, although the SEE8 have taken the initial steps to reform their financial sectors, only a SOUTH EASTERN EUROPEAN ECONOMY 9 few have financial sectors capable of providing significant lending to pri- vate enterprises. Although most commercial banks in the region have been privatized, competitive intermediation of financial resources has yet to effectively reach entrepreneurs.10 The financial sector is burdened by bad loans and lending based on common relationships. Such lending crowds out other productive investments. Also, the big spread between interest rates for deposits and lending in the SEE8 suggests that most banks operate inef- ficiently. Moreover, the lack of modern, risk-based screening and moni- toring mechanisms leads banks to make uninformed decisions. As a result, banks are not investing in the private sector. For example, in the SEE8 in 2002, only in Croatia was the level of domestic credit to the pri- vate sector slightly over 45 percent of GDP; the level was only 4 percent in Albania, and in Serbia and Montenegro it was 5.6 percent (EBRD 2002).11 The lack of affordable financial resources appears to have become one of the major obstacles to business development in the region, especially in the absence of alternatives to bank financing.12 Overall, the economic trends for output in the SEE8 show a sluggish recovery. The delayed restructuring in industry, agriculture, and services, which was caused in part by the lack of effective market-based institutions that would protect property rights, fair competition, and financial disci- pline, impeded a quick rebound of output and slowed economic growth in the SEE8. Although growth rates have finally begun to rebound region- wide, improving the business and investment environment through strengthened market institutions is essential for sustaining the recent growth and for reducing poverty in the region. Human Development Aspects of the SEE8 Transition Unemployment in the SEE8 in the 1990s has been high and continues to increase as a result of slow job creation, structural disruptions, and the lack of well-functioning market institutions in the region. For example, in 2002 registered unemployment in Bosnia and Herzegovina and FYR Macedonia was 41 percent and 32 percent of the total labor force, respec- tively. In the other Balkan countries, the unemployment rate varied between 7 and 8 percent in Moldova and Romania and 29 percent in Serbia and Montenegro (see figure 1.2).13 However, country-level labor and household surveys suggest that the actual level of unemployment in the region is much lower than the data in figure 1.2 indicate, given the size of the informal economy in the region. Estimates of the "gray economy" are difficult to gauge and vary significantly from country to country, but experts estimate that it repre- sents about a third of GDP in most of the SEE8 and close to half of GDP in 10 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 1.2 Registered Unemployment in the SEE8, 1994­2001 45 40 Bosnia and Herzegovina 35 30 Macedonia, FYR force 25 Serbia and Montenegro labor 20 Bulgaria Albania of % 15 Croatia 10 Romania 5 Moldova 0 1994 1995 1996 1997 1998 1999 2000 2001 2002a Source: EBRD (2003). FYR Macedonia and Moldova.14 According to a 2001 labor force survey, only 40 percent of the registered jobless in Bosnia and Herzegovina were in fact unemployed, and the informal sector provided jobs for 36 percent of the employed (World Bank 2002a, p. xi). More than half of the regis- tered unemployed in Serbia and Montenegro had jobs in the informal sector (World Bank 2002a, p. 13). In the late 1990s, the informal sector of Bulgaria was assessed at about 25 percent of output (Nenovsky and Hristov 2000). In FYR Macedonia, the 2001 labor force survey showed that over 57 percent of those who were unemployed in 2000 in fact held jobs in the informal sector (European Commission 2003a, p. 15). In Romania, the informal sector represented 30 to 40 percent of GDP in 2000, accord- ing to a report of the European Commission (EIU 2001b). The rise of unemployment in the region is not an isolated problem; it should be con- sidered in relation to output recovery, privatization, and new business creation. Labor hoarding (or overstaffing) and low labor productivity are typical during transition periods in many economies. At the outset of reform across Eastern Europe, the labor market was structurally distort- ed, with nearly full employment but low wages. Employment figures in all of the SEE8 declined because of a variety of factors, such as the initial collapse of output, the consequent (albeit limited) restructuring of public enterprises, the reduction of direct and indirect subsidies from the state, and the partial hardening of the budget constraints. As a result, job cuts have become typical for public enterprises in the region. Simultaneously, as the privatization of public enterprises gained momentum in the SEE8, the productivity of such firms increased, which also ultimately contributed to the layoffs. SOUTH EASTERN EUROPEAN ECONOMY 11 Labor market rigidities also emerged from the heavily regulated and protected formal sector. These regulations presented large and inflexible barriers to employment and impeded labor mobility. In addition, the slow pace of new business development in the SEE8 could not quickly offset the loss of jobs. Thus, job dynamics, measured by net growth in employment, have been slow, with job destruction outweighing the gains from job creation. For example, in Bosnia and Herzegovina the job flow rate in companies with more than 100 employees showed that, on aver- age, 4.2 jobs per 100 existing jobs were created in 1997­99, while 5.3 jobs were lost (World Bank 2002a, p. 30). Even in the countries where the busi- ness environment has improved in the past few years, unemployment has been rising because labor deficiencies are being reduced through pri- vatization, increased productivity, and slow job creation. For example, in Bulgaria, new businesses created 36 percent of all new jobs in 2000, and the job creation rate in the micro enterprises was 27 percent, as opposed to 2.1 percent in the large firms (World Bank 2002b). Similarly, during 1995­97 in Romania, the job destruction rate in firms of more than 100 workers was more than twice as high as the rate of job creation, leading to an overall decline in employment (World Bank 2002b, p. 30). Ironically, although unemployment is generally rising, the labor mar- kets remain overregulated and often hostile to new business formation; however, the dynamics of the SEE8 markets vary significantly. Employ- ment protection in the western Balkan states is very strictly regulated, with lengthy and costly dismissal procedures, restrictions on temporary employment, and inflexible wage structures determined by insiders (Rutkowski 1998, 2003). Bulgaria and, to a lesser extent, Romania have slightly more flexible labor codes in comparison with the countries formed after the split of Yugoslavia, although the laws could amplify the rigidity of the market and the increases in labor costs. In Croatia, the labor law introduced in 2003 has contributed substantially to improving the flexibility of the labor market. The outlier in the group is Moldova, which has not yet developed a market-oriented labor policy to expose and tackle its unemployment problem. Overall, employees are overly protected throughout the region, not only because of the written labor rules, but also because of the judicial interpretation of labor legislation. Achieving greater labor mobility and encouraging job creation will require that decisive steps be taken to improve labor legislation through- out the region. Deregulation, decentralization of collective bargaining to firm-level dialogue, improved flexibility of dismissal procedures, simpli- fied wage adjustment and overtime pay, and introduction of fixed-term contracts are some of the reforms being debated to improve the trans- parency and functioning of the labor institutions in the region. Such ini- tiatives, as well as formalization of the gray economy, are key to fighting the unemployment problem in the SEE8. 12 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE International and Intraregional Integration TRADE After the fall of the socialist regimes in Eastern Europe, trade flow and structure were disrupted. Price and structural distortions, outdated technologies, labor-intensive production, and trade restrictions made it difficult to identify and boost the most competitive sectors of the region so it could benefit from trade. As a result, merchandise trade slowed, growing only moderately after overcoming the initial postcommunist decline in output (see figure 1.3).15 Conflicts and war in the Balkans have also affected the supply side of trade and have reduced the oppor- tunities for diversifying exports. For example, exports from Croatia and FYR Macedonia remain subdued because of the conflict. After the end of the war in Bosnia and Herzegovina and Serbia and Montenegro, trade increased, but it has not yet reached prewar levels. The value of exports from Bulgaria, Moldova, and Romania fluctuated sharply in the 1990s because of the slow recovery of output and the initial loss of mar- kets. Albanian exports nearly tripled in the past 10 years, but from a negligible base. The systemic changes spurred two major shifts in the 1990s: (a) the loss of common markets in the other former socialist countries and (b) the lib- eralization of trade with the industrial world. Together these shifts changed the direction of SEE8 trade. Except for Moldova, the European Union has become the SEE8's biggest trading partner. The volume of exports from the SEE8 to the European Union doubled from US$7.5 bil- lion to US$15.3 billion during 1994­2001 (IMF 2002). Imports from the European Union more than doubled during the same period. The change in trade flows for the eight countries' merchandise trade is shown in figure 1.3. Exports of the SEE8 are concentrated in only a few products. Two main product groups are reaching European and world markets: (a) textiles and clothing and (b) heavy manufacturing. Of the latter, transportation equipment and metal processing accounted for over 50 percent of exports in Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro at the end of the 1990s. Basic metals have also been impor- tant exports for Bulgaria and Romania, in addition to low-value-added, labor-intensive products in textiles, clothing, footwear, and furniture. The textile sector has become a leading export sector for Albania as well as Moldova, where it has gained a steady share (18 percent in total exports in 2000). Overall, textiles and clothing from the SEE8 composed 1.6 per- cent of total EU imports in 2000. Agricultural exports, on the other hand, have played a minor role in the SEE8 trade, except in Moldova, where food, beverages, and tobacco products accounted for 42 percent of total exports in 2000, and in Serbia and Montenegro, where they accounted for 22 percent of exports in 2002. SOUTH EASTERN EUROPEAN ECONOMY 13 Figure 1.3 Direction of Trade in the SEE8 Exports, FOB, 1994 and 2001 SEE8 EU Russia 100 80 60 percent 40 20 0 2001 1994 and and 2001 1994 2001 1994 2001 1994 2001 1994 and and 2001 1994 2001 1994 2001 1994 acedonia,R acedonia,R ania ania AlbaniaAlbania Bosnia Bosnia Serbia Serbia BulgariaBulgaria Croatia CroatiaM FY M FY oldova oldova M M Rom Rom erzegovina erzegovina ontenegro ontenegro H H M M Imports, CIF, 1994 and 2001 SEE8 EU Russia 100 80 60 percent 40 20 0 2001 1994 and and 2001 1994 2001 1994 2001 1994 2001 1994 and and 2001 1994 2001 1994 2001 1994 acedonia,R acedonia,R ania ania AlbaniaAlbania Bosnia Bosnia Serbia Serbia BulgariaBulgaria Croatia CroatiaM FY M FY oldova oldova M M Rom Rom erzegovina erzegovina ontenegro ontenegro H H M M Source: IMF (2002). Note: FOB free on board; CIF cost, insurance, and freight. The sectoral composition of exports in the SEE8 did not shift markedly in the 1990s. In Serbia and Montenegro, the share of manufactured goods declined and the share of raw materials and other goods with limited processing increased. The reverse happened in Albania, Bulgaria, and 14 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Romania because of textile processing. The underlying reasons for this lack of change were the delayed economic reform in the industrial sector and the slow creation of new businesses in the SEE8. These two factors negatively affected supply and caused losses of markets (Michalopoulos 2001). In addition, the governments' provision of political and financial support to noncompetitive industries in the region slowed economic recovery and hampered international integration. Intraregional trade among the SEE8 remained at negligible levels during the 1990s, not exceeding 10 percent (EBRD 2003). The pace and scope of SEE8 trade relationships have varied. Although each of the Bosnia and Herzegovina entities (the Federation of Bosnia and Herzegovina and Republika Srpska) has a strong trading relationship with another former Yugoslav state (the Federation of Bosnia and Herzegovina with Croatia, and Republika Srpska with Serbia and Montenegro), they maintain little trade with each other. Similarly, FYR Macedonia and Serbia and Montenegro have had a strong trading relationship, but as of early 2001, little trade existed between Croatia and Serbia and Montenegro, between Albania and most of the rest of the SEE8, and between Moldova and the rest of the SEE8. To a large extent, this situ- ation reflected the legacy of political tensions and the high risks associ- ated with trade transactions during the war and with international sanctions. These trends in trade reflect the dynamics of intraregional and inter- national trade policies. After the war and the lifting of sanctions in Serbia and Montenegro, a regional initiative to liberalize trade among the South Eastern European countries emerged under the Stability Pact. The pact has become an important step in boosting regional exchanges and over- coming the politically driven disruption of trade between some of the countries (for example, between Croatia and Serbia and Montenegro, and between Bosnia and Herzegovina and Serbia and Montenegro). In June 2001, under the Stability Pact's Working Group on Trade Lib- eralization and Facilitation, Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Romania, and Serbia and Montenegro signed a Memorandum of Understanding on Trade Liberalization and Facilitation. (Moldova has since associated itself with the memorandum, signing it in 2002.) The aim of the memorandum of understanding was to promote free trade among the South Eastern European countries. Recognizing the political difficulties surrounding the creation of a single free trade agree- ment (FTA) in the region, the memorandum settled for a less ambitious goal of establishing a network of bilateral FTAs, which led to the creation of a "virtual" free trade area that covers all the South Eastern European countries.16 The main principles outlined in the memorandum are (a) to establish over a 6-year transitional period a network of bilateral FTAs based on a product coverage rule of at least 90 percent; (b) to work to SOUTH EASTERN EUROPEAN ECONOMY 15 deepen integration through liberalization of services; and (c) to take steps to harmonize legislation and regulations--including those on competi- tion, investment, and standards--and to bring them closer to those of the European Union. For the past 3 years, the memorandum has been the centerpiece of trade integration efforts in the region, and the working group has focused on monitoring the implementation of the commitments made by the countries and on exploring ways to deepen their integration efforts. As of March 2004, 24 bilateral FTAs had been signed or ratified among the SEE8. The short-term objectives are to ensure that these FTAs comply with the terms of the memorandum and to ensure that they are fully and efficiently implemented, including provisions that eliminate nontar- iff barriers, that identify the scope of use and management of tariff quotas and specific duties on agriculture, that impose consistency in the application of trade remedies, and that effectively implement prefer- ential rules of origin. In the medium term, the signatories are working toward harmonizing the scope of their FTAs, the rules and procedures governing competition policy, and sanitary and phytosanitary measures, as well as toward further liberalizing services.17 Observers consider the memorandum to be a useful step forward in intraregional integration; however, a number of unresolved issues remain, including the level of liberalization of the overall trade regimes (World Bank 2003b). The long-term vision of integrating SEE into the European and international markets requires the consolidation of the FTAs into a larger grouping or even into a single FTA with common rules and excep- tions. In addition, a system of cumulative rules of origin is needed that will foster intra-industry trade and investments across the European Union and the Balkans.An alternative arrangement to the numerous bilat- eral FTAs would be the Central European Free Trade Agreement (CEFTA), which some of the SEE8 have already joined.18 The evolving relationships of SEE8 with the European Union have greatly enhanced their integration into the global economy. In September 2000, the European Union introduced special measures for duty- and quota-free access for exports within the framework of the Autonomous Trade Preference (ATP) scheme for the western Balkan states (Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro).19 The measures are considered by experts to be "generous in providing market access opportunities to these five countries" (Michalopoulos 2001). The European Union also launched the stabiliza- tion and association process to parallel the ATP scheme. This process represents the European Union's commitment to enter into a bilateral stabilization and association agreement (SAA) with each of the five coun- tries, combined with a promise of some type of association with the European Union. The SAAs establish the legal framework for future 16 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE economic and political relationships between the European Union and the five countries and envisage the establishment of free trade areas among the five countries and with the European Union within 10­12 years. The SAAs also cover economic and institutional reform, coopera- tion of political and judicial entities, and harmonization of legislation with EU law in the areas of investment, competition, the environment, and standards. In addition, the SAAs call for intensifying regional coop- eration among the five western Balkan countries to encourage the deep- ening of regional trade and investments flows. The trade relationships between the European Union and Bulgaria and Romania have been of a different nature. Both countries are associate members of the European Union and candidates for full membership. Numerous agreements and documents between these two countries and the European Union have resulted in a fairly liberal trade regime across a wide range of sectors and have made exchanges easier.20 Trade in both directions has been steadily increasing. As a result, in 2001 over 55 percent of Bulgaria's total exports reached EU destinations, and half of its imports originated in the European Union (see figure 1.3). Bulgaria's major trade partners have been Germany, Greece, and Italy. Romania's trade flows are also dominated by the more attractive European markets. Close to 68 per- cent of Romania's total exports reached the single European market (mainly France, Germany, and Italy), and the country received over 57 percent of its imports from the European Union (see figure 1.3). Moldova has not yet reached its full trade integration potential with the European Union. As a former Soviet republic, Moldova has not greatly changed its trade patterns in the past decade, and the Russian Federation has remained its main trading partner. The Commonwealth of Independent States has accounted for close to two-thirds of Moldova's total export revenues since the country became independent (EIU 2001a). The composition of Moldovan exports has been very similar to that of other South Eastern European countries, consisting mainly of food products, beverages and tobacco, machinery and transportation equipment, and textiles. However, these products are reaching EU mar- kets at a much slower pace in contrast with the much deeper penetration by the other South Eastern European countries. Now that Moldova has become a full-fledged member of the Stability Pact, the country will inevitably foster trade and investment links with the rest of the region and with the European Union. Liberalization of trade and regional inte- gration are expected to bring opportunities for diversification of exports and new markets for Moldovan products. At the same time, exports will face the fierce competition and demand for quality on the world market, which would be difficult to meet if structural reforms in Moldova are slowed. SOUTH EASTERN EUROPEAN ECONOMY 17 Membership in the World Trade Organization (WTO) is also a means to further the international integration of the SEE8. There is a compelling argument that nonmember countries (Bosnia and Herzegovina and Serbia and Montenegro) should use WTO accession to further reduce their existing trade controls (see, for example, World Bank 2003b, pp. 80­85). Opportunities exist for the liberalization of tariffs as well as services. The WTO accession process gives governments a means to push forward "behind-the-border" measures that would otherwise be difficult to imple- ment, especially from a political perspective. Two main points can be made from the discussion above. First, although cross-border trade is gaining momentum in the SEE8 as bilateral FTAs pro- liferate, the major challenge continues to be effective implementation of those agreements. Existing nontariff barriers and cumbersome procedures must be abolished to facilitate the process of international and intraregion- al integration. In addition, establishing of a single free trade area will lead to more intensive trade and investment flows in the region. Second, achiev- ing a sustainable path of economic recovery and establishing a supportive business environment in the region are necessary to spur a supply response from the private sector. These two approaches would allow the SEE8 to better exploit their competitive advantages and would foster trade and exchanges among one another and with the rest of the world. FOREIGN DIRECT INVESTMENT As in other emerging markets, the experience of Eastern Europe has shown that foreign direct investment (FDI) has been the primary vehicle for advancing a country's economic structure, for creating new jobs, and for fostering economic growth (Broadman, Bergsman, and Drebentsov 2000; World Bank 2003a). However, a major gap exists between the South Eastern European region and the more advanced transition countries of Eastern Europe with regard to cumulative FDI flows. This gap suggests that the Balkans have not benefited much from the flow of foreign capi- tal and know-how during the past decade. For example, although the flow of FDI to Poland has been US$38.5 billion since 1990, in Romania-- the SEE8 country that has attracted the most FDI--the cumulative inflow for the same period has been less than one-quarter of Poland's (see table 1.2 and figure 1.4). The comparison of FDI flows of the SEE8 and the more advanced Eastern European countries on a per capita basis is also striking. For example, from 1990 to 2002, the cumulative per capita inflow of FDI was much higher in the Czech Republic (US$3,554) and Hungary (US$2,253) in comparison with that in even the largest recipients of FDI in the SEE8--that is, Bulgaria (US$560), Croatia (US$1,419), or Romania (US$415) (EBRD 2003, p. 65). 18 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 1.2 Foreign Direct Investment in the SEE8, 1989­2002 Cumulative Cumulative FDI inflows FDI inflows FDI inflows (US$ per capita per capita FDI inflows millions) (US$) (US$) (% of GDP) Country 1989­2002 1989­2002 2001 2002 2001 2002 Albania 936 303 66 44 4.8 2.8 Bosnia and Herzegovina 753 198 34 61 2.7 4.4 Bulgaria 4,390 560 79 55 4.7 2.8 Croatia 6,296 1,419 316 86 7.2 1.7 Macedonia, FYR 935 476 221 50 12.9 2.7 Moldova 849 199 37 25 10 6.6 Romania 9,008 415 52 50 2.9 2.4 Serbia and Montenegro 1,717 206 20 67 1.4 3.6 Source: EBRD (2003, p. 65). Figure 1.4 Inflows of Foreign Direct Investment in the SEE8, 1991­2003 2,400 2,000 1,600 millions 1,200 $ US 800 400 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 ate 2003 estim projection Romania Bulgaria Macedonia, FYR Croatia Albania Moldova Serbia and Montenegro Bosnia and Herzegovina Source: EBRD (2003, p. 65). SOUTH EASTERN EUROPEAN ECONOMY 19 The nature of the flow of FDI to the SEE8 also varies in comparison with that of the more advanced Eastern European countries. In the Balkans, both the volume and the composition of FDI inflows have been linked mostly to large-scale privatization transactions in telecommuni- cations, banking, and heavy industry. In contrast, greenfield FDI has been mainly in low-technology, labor-intensive, but export-oriented industries such as leather, textiles, and clothing. Greenfield investments in SEE have been very limited and directed primarily at servicing the domestic market (Demekas 2002). However, most recent data on Bulgaria and Romania suggest a shift in this trend as industries take advantage of lower production costs. Overall, the low level of greenfield invest- ment in the SEE8 suggests that once the sell-off of state-owned enter- prises is completed, the amount of FDI in the SEE8 may be small, unless an institutional environment that supports private investment takes hold. The main source of FDI in the region has been the Organisation for Economic Co-operation and Development (OECD) countries, which account for over 90 percent of FDI inflows in Bulgaria, Croatia, and Romania. Non-OECD countries, especially Russia, are active investors in the energy sector. However, intraregional investment in common com- mercial and supply networks has a negligible presence in the SEE8. The lack of such investment is a critical bottleneck in the creation of greater "economic space" in SEE, and it both reflects and contributes to the lim- ited interenterprise competition and limited entry of new enterprises in the SEE8. Foreign direct investment in the Balkans is limited both structurally and institutionally. As figure 1.5 conveys, there is a positive association between institutional development and the cumulative inflow of FDI per capita in the SEE8.21 Countries such as Albania, Bosnia and Herzegovina, Moldova, and Serbia and Montenegro, where restructuring was delayed, have not been able to attract foreign capital. Similarly, those countries with weaker business frameworks have been less attractive to foreign investors because of uncertain property rights and contracts, poor corpo- rate governance incentives, underdeveloped infrastructure and utilities, and corruption. Recent improvements in legislation and strengthening of market insti- tutions have started to produce positive results by increasing the flow of FDI to the SEE8. Bulgaria, Croatia, and Romania have benefited from more foreign investment than the rest of the SEE8, as a result of their recent progress in restructuring and privatizing the state-owned enter- prises and because of improvements to their institutional environment. These early results should encourage policymakers from the region to vigorously pursue their reform agendas for strengthening the institutional aspects of the business climate. 20 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 1.5 Institutional Development of the Business Sector and Foreign Direct Investment in the SEE8 1,500 ­2002 Croatia 1990 $), (US 1,000 capita per 500 Romania Bulgaria stock Macedonia, FYR Albania Moldova Bosnia and Herzegovina inward Serbia and Montenegro FDI 0 1.5 2.0 2.5 3.0 enterprise reform, 2002 Sources: EBRD (2002, 2003) and UNCTAD (2003). Note: The enterprise reform index is EBRD's governance and enterprise restructuring index. It ranges from 1 (indicating lax credit and subsidies that weaken financial discipline at the enterprise level and few reforms to promote corporate governance) to 4 (indicating standards and performance typical of industrial economies and effective corporate control exercised through domestic financial institutions and markets, thereby fostering market- driven restructuring). (See EBRD 2002, p. 21.) Stimulating intraregional trade and investment is a key challenge for the SEE8. To date, initiatives within the Stability Pact present some of the most important policy instruments for advancing the institutional cli- mate for business and investment in the region and for strengthening intraregional cooperation. These steps toward intraregional cooperation are important. They address the need for further reform of the policy and institutional frameworks within the SEE8. As we have shown, progress in trade and FDI in the region has been disappointing, slowing the process of international integration. Although trade has recovered for all of the SEE8, the composition of trade by prod- uct group has not shifted significantly in the past decade. Also, the levels of domestic and foreign investment in the SEE8 lag substantially behind those found in the more advanced formally socialist economies of Eastern Europe. Both of these observations reflect that, because of weaknesses in the institutional climate in the SEE8, insufficient economic restructuring has occurred, and new investment has not yet expanded the countries' capacity to trade and grow (Michalopoulos 2001). SOUTH EASTERN EUROPEAN ECONOMY 21 Scope and Methodology of the Study This study starts from the premise that further development and reform of basic market institutions in the SEE8 hold the key to increasing domestic and foreign investment in these countries and, thus, to reduc- ing poverty and accelerating their economic growth. The main message of this chapter is that, although the economic recovery of South Eastern Europe has started, its growth will not be sustained without progress in reforming the institutional framework for investment. In addition, improving that framework is essential to the integration of the SEE8 countries with the structures of the European Union. These two mutu- ally reinforcing objectives--reducing poverty and accelerating growth on the one hand and integrating with Europe on the other--are critical to achieving long-lasting peace and prosperity for all people of the region. The objective of the study is to empirically assess the nature and extent of the institutional constraints to improving the investment environment in the SEE8 and to develop policy recommendations to ease those con- straints. The study focuses on four policy areas: 1. Competition and economic barriers to entry and exit 2. Access to regulated utilities and services 3. Corporate ownership, financial transparency, and access to finance 4. Commercial dispute resolution The study systematically investigates these four topics across the SEE8 to allow for cross-country comparisons and to develop a regional perspec- tive on the corresponding policy challenges. The study's integrated approach addresses the interactions of the institutions that affect the structure of incentives for enterprise development. Without a theoretical framework, the study would risk focusing on a limited class of issues-- for example removing administrative barriers or improving dispute resolution--rather than tackling the systemic problems. Removing administrative barriers to entry is necessary, but it is unlikely to be suffi- cient to foster investment, as it fails to address the fundamental problems of anticompetitive market structures and conduct. Similarly, improving dispute resolution is important, but such reforms alone would be insuffi- cient to encourage investment without complementary measures such as greater financial transparency, accountability, and disclosure. The study's approach provides a rationale for pursuing structural reforms and avoid- ing partial fixes. It encourages the establishment of priorities for building or strengthening key institutions that will reduce firms' transaction costs and facilitate business development and expansion. 22 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Data Sources OFFICIAL STATISTICS To analyze the institutional constraints to improving the investment environment in the SEE8, the study relies on official data from the eight countries to assess the characteristics of and trends in infrastructure, investment, employment, and trade. However, an analysis of economic progress that is based solely on official statistics could not adequately assess the challenge of improving the investment climate in the region. To minimize the risk of being superfluous and short-sighted, the study uses two additional instruments: a set of enterprise-level case studies and the two European Bank for Reconstruction and Development (EBRD)­World Bank Business Environment and Enterprise Performance Surveys (BEEPS). Both instruments cover all eight countries. CASE STUDIES In the summer of 2002, we conducted 40 in-depth case studies (repre- senting five enterprises in each of the eight countries). The case studies were intended to qualitatively assess the nature and extent of institution- al barriers and their interrelationships in the business environment of the SEE8. The focus of the case studies reflects the four policy areas identified above, and the design provides for the development and testing of alter- native hypotheses. To achieve intra- and intercountry comparisons, we selected the business cases based on a set of specific criteria, such as firm size, sectoral representation, firm location, direction of trade, enterprise ownership structure, and age of firm. Firms were chosen from sectors that had relative economic importance in SEE, but we also allowed for the diversity of firms within each country and selected firms that represent- ed certain common characteristics across the countries. The case studies were conducted in the software, textile, food retail, construction, and metalworking industries. Table 1.3 summarizes the sectors and charac- teristics of the interviewed firms. BUSINESS ENVIRONMENT AND ENTERPRISE PERFORMANCE SURVEY The study also uses the results of a survey developed by the EBRD and the World Bank and the EBRD. The survey instrument covers nearly 6,000 firms in 26 postcommunist transition countries. The BEEPS com- plements the methodology described above as well as captures the mag- nitude of the institutional barriers faced by enterprises, thus providing a quantitative assessment of the relative importance of those barriers.22 The BEEPS was conducted in two rounds: BEEPS1 in 1999, and BEEPS2 in the summer of 2002. BEEPS became a primary vehicle for this study. More than 1,600 SEE8 enterprises took part in BEEPS2. The firms operated in industrial sectors such as mining, construction, or 2 3 2 3 Both 10 5 1 8 6 3 market 23 Domestic Main Macedonia, eign 1 3 3 7 FYR For oatia, c Cr ge 2 7 5 8 22 Lar b Bulgaria, 4 2 3 9 Size Medium a Herzegovina, 4 3 1 1 9 Small and 1 2 2 5 Bosnia Mixed confidential. is owner eign 3 3 Albania, firms main in of For the of Origin 8 7 7 6 4 23 interviewed identity Domestic e Studies wer The o. 1 3 3 3 4 41 Case Privatized state-owned studies. companies Montenegr enterprise 40 case firms) of and 1 4 5 2002, ypeT State- owned of Serbia 7 3 5 5 1 employees. De novo 21 and 249 Enterprise-Level enterprise-level summer employees. employees. interviewed the 50 and of 249 50 1.3 Romania, e than etailr uction Authors' than During e ce: ableT (number Sector Softwar extileT Food Constr Metalworking otalT Fewer Between Mor Sour Note: Moldova, a. b. c. 23 24 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE manufacturing or were active in services such as transportation, trade, real estate and business, or tourism. In designing the sample, the creators of the BEEPS relied on predetermined respondents' quotas. Hence, smaller firms were overrepresented in all of the surveyed countries, including the SEE8. The age and ownership of the surveyed companies, for which the BEEPS creators also established sample quotas, also differ. Among the respondent firms are representatives of state-owned, privatized, and start-up (de novo) firms. State-owned firms are strongly represented in the manufacturing, transportation, storage, and communication sectors, whereas the surveyed de novo and privatized firms are mainly in whole- sale and retail trade and in manufacturing. The profile of the surveyed enterprises in the SEE8 is presented in tables 1.4 and 1.5. Structure of the Study The study is organized in five more chapters. Chapter 2 focuses on the overall assessment of progress made by the SEE8 governments in improving the business and investment climate. It also assesses the unfinished reform agenda in the eight countries using the four core pol- icy areas. To evaluate the progress to date and to highlight the remaining reform challenges for the region, we juxtapose recent reform initiatives in the SEE8 against the perceptions of the business community in the region. Chapter 3 focuses on the institutional impediments to interfirm com- petition within the SEE8. The chapter analyzes the nature and determi- nants of barriers to entry and exit. In so doing, it assesses the effects of horizontal and vertical elements of market structure on competition as well as assessing the role that government policies and institutions play in facilitating market exchanges and fair play. It also analyzes the extent to which certain aspects of competition affect firm performance and explores why particular sectors, ownership forms, or countries are more competitive than others. Chapter 4 investigates businesses' access to regulated utility and infra- structure services, including prices paid for, access to, and quality of services provided by regulated utility suppliers. It explores the links between procompetition regulations and improved performance. It delves into the economywide effects of private sector delivery of utility services and of the privatization of such services. In addition, the chapter establishes links between infrastructure development and investments on the one hand, and opportunities for regional integration on the other. Chapter 5 sheds light on the issues of property rights, corporate gov- ernance, and financial transparency in the SEE8. It reviews the channels otalT 616 17 134 465 133 530 133 171 109 322 238 219 1,022 1,078 1364 1021 262 1897 1999 1986 1993 1997 o and 91 4 81 69 159 22 74 72 81 81 155 51 44 24 197 170 27 1898 1999 1983 1991 1999 Serbia Montenegr . 106 42 82 149 20 68 62 71 81 154 63 38 83 1 21 172 39 1800 1999 1988 1993 1997 Romania 55 . 5 50 911 11 74 3 9 22 811 35 21 72 145 109 36 1944 1999 1990 1995 1996 Moldova 62 2 13 47 11 6 6 108 14 63 14 120 28 22 163 134 29 FYR 1944 1999 1987 1990 1998 Macedonia, BEEPS2 oatia 65 3 24 38 122 15 59 28 10 10 125 34 28 28 139 111 28 in 1884 1999 1982 1992 1993 Cr equal. not 71 3 is 19 49 179 25 93 22 21 18 174 38 38 37 207 162 45 1892 1999 1983 1992 1998 Bulgaria category Participating and each 83 3 12 68 99 12 57 7 15 8 111 42 29 23 159 411 45 for 1885 1999 1984 1995 2001 Firms Bosnia Herzegovina firms total of 83 2 19 62 87 14 42 9 13 9 SEE8 lbania 121 31 18 18 143 130 13 1930 1999 1992 1995 1995 of A BEEPS2. number in total and firms) the included e firms) and of (median) (2002). of firms) epairsr firms) not of e of and social,, Bank values, wer structur storage, business (number completed orld Characteristics (number W quarrying (number etail,r and estaurantsr firms) (number services a missing of state-owned (50­249) enterprise and of 1.4 sample sector and uction and sector community (2­49) (250­9,999) established) estate ownership oprietorships communications personal ge (number ownership novo EBRD pr privatization Because ableT Mining Constr Manufacturing ransportation,T enterprise (year Wholesale, Real Hotels Other Small Medium Lar De Privatized Oldest oungestY verageA ce: Median BEEPS2 Industrial Services Size State Private Age earY Sole Sour Note: a. 25 otalT 549 86 01 86 5 398 450 04 276 56 81 15 537 227 228 213 762 554 208 the 67 2 2 4 58 1 58 0 40 0 0 81 77 26 22 25 100 85 51 services. esents 1899 1999 1988 1992 pr Romania table financial The and 84 42 0 8 34 0 54 9 34 7 3 1 50 42 47 25 104 47 75 1825 1999 1987 1994 Moldova ration; services. gene ate est 83 2 3 31 65 0 52 1 42 9 0 0 88 24 24 25 111 97 41 power ealr FYR or 1882 1999 1969 1987 Macedonia, estry; for services; and oatia 68 0 0 3 64 1 59 9 14 3 6 72 31 39 57 27 100 34 66 1827 1999 1987 1993 Cr personal fishing, BEEPS1 and in 95 19 2 8 66 0 35 9 21 3 2 0 67 21 41 25 103 77 62 equal. farming, e social,, 1909 1999 1975 1991 not ar Bulgaria is These community and category 84 1 1 32 58 1 5 3 0 2 Participating 108 74 26 135 35 22 56 BEEPS2. 135 133 other 1885 1999 1988 1994 each in Bosnia for ed Herzegovina sector; Firms firms cover 68 2 2 9 53 2 84 7 51 17 4 5 total not 89 40 13 30 109 81 28 of estaurantr BEEPS1. 1920 1999 1990 1994 in SEE8 Albania sectors and of in number hotel BEEPS1. firms in total the participated firms) the some that a e firms) estry and services (1999). omfr of for firms) epairsr firms) of enterprise included of of Bank values, firms firms e and and b includes wer structur storage, business (number orld SEE8 Characteristics (number W quarrying (number etail,r firms) (number missing include all and fishing, services of state-owned services enterprise and of sample not of 1.5 sample sector and uction generation established) sector estate ownership does oprietorships communications ge novo EBRD (number ownership BEEPS1 pr ableT Farming, Mining Constr Manufacturing Power ransportation,T (year Wholesale, Real Financial Personal Small Medium Lar De Privatized Oldest oungestY verageA Because ce: Median The Sole BEEPS1 Industrial Services Size State Private Age Sour Note: a. BEEPS1 characteristics b. 26 SOUTH EASTERN EUROPEAN ECONOMY 27 through which the current ownership structure in the region has evolved. Stock exchanges, laws, and regulations, as well as the state of the finan- cial and the state-owned sectors, are viewed as key forces, which shape the corporate governance and ownership structures in the region. The chapter assesses the links between corporate performance and various ownership and governance structures. Chapter 6 looks at the experience and strategies of the business com- munity in the SEE8 in resolving commercial disputes. The chapter inves- tigates the factors that influence the use of courts in business disputes and establishes that judicial formalism reduces the demand for bringing a dispute to court. In chapters 3 through 6, we also include recommendations for policy reform. We designed the recommendations to help government policy- makers remove obstacles to private investment in the region as well as to provide input to policy dialogue and policy-based lending to the interna- tional donor community. The recommendations also inform the strategy for the next phase in implementing the Stability Pact's Investment Compact. Endnotes 1. The Stability Pact for South Eastern Europe was adopted on June 10, 1999, in Cologne, Germany, at the European Union's initiative. There are three political instruments (working tables) in the pact: (a) Working Table I on Democratization and Human Rights; (b) Working Table II on Economic Reconstruction, Cooperation, and Development; and (c) Working Table III on Security Issues. Working Table III has two subtables: one on Security and Defense, and one on Justice and Home Affairs. Members are (a) countries from the South Eastern European region (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Romania, and Serbia and Montenegro); (b) countries out- side the region (the European Union member states, Canada, Japan, Norway, the Russian Federation, Switzerland, Turkey, and the United States); (c) international organizations (the United Nations, Organization for Security and Co-operation in Europe, European Council, United Nations High Commissioner for Refugees, Northern Atlantic Treaty Organisation, and Organisation for Economic Co- operation and Development); (d) international financial institutions (the World Bank, International Monetary Fund, European Bank for Reconstruction and Development, European Investment Bank, and Council of Europe Development Bank); and (e) regional initiatives (the Black Sea Economic Co-operation, Central European Initiative, South East European Co-operative Initiative, and South East Europe Co-operation Process). All members are on an equal footing in shaping ini- tiatives and policies on the future of the region and in setting priorities concerning the content of all three areas studied by the working tables. Further information on the Stability Pact for SEE can be accessed at http://www.stabilitypact.org. 28 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE 2. The Investment Compact is an initiative of Working Table II on Economic Reconstruction, Cooperation, and Development. It was launched in February 2000 in Skopje. It takes a three-phase approach: (a) diagnosis of current invest- ment conditions in the countries of the region (already finished); (b) development of country-specific policy recommendations and design of regional policy initia- tives; and (c) monitoring of progress in policy implementation, in improvement of the investment conditions, and in investment performance in South East Europe. For more information see http://www.investmentcompact.org. 3. Given the special institutional treatment and weaker knowledge base per- taining to Kosovo, we did not include it in this study. 4. Data are from the UNECE. These data were averaged for the South Eastern European region (with the exception of Bosnia and Herzegovina) using simple averaging (UNECE 2002). 5. Agricultural output in Romania has been positive too, but not labor pro- ductivity. See EBRD (2002, p. 76) for a detailed discussion about agriculture in transition. 6. Farmland in Albania and Romania was distributed to farm workers or rural households on an equal per capita basis (EBRD 2002, p. 77). 7. Levels shrank by 61 percent for pigs, by 55 percent for cattle, and by 30 per- cent for sheep and goats (EIU 2001a, p. 59). 8. For example, in Romania in the 1990s, nonpayment for energy became a chronic practice for the state-owned enterprises. Payments were made through mutual settlement of dues, by barter, and by promissory note. Moreover, energy companies continue to direct funds to selected state enterprises as bank lending to loss makers has declined. Similarly, most of the 44 large enterprises in Serbia have debts and arrears to the utility suppliers. These borrowers do not have the financial capacity to serve their obligations and have amassed approximately 18 percent of total liabilities in debt to suppliers, including the utilities sector. As a result, the natural monopolies have become one of the most burdensome fea- tures of the transition to markets, not only fiscally impeding the governments in these countries, but also slowing their enterprise restructuring. 9. Figures are share in GDP (constant market prices). Data for Croatia and Romania are from the national statistical institutes in each country. 10. For a succinct discussion, see Berglof and Bolton (2003) and Meyer and Nash (2002). 11. Data for Serbia and Montenegro for 2001. See EBRD (2003, p. 190). 12. For an interesting discussion, see Bukvic and others (2001). 13. The registered unemployment data presented in figure 2 reflect the International Bureau of Labor unemployment statistics for Moldova (see EBRD 2003, p. 175). The labor force survey of 1999 shows that unemployment in Moldova was 14 percent of the labor force in the first quarter of 1999 (Rutkowski 2000). 14. For estimates of the informal sector in SEE, see Schneider (2002). 15. This section draws extensively on the findings of a major World Bank trade study covering the western Balkans (see World Bank 2003b). The official SOUTH EASTERN EUROPEAN ECONOMY 29 merchandise trade statistics are an important source for drawing the trends in the region. However, the reliability of the data is questionable because of the size of the gray economy in some of the countries as well as the common practice of smuggling goods in an environment with a weak customs system. Goods have been imported and traded in the South Eastern European countries, bypassing the requirements for declaration and duties at the point of entry. Observers report that, in Kosovo and FYR Macedonia, for example, such trading practices are asso- ciated with tariff evasion and weak customs administration. Customs delays and widespread demands for bribes to speed up the administrative procedures in the movement of goods have become a major obstacle to trade in the region. 16. The trade initiative of the Stability Pact complements the ongoing EU processes--the accession process for Bulgaria and Romania, the stabilization and association process for the five western Balkan states, and the partnership and cooperation process for Moldova. The stabilization and association process explicitly links liberalization of trade with the European Union to regional coop- eration and liberalization among the five western Balkan countries, as stated in an EU Council regulation (No. 2007/2000) of September 2000. 17. See results of the Rome ministerial meeting at http://www. stabilitypact.org/trade/default.asp. 18. Bulgaria joined CEFTA in 1998, Croatia joined in March 2003, and Romania joined in 1997. The effects of joining CEFTA should not be overexagger- ated, however, as five of the eight CEFTA members are planning to join the European Union in May 2004, leaving only the South Eastern European countries (Bulgaria, Croatia, and Romania) in the agreement. 19. Bilateral agreements for duty- and quota-free access govern trade in textile products between the European Union and each of the western Balkan countries except for Serbia and Montenegro. In November 2003, the European Union and Serbia and Montenegro also reached an agreement for duty- and quota-free access for textiles. 20. Important exceptions exist for Eastern European products, including agri- cultural products, iron and steel, and textiles, on which the EU has imposed restrictions. Such sensitive areas represent a considerable portion of trade flow for the SEE8 and restrict the potential volume of trade with the European Union. 21. The association between institutional development and cumulative inflow of FDI per capita is even stronger if Croatia is excluded from the sample. 22. See EBRD (2002, chapter 2) for a discussion of the business environment in the transition countries and the BEEPS. References Berglof, Erik, and Patrick Bolton. 2003. "The `Great Divide': Financial Architecture in Transition." CEPR Discussion Paper 3476. Centre for Economic Policy, London. 30 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Broadman, Harry, Joel Bergsman, and Vladimir Drebentsov. 2000. "Improving Russia's Foreign Direct Investment Policy Regime." Policy Research Working Paper 2329. World Bank, Washington, D.C. Bukvic, Vladimir, Will Bartlett, Andrej Rus, Djevad Sehic, and Vesna Stojanova. 2001. "Barriers to SME development in Slovenia, Bosnia and Macedonia." Final report PHARE/ACE P97-8089-R. Demekas, Dimitri G. 2002. "Building Peace in South East Europe: Macroeconomic Policies and Structural Reforms since the Kosovo Conflict." A joint World Bank­International Monetary Fund paper pre- sented at the Second Regional Conference for South East Europe, Bucharest, October 25­26, 2001. EBRD (European Bank for Reconstruction and Development). 2002. Transition Report 2002: Agriculture and Rural Transition. London. ------. 2003. Transition Report 2003: Integration and Regional Cooperation. London. EBRD and World Bank. 1999. Business Environment and Enterprise Performance Survey (BEEPS1). London and Washington, D.C. Data available online at http://info.worldbank.org/governance/beeps. ------. 2002 Business Environment and Enterprise Performance Survey (BEEPS2). London and Washington, D.C. Data available online at http://info.worldbank.org/governance/beeps2002. EIU (Economic Intelligence Unit). 2001a. Country Profile 2001: Moldova. London. ------. 2001b. Country Profile 2001: Romania. London. ------. 2002. Country Profile 2002: Bosnia and Herzegovina. London. European Commission. 2003a. "Former Yugoslav Republic of Macedonia: Stabilisation and Association Report 2003." Commission Staff Working Paper. Brussels. Available online at http://europa.eu.int/comm/ external_relations/see/sap/rep2/com03_342_en.pdf. ------. 2003b. "Report from the Commission: The Stabilization and Association Process for SEE. Second Annual Report." Brussels. FIAS (Foreign Investment Advisory Services). 2001a. Administrative Barriers: Romania. Washington, D.C. SOUTH EASTERN EUROPEAN ECONOMY 31 ------. 2001b. The Climate for FDI: Serbia. Washington, D.C. IMF (International Monetary Fund) Bureau of Statistics. 2002. Direction of Trade Statistics Yearbook. Washington, D.C. Levine, Ross. 1996. "Financial Development and Economic Growth: Views and Agenda." Policy Research Working Paper 1678. World Bank, Washington D.C. Meyer, Edward C., and Nash, William L. 2002. Balkans 2010: Report of an Independent Task Force Sponsored by the Council on Foreign Relations Center for Preventive Action. New York: Council on Foreign Relations. Michalopoulos, Constantine. 2001. "The Western Balkans in World Trade." World Bank, Washington D.C. Processed. Nenovsky, Nikolay, and Kalin Hristov. 2000. Currency Circulation after Currency Board Introduction in Bulgaria. BNB Discussion Paper 13. Sofia: Bulgarian National Bank. Rutkowski, Jan. 1998. "Employment Adjustment and the Wage Structure in FYR Macedonia." World Bank, Washington D.C. Processed. ------. 2000. "Active Labor Market Policies in Moldova: Current State and Planned Changes." World Bank, Washington D.C. Processed. ------. 2003. "Does Strict Employment Protection Discourage Job Creation? Evidence from Croatia." Policy Research Working Paper 3104. World Bank, Washington D.C. Schneider, Friedrich. 2002. "The Value Added of Underground Activities: Size and Measurement of the Shadow Economies of 110 Countries All over the World." Johannes Kepler University, Linz, Germany. Processed. UNCTAD (United Nations Conference on Trade and Development). 2003. World Investment Report 2003. FDI Policies for Development: National and International Perspectives. United Nations: New York and Geneva. UNECE (United Nations Economic Commission for Europe). 2002. Economic Survey of Europe No.1. New York and Geneva: United Nations. Available online at http://www.unece.org/ead/pub/ surv_021.htm. 32 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE World Bank. 2002a. Labor Market in Postwar Bosnia and Herzegovina. How to Encourage Businesses to Create Jobs and Increase Work Mobility. Washington, D.C. ------. 2002b. Bulgaria: A Changing Poverty Profile. Washington, D.C. ------. 2003a. Global Economic Prospects and the Developing Countries: Investing to Unlock Global Opportunities. Washington, D.C. ------. 2003b. Trade Policies and Institutions in the Countries of SEE in the EU Stabilization and Association Process. Washington, D.C. ------. 2003c. World Development Indicators 2003. Washington, D.C. 2 Institutional Reform Progress to Date and Remaining Challenges in South Eastern Europe As shown in chapter 1's review of the economic trends in South Eastern Europe (SEE), output recovery and integration of the region into the world markets have been insufficient for sustainable growth. A successful tran- sition process hinges on a well-functioning institutional environment for investment that safeguards property rights and contracts, supports day- to-day business transactions, creates jobs, accelerates poverty reduction, and helps integrate the region into the world economy. To assess the progress of institutional reform and to highlight the remaining challenges, we present in this chapter an overview assessment of each of the four core issues that will be analyzed in detail in the book: competition, regulated infrastructure utilities, corporate ownership, and resolution of commercial disputes. The chapter is organized as follows. First, we review in the aggregate the state of market institutions that influence the business environment in the eight countries that are the focus of this study (the SEE8). Next, we present a more disaggregated analysis of the institutional impediments and the reform progress to date of the eight governments in each of the four policy areas. The last section sets the stage for the in-depth compar- ative analyses in chapters 3 to 6. Aggregate Assessment of the Business Environment in SEE The snapshot analysis of the business environment in SEE based on the two European Bank for Reconstruction and Development (EBRD)­World Bank Business Environment and Enterprise Performance Surveys (BEEPS1 and BEEPS2) suggests that the 2002 investment climate in the region has improved in comparison with the climate in 1999. Figure 2.1 presents how the surveyed SEE8 enterprises perceived in 1999 and 2002 the relative 33 34 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 2.1 Aggregate Assessment of Institutional Barriers in the Business Environment in the SEE8, 1999 and 2002 1999 2002 Albania Albania 4 Bosnia and Serbia and 4 Bosnia and Romania 3 Herzegovina Montenegro 3 Herzegovina 2 2 1 1 0 Romania 0 Bulgaria Moldova Bulgaria Moldova Croatia Macedonia, FYR Croatia Macedonia, FYR corporate governance competition utilities disputes Sources: EBRD and World Bank (1999, 2002). Note: The term corporate governance includes financial transparency (for firms with more than 50 workers) and access to financing. Regulated infrastructure utilities includes infra- structure services (telecommunications, electricity, transportation, and access to land). Competition includes entry barriers (macroeconomic stabilization, legal barriers, and struc- tural barriers) and exit barriers (arrears). Business disputes includes attributes of the court system in resolving business disputes. A simple average of the components is calculated for each of the four dimensions. On the scale from 1 to 4, 4 represents the most severe obstacle. importance of policy-related problems in each of the four thematic areas described above. The responses of the enterprises are averaged by coun- try and are normalized on a scale from 1 to 4, with 4 representing the most severe obstacle. The chosen graphical representation is particularly effective because it allows us to capture (a) intertemporal variations in the perceptions of the surveyed firms, (b) changes across and within coun- tries with respect to each policy issue, and (c) the severity of the problems in the four areas of the study. As figure 2.1 shows, access to regulated infrastructure utilities has sig- nificantly improved in the eight countries.1 Nonetheless, remnants from the old system, such as inefficient pricing, cross-subsidies, and lack of compe- tition on the utilities market, have caused bottlenecks for the development of the private sector and have discouraged investment in SEE. Moreover, for countries such as Albania, access to regulated utilities still represents one of the major obstacles hindering expansion and growth of enterprises. One striking observation from figure 2.1 is that, almost universally, corporate governance problems and access to financing remain rated among the most prevalent obstacles throughout the region. In the area INSTITUTIONAL REFORM PROGRESS 35 of corporate governance, implementation of international accounting standards and financial audits has been the weakest in FYR Macedonia, Romania, and Serbia and Montenegro. This finding reflects a low level of transparency in privatization and a high level of state interference in FYR Macedonia and Serbia and Montenegro. For Romania, the finding is related to the low number of enterprises to adopt independent financial audits before 2003. A change in legislation at the beginning of 2003 required all companies listed on the Romanian stock exchange to adopt local accounting standards that are based on international accounting standards (IAS). Enterprises in Bulgaria and Moldova experience more obstacles in obtaining access to financing than the other countries in the region do. Financial regulation has been stringent with respect to bank lending in Bulgaria, especially after the crash of the banking sector in early 1997, and banks generally use more conservative methods in making loans now than they did during the period of lax lending before the crisis. The business disputes data in figure 2.1 indicate that the judicial sys- tems in the SEE8 have only slightly improved from 1999 to 2002. The region's weak institutional and governance capacity, including its inabil- ity to enforce its laws and regulations, is widely recognized. As the com- petition indicator in figure 2.1 shows, barriers to entry are also perceived as a major obstacle to business development in the SEE8. The problem is most pronounced in Albania and Moldova. There is limited cross- country variation in the area of exit barriers in the eight countries in 2002. The presence of subsidies and arrears has gradually declined since 1999, most likely because of an improved institutional environment, which includes the enforcement of bankruptcy and liquidation. Figure 2.2, which is based on the EBRD transition indicators, shows the progress the countries have made in carrying out institutional reforms in each of these four policy areas during 1999 and 2002. Com- pared with the performance indicators shown in figure 2.1, the transition indicators in figure 2.2 show a somewhat stronger cross-country and intertemporal variance. The leaders in terms of institutional reforms are Bulgaria, Croatia, and Romania. FYR Macedonia and Moldova are still lagging behind but have made more progress than Albania, Bosnia and Herzegovina, and Serbia and Montenegro. Relatively speaking, FYR Macedonia has substantially strengthened its institutions to reduce barri- ers to entry and exit. In contrast, Albania, Bosnia and Herzegovina, and Serbia and Montenegro have made no progress on competition policy reform since 1999. In the area of business dispute resolution, Bulgaria, Moldova, and Romania have adopted more comprehensive commercial legislation; these countries have the highest scores in the region (see figure 2.2). Albania and Bosnia and Herzegovina have also improved their commercial law frame- works to promote investment and growth; however, the observed progress 36 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 2.2 Institutional Progress in the SEE8, 1999 and 2002 1999 2002 Albania Albania Serbia and 4 Bosnia and Serbia and 4 Bosnia and Montenegro 3 Herzegovina Montenegro 3 Herzegovina 2 2 1 1 Romania 0 Bulgaria Romania 0 Bulgaria Moldova Croatia Moldova Croatia Macedonia, FYR Macedonia, FYR corporate governance competition regulated infrastructure utilities business disputes Source: EBRD (2002). Note: To maintain consistency with the perception indicators used in the BEEPS1 and BEEPS2, we have constructed corporate governance, regulated infrastructure utilities, and competition indicators for 1999 and 2002 from composite indexes of the European Bank for Reconstruction and Development transition indicators. The business disputes indicator is based on the EBRD Legal Transition Team's assessment of surveys directed at lawyers and legal experts from each of the countries (see Ramasastry 2002). The scale for each indicator ranges from 1 (indicating a poor institutional framework in the respective area) to 4.33 (indicating that the institutional framework in the respective area is comparable to those found in industrial countries). must be measured against poor initial conditions in 1999. As figure 2.2 shows, Romania has the highest rating on the infrastructure indicator for 2002, although Albania and Bosnia and Herzegovina have made the strongest steps forward in improving their infrastructure regulatory frame- works. In the area of corporate governance, the indicators in figure 2.2 sug- gest that much more effort is needed in all countries if they are to achieve substantial improvements in hardening budget constraints and promoting more rigorous and transparent financial accounting and auditing practices. A comparative analysis of the two sets of indicators--the one derived from the perceptions of the business community through BEEPS1 and BEEPS2 (see figure 2.1) and the one reflecting the institutional assessment (see figure 2.2)--reveals two interesting features. First, policy seems to have been appropriately targeted on the underlying institutional prob- lems. In the case of entry and exit, reforms appear to be more advanced in Bulgaria and Croatia, the countries where the obstacles are rated the highest (as evident in figure 2.1). Similarly, Albania and Bosnia and Herzegovina have targeted institutional reforms in the infrastructure INSTITUTIONAL REFORM PROGRESS 37 sectors in response to low access to utilities. Second, these countries appear to have carried out reforms to alleviate the barriers in ways that have limited effectiveness. This issue will be explored and presented in more detail in the following section. Institutional Impediments to Investment and Growth All eight countries face institutional impediments to investment and growth, but the severity is different in each country. In this section, we will discuss these impediments as they relate to the four core issues: competition, regulated infrastructure utilities, corporate ownership, and resolution of commercial disputes. Interenterprise Competition To encourage interenterprise competition, the SEE8 need to concentrate reform efforts in four areas: (a) eliminating impediments to business entry and growth, (b) hardening budget constraints and removing exit barriers, (c) strengthening the bankruptcy regime, and (d) reforming the tax code. ELIMINATING IMPEDIMENTS TO BUSINESS ENTRY AND GROWTH New small businesses, especially in trade and services, have emerged rapidly in the 1990s across the region. Entrepreneurs have engaged in small-scale,labor-intensivesectorsoftheeconomysuchastextile,footwear, timber, and furniture making, often through subcontracting and process- ing for foreign firms. Many of these new firms were created through the breakup of larger enterprises and through the sale of smaller units as small- and medium-scale privatization picked up momentum in the second half of the 1990s.2 As noted in chapter 1, because of the layoffs caused by the transitional recession, self-employed workers (for example, sole proprietors) and employees in small and medium-size enterprises (SMEs) have, in the past decade, become the main new job drivers in the SEE8. For example, self- employed workers in Romania accounted for 25.4 percent of total employ- ment in 2001.3 The share of the self-employed in the other countries is smaller, but still significant. As figure 2.3 shows, throughout the region, job creation among the surveyed firms is significantly higher for de novo and privatized enter- prises than for state-owned enterprises, which registered a negative rate of employment growth from 1999 to 2002. Only in Albania did surveyed state-owned enterprises create more job opportunities than the de novo 38 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 2.3 Changes in Average Employment by Enterprise Ownership, 1999­2002 135 state-owned de novo privatized 115 95 75 55 percent 35 15 5 25 and and FYR Albania Bulgaria Croatia Moldova Romania Bosnia Macedonia, Serbia Herzegovina Montenegro Source: EBRD and World Bank (2002). and privatized establishments in the period between 1999 and 2002. The job creation rate for surveyed de novo enterprises ranges from 11 percent (in Moldova) to 52 percent (in Bosnia and Herzegovina and Serbia and Montenegro) over the same period of time (see figure 2.3). Surveyed state firms (excluding those in Albania) have contracted at a rate of 10 percent on average since 1999. Despite the growth of the SME sector and self-employment, the trends in the economic output suggest that the creation of new enterprises and new jobs has fallen short of expectations in the region. This finding can be explained partially by the persistence of severe entry regulations. To start and operate a business, entrepreneurs need to obtain a myriad of the necessary permits and licensing and need to fulfill all the legal requirements and procedures. Currently, the process is costly, time con- suming, and poorly administrated in most of the SEE8, as illustrated by table 2.1. For example, it takes 74 business days, the equivalent of US$664 in fees, and 12 separate but interdependent procedures to legally start a business in Bosnia and Herzegovina. Similarly, in Albania, the same process takes 62 days, US$719 in fees, and 11 procedures. In contrast, opening business in Bulgaria involves 30 days, US$120 in fees, and 10 procedures. INSTITUTIONAL REFORM PROGRESS 39 Table 2.1 Business Entry Duration Country Number of procedures (business days) Local cost (US$) Albania 11 62 718.98 Bosnia and Herzegovina 12 74 663.73 Bulgaria 10 30 120.38 Croatia 13 51 798.01 Moldova 11 41 123.15 Romania 9 48 543.39 Serbia and Montenegro 16 71 200.11 Source: World Bank (2003a). Note: FYR Macedonia was not included in the survey. Regardless of the peculiarities of the eight countries, all govern- ments in the region have engaged in programs designed to foster new business creation and development and to reduce barriers to entry in the South Eastern European market. Improvement is needed even in the countries that have most successfully streamlined the process. For exam- ple, although administrative procedures for registering a firm have been reduced in Bulgaria, numerous permits are still required. Government efforts to reduce the current number of permits by half and to simplify the procedures have been established, but across-the-board results are yet to be seen. Other countries are also dealing with the issue of excessive licensing requirements and permits. In Bosnia and Herzegovina, the authorities are finalizing an action plan to streamline business registration and licensing procedures by introducing a single business registration sys- tem across both entities (the Federation of Bosnia and Herzegovina and Republika Srpska) and by eliminating approval duplication at the five levels of government (state, entity, canton, city, and municipality). In addition, both entities are working on ways to simplify business entry by implementing a state law on foreign direct investment and by har- monizing their company laws.4 In early 2003, 500 businesspeople in Bosnia and Herzegovina, with the assistance of representatives of the international financial institutions, formed the Bulldozer Committee. The committee's mandate was to identify the main obstacles to the business environment in the country and discuss ways to remove them. In May 2003, the parliament enacted approximately 50 of the Bulldoz- er Committee's proposals in the areas of harmonizing standards among entities, establishing rates of taxation, and simplifying procedures for foreign direct investment (FDI). Another institutional solution for overcoming the administrative bur- den of opening up a business venture is to establish one-stop shops for 40 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE business registration. Such shops have been created in FYR Macedonia and Romania to ease the constraints of business entry. A "consent by silence" rule has also been enforced in FYR Macedonia, under which consent for certain regulatory approvals and licenses is automatic after an 8-day period. Similarly, the principle of "silent approval" also has been introduced recently in both Bulgaria and Romania and allows businesses to assume official consent for new permits or certificates (but not licenses) should the relevant authorities not respond within 30 days of the applications (see EBRD 2003, pp. 129, 181). Yet during case study interviews of enterprises in the SEE8, businesses share concerns that the one-stop-shop model is rigid and inflexible. Merely simplifying the administrative requirements for business cre- ation is not sufficient to stimulate entrepreneurship. Few of the countries have strengthened the fundamental market institutions that protect firms from anticompetitive structures and conduct. Although some of the coun- tries have sound competition laws, they almost universally neglect using these instruments to reduce economic barriers to entry. Some efforts have been undertaken to strengthen institutional support for SME develop- ment and greenfield investments. In January 2001, Romania established a dedicated Ministry for Small and Medium-Size Enterprises and Cooper- atives with the goal of developing an SME policy and strategy for the country. After the government's reshuffle in June 2003, the ministry was abolished and replaced by a state agency that reports directly to the prime minister. Notwithstanding these institutional changes, an action plan to remove regulatory barriers for SMEs and to create a State SME Credit Guarantee Fund are under way. Similarly, in Albania, a special program to establish SMEs and to pro- mote foreign investment and exports was launched after the 1997 crisis. The government has already approved a strategic document for SME development (Albanian Council of Ministers 2001). This document contains measures such as the approval of a special law on SMEs, the improvement of microcrediting schemes, and the establishment of an SME promotion agency. An Albanian Investment Promotion Agency that would provide one-stop facilities for foreign investors and credit infor- mation bureaus was launched in April 2002.5 To foster entry and new business development, the government of Croatia adopted a program to support SMEs. Under the program, SMEs receive financing on favorable terms and technical advice that can boost technology and market development. Also, Croatia is revising its Law on Competition to strengthen its Agency for Market Competition and to bring the country into conformity with European Union (EU) practice. The agency is also upgrading the technical skills of its staff members and improving enforcement procedures. INSTITUTIONAL REFORM PROGRESS 41 In Serbia, drafts of an enterprise law, a foreign investment law, and an antitrust law are advancing, although simplifications in incorpora- tion and registration procedures are yet to fully materialize. In 2000, Montenegro approved a new foreign investment law that guarantees, among other provisions, the right to repatriate profits. Besides the initiatives on the national level to improve the environ- ment for start-ups and SMEs, efforts at the regional level to foster small business growth are also visible. The Stability Pact has created new ini- tiatives to address problems of starting up and developing a business. In July 2003, the ministers of economy of the SEE8 attended the second ministerial conference of the Stability Pact. At the conference, which was held in Vienna, the ministers issued a joint statement that commits the countries to further removal of the obstacles to investment in SEE. Specifically, taking into consideration the legal situation in each country, the ministers agreed to implement key measures over the coming years in the following areas: reducing licensing and approval procedures; sim- plifying acquisition of real estate for productive purposes; reducing unnecessary reporting requirements for investors; establishing more transparent laws, regulations, and procedures; streamlining residence permit procedures for key personnel for investment; and removing spe- cific obstacles to investment in the service sectors (Stability Pact 2003c). In June 2003, the countries of the western Balkans (Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro) endorsed the European Charter for Small Enterprises at the EU Western Balkans Summit in Thessaloniki (see box 2.1). By committing to the charter's principles, the five countries join 29 other European countries (including Bulgaria and Romania) in an effort to reinforce business development and good practice in a wider Europe. The char- ter provides a framework for international and intraregional coop- eration on enterprise development, with the aims of overcoming the local challenges of a receding and reforming state sector and of exploit- ing the opportunities arising from the introduction of market reforms in SEE. Although Bulgaria and Romania have been proactive for years in forming investors' organizations (such as the Bulgarian International Business Association and the Romanian Foreign Investors Council) for assisting in policy reform and attracting investments, efforts to establish similar organizations in the rest of the region have begun only recently In July 2003, during the second ministerial conference of the Stability Pact, all of the SEE8, with the support of the Organisation for Economic Co-operation and Development (OECD), agreed to establish a regional network of foreign investors' councils (FICs) and to fill the gap in com- municating key policy issues affecting the business environment in the 42 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 2.1 The European Charter for Small Enterprises The EU leaders at the Feira European Council approved the European Charter for Small Enterprises on June 19­20, 2000. The charter calls on member states and the commission to take action to support and encour- age small enterprises in 10 key areas: 1. Education and training for entrepreneurship 2. Cheaper and faster start-ups 3. Better legislation and regulation 4. Greater availability of skills 5. Improved online access 6. Improved benefit from the European single market 7. Taxation and financial support 8. Strengthened technological capacity of small enterprises 9. Access to successful e-business models and to top-class small business support 10. Stronger, more effective representation of small enterprises' interests at EU and national levels The EU candidate countries endorsed the European Charter for Small Enterprises at the landmark conference in Maribor, Slovenia, on April 23­24, 2002. The candidate countries will be included in the charter report- ing system from 2003 onward on an equal footing with the member states. In June 2003, the countries of the western Balkans (Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro) also endorsed the European Charter for Small Enterprises at the EU Western Balkans Summit in Thessaloniki. For the western Balkan countries, the commission will issue a separate report, which will likely include targets and benchmarks. Source: European Commission (2003b). region. As outlined by the Stability Pact (2003b), the general objectives of local FICs are · to improve the investment and business development climate; · to assist members in expressing business and operational difficulties and in proposing suitable reform measures to relevant authorities; · to formulate concrete proposals to improve the business environment and to provide constructive feedback to government on policies; · to cooperate with government authorities in undertaking action to implement policies. FICs have been established in Albania, Bosnia and Herzegovina, FYR Macedonia, Romania, and Serbia and Montenegro, and discussions are INSTITUTIONAL REFORM PROGRESS 43 currently under way to establish an FIC in Moldova. The regional network will complement the efforts of individual countries to attract new busi- nesses and investment. HARDENING BUDGET CONSTRAINTS AND REMOVING EXIT BARRIERS Despite the institutional improvements to foster new business creation, many incumbent enterprises in SEE continue to operate under nonmar- ket conditions and to enjoy soft budget constraints. Soft budgets breed business inefficiencies, undercut restructuring efforts, and distort compe- tition. Distortions arise, among other reasons, when some enterprises within the same industry are entitled to special privileges in terms of both price setting and access to infrastructure, which likely diverge from socially desirable outcomes. Hardening of budget constraints for all firms in the region is vital if the SEE8 are (a) to induce nonviable firms to exit the market or restructure, (b) to reallocate resources toward more pro- ductive uses, and (c) to create economic space for new entrants. Soft budgets in the region have been perpetuated in numerous ways, the most direct one being by means of budgetary subsidies. Direct forms of subsidies have gradually declined since the mid-1990s, yet indirect forms of support (such as the tolerance of tax arrears, suppliers' arrears, nonpay- ment of utility bills) remain sizable and, in some cases, are increasing. From information provided in BEEPS1 and BEEPS2, figure 2.4 reports the average proportion of SEE8 enterprises with subsidies and arrears on Figure 2.4 Firms with Subsidies and Arrears in the SEE8 under BEEPS1 and BEEPS2 (percentage of total firms) utilities 50 40 30 20 subsidies taxes 10 0 suppliers employees 2002 (BEEPS2) 1999 (BEEPS1) Sources: EBRD and World Bank (1999, 2002). 44 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE an intertemporal basis--1999 compared with 2002. Although the average level of arrears among the surveyed firms has contracted substantially since 1999, suppliers' arrears have remained the most recurrent ones on average, followed by arrears in payments for taxes, receivables, utilities, and worker compensation. Disaggregated cross-country data reveal that every fourth surveyed firm in Croatia and every fifth in Albania and Bosnia and Herzegovina reported payments to material input suppliers that were overdue by more than 90 days. Arrears to the utilities compa- nies among the surveyed firms were most pronounced in Albania and Bosnia and Herzegovina, whereas the interviewed firms in Bosnia and Herzegovina, Bulgaria, and Romania were characterized by substantial incidence of tax arrears. For example, in Romania, overdue taxes account for 20 percent of total annual sales for many surveyed enterprises. Figure 2.4 shows that, in 1999, surveyed firms indicated that direct subsidies were less prevalent than arrears, as suggested above. However, the share of firms receiving government subsidies in 2002 was not appre- ciably lower than in 1999. Indeed, there was less progress in reducing subsidies than in reducing all other categories of arrears. Institutional reforms in SEE to harden budget constraints and to encourage the exit of nonviable firms have focused on several fronts. In two areas, government actions are critical: (a) making bankruptcy regimes more effective and (b) enforcing tax collection and reforming tax structures to minimize tax privileges and reduce investment distortions. STRENGTHENING THE BANKRUPTCY REGIME A good bankruptcy regime provides either the institutional tools for restructuring an enterprise's debts and capital structure to restore its eco- nomic viability or the sale of the enterprise's assets to new owners capa- ble of using them in a productive way. The existing bankruptcy systems in the region generally do not fully meet these objectives. Creditors lack control over the process and have little expectation of seeing repayment of even a portion of their debts within the foreseeable future. The courts and bankruptcy managers are inexperienced and have been subject to significant pressure to act in the interests of insiders rather than creditors. As with all other court procedures, bankruptcy is extremely slow--further dissipating the value of assets available to pay creditors. As table 2.2 summarizes, the average time for carrying out bankrupt- cy cases in the region is close to 3.5 years, and the cost reaches as much as 38 percent of the asset value (see World Bank 2003a for assumptions and definitions). According to the data, only in Albania and Serbia and Montenegro does the insolvency regime deliver efficient outcomes (meaning that the insolvency results in foreclosure, in liquidation, or in a successful rehabilitation of the business under new management). Never- theless, although the actual time for carrying out bankruptcy in Albania INSTITUTIONAL REFORM PROGRESS 45 Table 2.2 Bankruptcy Indicators Actual timea Actual costb Preservation of Efficiency Country (in years) (% of assets) absolute priorityc of outcomed Albania 2.0 38 0.67 1 Bosnia and Herzegovina 1.9 8 0.67 0 Bulgaria 3.8 18 1.00 0 Croatia 3.1 18 1.00 0 Romania 3.2 8 0.33 0 Moldova 2.8 8 0.67 0 Serbia and Montenegro 7.3 38 0.33 1 Source: World Bank (2003a). a. Actual time is expressed in years and includes all delays caused by legal derailment tac- tics that parties to the insolvency may use. It captures the average duration that insolvency lawyers estimate as necessary to complete a procedure. b. Actual cost is defined as the cost of the entire bankruptcy process--including court costs; insolvency practitioner's costs; and the cost of independent assessors, lawyers, accountants, and so forth. It excludes the cost of bribes. Range of costs is expressed as the percentage of asset value and includes ranges of 0­2 percent, 3­5 percent, 6­10 percent, 11­25 percent, 26­50 percent, and more than 50 percent. c. Preservation of absolute priority is scaled so that higher values imply stricter observance of priority. A value of 1.00 means that secured creditors are paid before court costs, labor claims, and tax claims. A value of 0.67 means that secured creditors are paid second, and a value of 0.33 means they are paid third. A value of 0.00 means that secured creditors are paid after all court costs, labor claims, and tax claims are satisfied. d. Efficiency of outcome documents the success of the insolvency regime in reaching eco- nomically efficient results. A designation of 1 means that the insolvency process results either in (a) foreclosure or liquidation with a going-concern sale or (b) successful rehabili- tation by maintaining the business but hiring new management. A designation of 0 means that neither of the options in the first designation was met. is comparatively short, experts find that the country has contradictory bankruptcy legislation, especially with respect to prioritizing claims (see box 2.2). Moreover, in Serbia and Montenegro, the bankruptcy procedure takes more than 7 years to achieve efficient results; the country is also characterized by poor observance of priority claims in paying creditors. Indeed, only in Bulgaria and Croatia is the observance of priority strict. The overall number of enterprises that have entered bankruptcy or liquidation in SEE has been low because exit rules have been carried out in cumbersome and ineffective ways. As noted already, although Albania fares well on the indicators presented in table 2.2, the insolven- cy law enacted in 1995 proved detrimental to the bankruptcy procedure. As of May 2002, not a single case involving large-scale firms, particu- larly in proceedings involving state-owned enterprises, has been processed under the business-exit legislation.According to experts, judges 46 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 2.2 Challenges in Establishing a Working Bankruptcy Institution in Albania and Bosnia and Herzegovina In Bosnia and Herzegovina, if a company files for bankruptcy, it faces a lengthy court procedure that is conducted by a panel of three judges and is governed by strict rules denying the court the flexibility required for a speedy process that could save healthy parts of the firm and recover assets for creditors. In addition to the challenges concerning court procedures and the organization of the bankruptcy process, unique country-specific problems stem from the poor coordination between cantons and munici- palities and from their different viewpoints with respect to their future in a unified economic space. The various levels of government continue to apply complex rules, which often duplicate or contradict one another. A case in point is the bankruptcy issue. Each of the entities of Bosnia and Herzegovina (the Federation of Bosnia and Herzegovina and Republika Srpska) has passed a separate bankruptcy law, which regulates the bankruptcy procedure only within the entity, not across the country. The Albanian bankruptcy legislation is also problematic. The law is contradictory in places, particularly with respect to the priority of claims. The law on bankruptcy procedure requires the court to prepare a list of claims submitted by creditors, giving first priority to tax and other state obligations. However, the civil code, which was amended to reflect the enactment of a new law on securing charges, has a completely different list for ranking the creditors. According to the civil code, claims arising from purchase money security receive first priority, and claims made by secured creditors specifically mentioned in the code (other than those who have a purchase money security) receive seventh priority. How this contradiction will be managed in practice is not clear, although a new bankruptcy law was passed in October 2002 to iron out the differences. In both countries, building consensus for a uniform policy and institu- tions is key to the introduction of new legislation to promote domestic and foreign investment. Effects thus far have been limited. and lawyers do not understand the legal style of the new bankruptcy reg- ulation; moreover, the law itself engages multiple--and often inconsis- tent--traditions and complicated procedures, which makes it difficult to interpret and enforce (Gupta, Kleinfeld, and Salinas 2002, p. 17). The problems involved in carrying out bankruptcy proceedings in Bosnia and Herzegovina and Moldova6 stem from the lack of a registrar for pledges; the lack of specialized bankruptcy courts; and the scarcity of well-trained judges, trustees, and lawyers who are capable of interpret- ing and enforcing the law. Furthermore, the bankruptcy regulation in Bosnia and Herzegovina falls entirely within the ambit of the entities and further complicates the implementation of exit regulation (see box 2.2). INSTITUTIONAL REFORM PROGRESS 47 Yet another source of problems in carrying out the intent of the law comes from the content of those laws. For example, the current federal bankruptcy law of Serbia and Montenegro is too constraining to provide adequate safeguards for creditors.7 Priority measures include helping creditors foreclose on collateral outside formal bankruptcy proceedings, giving creditors (as opposed to judges) more power to oversee adminis- trators, and introducing incentive compensation to encourage adminis- trators to focus on maximizing creditor recoveries. As of fall 2003, a new bankruptcy law was being prepared in Serbia, although it was still not enacted. In Croatia, the bankruptcy law is relatively well crafted, and yet the bankruptcy mechanism proceeds with a sluggish pace. The total of about 600 cases of bankruptcies processed per year is low compared with a pop- ulation of enterprises exceeding 60,000 (including de novo firms and for- mer state-owned enterprises) and is abnormally small compared with the total in other countries in transition (World Bank 2000). Despite the difficulties in facilitating market exit, most of the SEE8 con- tinue to invest efforts to overcome the loopholes in existing regulations and to strengthen bankruptcy institutions. In October 2002, the Albanian government passed a new bankruptcy law in response to the uncertainty surrounding the ranking of creditors' claims and priorities (see box 2.2). The goal of the law was to foster the practical enforcement of the insol- vency law through special courts that have exclusive jurisdiction over insolvency proceedings. Amendments to the Croatian bankruptcy law, which were enacted in 2000, created problems involving the qualifi- cation requirements for trustees and the role of bankruptcy tribunals. In response to these challenges, the Croatian government enacted addition- al amendments to the law in July 2003 to make bankruptcy proceedings quicker and, thus, to help overcome the inadequate institutional capacity of the commercial court system to handle bankruptcies expeditiously.8 In FYR Macedonia, 2003 amendments to the bankruptcy law have improved creditor rights by simplifying and accelerating bankruptcy and collateral foreclosure proceedings and by closing loopholes that had allowed debtors to delay creditor actions. Bulgaria and Romania have made several amendments to their insol- vency laws since that legislation was initially established. Although the legal framework was well advanced, significant shortfalls in the bank- ruptcy procedures arose in practice. For example, the bankruptcy process in Bulgaria used to take longer than a year. However, as of June 2003, amendments to the insolvency section of the commercial code have shortened the period for court-declared bankruptcy to 4 to 7 months. The amendments also present more detailed merger regulations. These changes enable a company to be considered insolvent when it has not performed within 60 days of the due date. The amendments also provide 48 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE for the creation of regional legal chambers to deal with bankruptcy pro- cedures (see EBRD 2003, p. 128). Streamlining bankruptcy court proce- dures and introducing short appeal deadlines should presumably help speed up the process. A major change in the Romanian bankruptcy reform in 1998 put administrative duties related to bankrupt companies in the hands of pri- vate liquidation companies that had the business skill and knowledge to handle these cases efficiently. As a result, thousands of cases have been processed, and a field of 132 registered private liquidators has emerged (Gupta, Kleinfeld, and Salinas 2002). In summary, the lack of well-functioning bankruptcy mechanisms throughout the region still appears to be a major impediment to improv- ing the investment climate in SEE. Further reforms are needed in each of the SEE8 to address court and case management issues as well as to help inexperienced commercial judges, trustees, and receivers. Modernizing the existing commercial courts and designing a regulatory framework for bankruptcy trustees and administrators will strengthen the public's trust in the bankruptcy process and will facilitate the exit of unsound (illiquid and insolvent) firms so that resources are more efficiently used in the economy, thus permitting greater prospects for growth. REFORMING THE TAX CODE As pointed out above, soft budget constraints also are perpetuated through lax enforcement of taxation, selective tax exemptions for privi- leged enterprises, or both. Poor enforcement of tax rules discourages not only the government-shielded state enterprises but also the rest of the market participants from complying with the legislation. Moreover, selective tax enforcement that protects the state sector creates uncompet- itive markets, disheartens entrepreneurship, and stimulates the shadow economy. Apart from hurting new entrants, soft budgets help unsound enterprises stay unrestructured and afloat, which bottles up resources. As evidence from BEEPS1 and BEEPS2 and from the case studies shows, a culture of extensive tax evasion still pervades the region. To strengthen the collection of taxes and the enforcement of tax regulation, the SEE8 have launched fiscal reforms. Through these reforms, they intend not only to recover lost tax revenues but also to create a fair and competitive environment for all market participants. How far have they come in achieving this goal? Tax reforms that are designed to simplify rate structures and treat market agents equally have been introduced throughout the region. For example, in Romania, two new laws that are related to enterprise taxation came into force in 2002: the value added tax (VAT) law, which established a 19 percent VAT rate, and the profit tax law, which enforced a standard 25 percent tax rate. Similarly, in Bulgaria, the corporate profit tax and INSTITUTIONAL REFORM PROGRESS 49 municipality tax were consolidated at a 23.5 percent rate as of January 2003; this consolidation resulted in a major simplification of fiscal obliga- tions for firms. In addition, the Bulgarian government intends to gradu- ally decrease the corporate profit tax rate to 15 percent by 2005 (Stability Pact and OECD 2003, p. 20). In FYR Macedonia, a VAT law was introduced in April 2000. The gov- ernment simplified and reduced the personal income tax rate at the beginning of 2001 and reduced the VAT rate in 2003.9 To attract invest- ment to the country, the parliament adopted in July 2003 changes to the law on profit tax. Under the amendments, investments of up to 100,000 will be completely deductible from taxable profits, and investments above that threshold will be granted a 30 percent tax write-off. The Serbian government has also introduced wide-ranging reforms to its tax system. Since 2001, the government has greatly reduced the number of taxes, lowered the tax rate on various goods and services, and widened the tax base by eliminating exemptions. The sales tax rate was unified at a rate of 17 percent, and preparations for the introduction of VAT in July 2004 are under way. The government in Montenegro has prepared a tax action plan, which is intended to broaden the effective tax base and to lower tax rates. Initial efforts to carry out this plan will focus on amend- ments to the turnover tax legislation. VAT was introduced in April 2003. Similarly, tax reforms in Bosnia and Herzegovina have been designed to reduce high tax rates, to broaden the base for tax collection, and to put in place effective enforcement and deterrence mechanisms to reduce bar- riers to entry. The basic sales tax on goods is now the same in both enti- ties (20 percent), but business tax rates have been reduced only in Republika Srpska. There are plans to introduce VAT at the state level by January 2005 and to set up a database that will identify each taxpayer with a unique number to monitor compliance. In addition to the reforms discussed above, countries have also taken steps toward strengthening the administrative capacity of the tax agen- cies in the region. For example, FYR Macedonia, like the other former Yugoslav republics, established a treasury system to begin the transition away from the central payments systems inherited from the former Yugoslavia. The Payment Operation Offices are also in the process of being dismantled. Bosnia and Herzegovina closed its payment bureaus in January 2001 and replaced them with (a) giro-clearing arrangements with participating banks for smaller transactions and (b) a real-time gross settlements system for large transactions.10 In Bulgaria, the Council of Ministers created the National Revenue Agency in July 2002 to administer the collection of all public receivables. The agency will be fully functional by 2005. The Albanian government has invested efforts in strengthening tax and customs administration by decen- tralizing customs offices, improving the valuation system, elaborating 50 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE reward-based performance schemes, and launching an independent tax- payer appeals commission. Overall, though some progress has been made in addressing weak- nesses in the competitive environment for business in SEE (as the detailed analysis in chapter 3 makes clear), significant challenges remain. Access to Regulated Infrastructure Utilities Although the data in figure 2.1 suggest a major improvement in the per- ceptions that the businesses in SEE8 maintain with respect to the public infrastructure sector since 1999, the quality and efficiency of these ser- vices has remained rather weak across all countries in the region. Fur- thermore, as our case studies corroborate, poor delivery of infrastructure utility services has discouraged investors and limited the growth oppor- tunities for the local businesses in SEE. In addition, public sector utilities often struggle to maintain resources when they are pressured by political entities to sell services below cost. The quality of infrastructure in SEE varies at the country level. Figure 2.5 presents the aggregate picture of the perceptions held by the surveyed firms across the eight countries with respect to the infrastructure services in 1999 and 2002. Figure 2.5 Assessment of Quality of Infrastructure Albania 4 Serbia and Bosnia and Montenegro 3 Herzegovina 2 1 Romania 0 Bulgaria Moldova Croatia Macedonia, FYR 2002 (BEEPS2) 1999 (BEEPS1) Sources: EBRD and World Bank (1999, 2002). Note: The results for BEEPS2 are aggregated. To derive the measure of the quality of infrastructure in figure 2.5, we have used simple averages of the following indicators: telecommunications, electricity, transportation, and access to land. Indicators range from 1 to 4, with 4 representing the worst state of infrastructure quality. INSTITUTIONAL REFORM PROGRESS 51 Again, although figure 2.5 indicates an improvement between 1999 and 2002, firms participating in the case studies and the enterprise-level surveys indicate that the infrastructure in the SEE8 is still weak, especially in Albania. According to our overall business environment indicator (fig- ure 2.1), Albanian enterprises complain substantially more than those in other countries of the region about poor infrastructure. The SEE8 governments face several important challenges in terms of regulating and carrying out efforts to improve the quality of the infra- structure services in the region, challenges that chapter 4 tackles in more detail. Yet, country-specific and regional progress has been made in the telecommunication, energy, transportation and border crossing, and water sectors, as the following sections make evident. TELECOMMUNICATIONS Of the regulated utility services, the telecommunication sector has expe- rienced the most dynamic transformation during the 1990s in SEE. The telecommunication sector has expanded primarily because competition (particularly in cellular and Internet services) has been introduced and because the dominant operators have been privatized. Four of the SEE8 have already privatized their telecommunication operators, and divesti- ture of the state ownership in the remaining countries is under way but still not completed. Here, we briefly review the experience of the SEE8 with the privatization of their national telecommunication firms. In December 2000, a consortium led by Matáv (the dominant telecom- munication operator in Hungary), which is 60 percent owned by Deutsche Telekom, won a tender for a 51 percent controlling stake of Makedonski Telekomunikacii (the telecommunication operator in FYR Macedonia), ahead of the OTE (O ó T ' E ' of Greece) and Telekom Slovenija. Through an agreement reached in July 2001, Deutsche Telekom has taken majority ownership in Hrvatski Telekom, the dominant telecommunication operator in Croatia. In 1997, 49 percent of the fixed-line telecommunication company in Serbia, Telekom Srbija, was sold to a consortium led by the Italian Stet (29 percent) and the Greek OTE (20 percent), although the government of Serbia purchased back the 29 percent stake from Stet in January 2003. Privatization of the Bulgarian fixed-line state telecommunications monopoly, Bulgarian Telecommunications Company, has been finalized, and in February 2004, Viva Ventures of Austria acquired 65 percent own- ership. The Telecommunications Regulatory Authority, an independent body, was formed in 1998, but it has yet to show that it is capable of implementing regulations and is effectively independent. In Bosnia and Herzegovina, more progress has been made in Republika Srpska, where the government committed to privatize the state-owned company by the end of 2004, than in the Federation of Bosnia and 52 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Herzegovina. Several attempts to privatize the Albanian and Moldovan dominant operators have not been successful, and the countries were not able to attract strategic investors. The eight countries also have made first steps toward intraregional cooperation in the information and communication technology field. Ministers of the SEE8 signed an agenda that launches plans for the devel- opment of an information society in the region. Privatization of the state-owned telecommunication firms and demo- nopolization of the sector in SEE are essential for increasing the quality and accessibility of services. Abolishing the state monopoly and liberal- izing the sector means that telecommunication subscribers have addi- tional choices of operators and services at competitive prices. However, setting up and strengthening an independent regulator in each of the countries is key because that effort (a) establishes the institutional frame- work to formulate the rules of market conduct, (b) safeguards the bene- fits from competition, and (c) prevents the government from interfering in the industry. ENERGY Progress in privatizing electricity distribution and generation and in opening up the market to competition has proceeded at a sluggish pace and, generally, has varied by sector and by country. In addition, obsolete machinery and equipment, the low number of investments, the legacy of widespread expectations that energy should be provided at little or no cost, and a reform stalemate resulted in power shortages and in an inad- equate energy supply policy throughout SEE. Only Bulgaria is a net exporter of energy among the SEE8. To overcome the supply challenges, the SEE8 established the South Eastern Europe Electricity Regulatory Forum initiative. The initiative is intended to provide a coordinated solution on a regional level, thereby setting the framework for a regional energy market (see chapter 4). At the country level, the government in FYR Macedonia is struggling to jumpstart reforms in the sector. The state-owned electricity company still controls most of the energy sector and administratively sets most energy prices (see box 2.3). The government has launched initiatives to rehabilitate seven small hydroelectric power plants under revitalization, operation, and transfer projects. An independent regulator was estab- lished only in July 2003, thus delaying the modernization of the utilities and infrastructure sector. Despite the limited progress, major steps toward the unbundling and privatization of the energy sector are yet to be taken in FYR Macedonia (see box 2.3). In Serbia and Montenegro, energy was one of the sectors worst affect- ed by the Kosovo conflict in 1999. Since then, blackouts have been fre- quent and widespread, especially during the winter months, and the INSTITUTIONAL REFORM PROGRESS 53 Box 2.3 Energy Problems and Setbacks for Reform in FYR Macedonia The electric power company of FYR Macedonia (Elektrostopanstvo na Makedonija or ESM) continues to struggle with its supply of electricity. In the spring 2003, for example, ESM disrupted electricity for hours to whole towns in the area of Kumanovo and Prilep mainly because of debts from unpaid utility bills. ESM's bill-collection rate is below 10 percent, and the company has arrears of approximately US$200 million (of which more than 62 percent represents overdue payments of industrial consumers). To tackle the energy problem, ESM announced that the government of FYR Macedonia had signed an agreement with a foreign investment bank (Meinl Bank of Vienna) to manage the restructuring of the state utility. To meet the increasing needs of electric power, ESM is planning to construct two new thermal power plants (coil fired and gas fired), upgrade six hydropower plant facilities, and supply a new dispatching system to monitor the electricity production. Although the state monopoly has made some restructuring efforts, more fundamental changes have been postponed. The restructuring and modernization efforts will not bring an effective solution to the energy troubles in FYR Macedonia if ESM continues to tol- erate the arrears of industrial consumers and if the government allows ESM to keep its monopoly position on the FYR Macedonian market. ESM will not be attractive to foreign investors until it settles the problem of unpaid bills. The unbundling of the firm into separate generation, distri- bution, and transition companies, followed by the privatization of the inte- grated monopoly, is key to liberalizing the sector and solving the local energy problems. Source: European Commission (2003c). country has had to import electricity. Power facilities that were damaged by the war need urgent repairs. Investment decisions are usually made at the municipal or national government level with a strong bias toward new infrastructure, disregarding maintenance and rehabilitation. Priori- ties for reform in the sector include (a) setting up a basic institutional reg- ulatory and policy framework, (b) transferring ownership of assets fully to the municipal level while developing planning and overall regulatory responsibilities at the republic level, and (c) replacing the tariff formulas with one that provides incentives for cost reduction (EBRD 2001a). Similarly, theAlbanian government has intensified its efforts to tackle its poor energy supply services, focusing on regulatory reform. But progress has been slow. It plans to restructure the state-owned energy company, Korporata Elektro-energjetike Shqiptare (KESH), with management 54 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE assistance from the Italian company Enel. A reform strategy has been launched for the electricity sector that includes specific quantitative targets for improving the main indicators of KESH's performance. As part of the effort to combat electricity shortages, a two-tier tariff structure was adopt- ed to reduce excessive demand for electricity for heating purposes and still protect the most vulnerable. Because of strong actions against electricity theft and increased penalties for nonpayment, KESH is gradually being brought back to profitability.11 However, the privatization of KESH, origi- nally intended for 2001, has been postponed. The government has devel- oped an action plan for 2003­04 to tackle the problems in the power sector. It indicates, however, that even with significant measures being taken to curb illegal use of electricity and to reduce electricity demand, a subsidy of about US$35 million and a layoff of 40 percent of its employees are required to restructure the utility before privatizing it.12 In contrast, independent regulatory frameworks in the energy sector have been established through primary legislation in Bulgaria, Croatia, and Romania, and restructuring of utility services has been launched. The five energy laws approved by the Croatian parliament formalize the restruc- turing of Industrija Nafte (INA), the oil and gas company, and Hrvatska Elektroprivreda (HEP), the electric power company, as well as formalizing the establishment of the district heating enterprises in the country. In July 2003, the government approved the sale of 25 percent of INA plus one of INA's assets to the Hungarian company Magyar Országos Levéltár. Despite these positive developments in the sector, HEP still retains state monopoly and dominant status in the area of energy transmission and distribution. In addition, new entrants in the energy sector in Croatia find it particularly difficult to launch business operations because of cumbersome restrictions with respect to energy distribution. It takes 3 to 5 years for a new firm to obtain an operating license in the energy sector, whereas incumbent energy firms are granted the same licenses in 15 days.13 Power distribution companies in Bulgaria and Romania are in the process of privatization, too. For example, in March 2003, the Bulgarian Privatization Agency launched a two-stage competition for the privatiza- tion of two district heating distributors--Toplofikatsia Samokov and Toplofikatsia Lovech. Parallel to the privatization initiative of the two district heating companies, a competitive tender for the modernization of the heating supply network in Sofia and Pernik also is under way. The future contractor will be in charge of more than 1,350 substations for the district heating in Sofia. In Romania, the privatization process of the first four electricity distribution companies and the two gas distribution com- panies is ongoing. The experience with the divestiture of state ownership in the district heating and power distribution companies in Bulgaria and Romania, as well as their experience with labor restructuring, is likely to bring valuable lessons for the rest of the region. INSTITUTIONAL REFORM PROGRESS 55 Box 2.4 Implementation Problems in Moldova In June 1997, the government launched a Strategy for Energy Development as a first step in moving the sector toward better economic and financial management. In October 1997, the state monopoly Moldenergo was broken up into 16 separate entities, including 3 joint-stock combined heat and power generation companies, 5 joint-stock power distribution net- works, and the transmission and dispatch company Moldtranselectro. Although Moldtranselectro still remains in state hands, three distribution companies have already been privatized, and the remaining generation and distribution companies are lined up for full privatization. However, the new regulatory authority (which was set up in 1997) has experienced growing interference from the government and from the court system, particularly with respect to the implementation of tariff increases, which has caused delays to the development of the sector. Privatizing energy providers and introducing market-driven incen- tives would improve the quality and supply of energy in the region. In Moldova, for example, the early 1990s were characterized by blackouts, widespread barter transactions, and nonpayment compliance, which hampered the hardening of budget constraints and introduction of finan- cial discipline among energy consumers. After Moldova conducted a suc- cessful privatization of three power distributors with a strategic foreign investor, blackouts were rare and the collection rate of bills improved. However, problems of a different nature have emerged in Moldova (see box 2.4). The court system, which supported the government's postpri- vatization motion, questioned not only the commitment of the cabinet to market reforms but also the ability of the system to protect property rights and contracts. TRANSPORTATION AND BORDER CROSSING In its 2003 annual report on the stabilization and association process for South Eastern Europe, the European Commission suggested that, for the Balkans, "the only realistic and sustainable approach to transport invest- ment needs is a transnational one" (European Commission 2003d, p. 13). Given the large amount of investment needed for modernizing and restructuring the transportation sector, the international donor commu- nity has focused on providing assistance in the rebuilding of the region after the conflicts of the 1990s. For example, 28 percent of the EU assis- tance to the western Balkans under the Community Assistance for Recon- struction, Development, and Stabilization scheme is, for 2000­2004, allocated to infrastructure projects, which constitute the first stage of the 56 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE assistance process focusing on emergency operations and reconstruc- tion. Yet intraregional and international efforts with a decisionmaking authority to support the development needs of the transportation sector in SEE are still small, except for the establishment of the pro-committees under the Southeast European Cooperative Initiative. The pro-committees are a working mechanism for identifying key measures in the trans- portation sector in SEE. They impose pressure on government institu- tions to implement reforms, and monitor the reform process (World Bank 2003b). However, problems of a regulatory nature--for example, liberalizing road transit traffic, establishing technical standards for vehicles, and har- monizing documentation requirements and transit permits--are issues that need to be tackled on a national level in each of the SEE8. Moreover, the surveyed businesses in the region perceive the conduct of law enforce- ment officials and the operation of customs agencies as especially prob- lematic because of the rigid and unpredictable application of rules and the widespread corruption (EBRD and World Bank 2002). Beyond the national peculiarities in overcoming customs and inspection obstacles, excessive waiting times and petty corruption at border crossing points have been constraining trade opportunities for the businesses in the region, as further discussed in chapter 4. The international donor community and the governments of South Eastern Europe have recognized the impediments created by poor cus- toms procedures and the need for a mix of institutional reforms, simpli- fied procedures, improvements in information technology, and upgraded border crossing facilities to support regional cooperation.14 In this vein, steps to modernize customs administration and simplify the bureaucratic burden of overregulation in the region have produced positive results. The lack of transparency and the complexity of inspections, customs operations, and tax administration have also posed great constraints to business development. In Bosnia and Herzegovina, the problem is par- ticularly acute because the legislature needs (a) to rationalize the multi- ple processes now in effect for business inspections and (b) to eliminate the overlap that occurs at different levels of government and among different types of inspections. At the country level, the transportation authorities in SEE often face challenges related to regulatory issues involved in accommodating the needs and means of the transportation operators (World Bank 2003b). In addition, conflict in the region has damaged transportation infrastruc- ture facilities, especially in Bosnia and Herzegovina and in Serbia and Montenegro. For example, the Bosnian railway system suffered severely during the war and has been in urgent need of rehabilitation. The public railway corporation (Bosansko-Hercegovacke Zljeznicke Javne Korpo- racije) will be the executing agency for a modernization project, EBRD's INSTITUTIONAL REFORM PROGRESS 57 Railways Recovery Project for Bosnia and Herzegovina (EBRD 2001b). Key covenants of the project stipulate that the two railway companies cur- rently operating in the Federation of Bosnia and Herzegovina be consoli- dated into one company and that the railway companies operating after the consolidation (one in the Federation of Bosnia and Herzegovina and one in Republika Srpska) each prepare a new business plan and a labor restructuring plan. Ports and water facilities throughout the region are also undergoing major restructuring efforts, but the process is hampered by controversies. In Croatia, for example, a court ruling has impeded the privatization of management and operation of the port of Rijeka, one of Croatia's most essential transportation links with the region. In Bulgaria, the privatiza- tion of shipyards and ports has been launched but has advanced at a sluggish pace. For example, in December 2003, the privatization of the Bulgarian Varna shipyard had almost been completed, but one of the con- ditions for the privatization of the shipyard had been to divest it from its current owner the Bulgarian Sea Fleet (Navibulgar). Navibulgar con- ducted a tender and selected Bulyard consortium, which is to take more than 75 percent of the shipyard. To complete the transaction, Navibulgar has to request the permission of the privatization agency, which is expected to be granted sometime in 2004. The systemic recession, obsolete equipment, and poor maintenance of the shipyards and ports in SEE have made them deteriorate and assume heavy debt. Several of the governments in the region are seeking assis- tance from the international donor community to open ports to private operators through concessions, something that the new port law in Bulgaria, for example, makes possible. WATER Although the region has adequate water resources, challenges exist in the water sector of each of the eight countries. The problems vary by country, but the countries share some common deficiencies, including problems with water quality, access to piped water, sewerage service, intersectoral allocation, and wastewater treatment. All of these areas need major improvement (see box 2.5 for an overview of the problems in Albania). For example, approximately 25 percent of the population in the region has no access to piped water. In the rural areas, the problem is more acute; only 51 percent of the population receives piped water, and only 17 percent of the population has access to sewerage services.15 A recent study by the World Bank (2003c) assessed the consequences of poor water resource management. Its principal findings are that poor water resource management (a) leads to damage and loss of life from floods, droughts, landslides, and erosion; (b) imposes health risks; (c) damages 58 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 2.5 Water Challenges in Albania Albania faces acute challenges related to watershed and flood manage- ment; water sanitation and irrigation and drainage; and management of lakes, wetlands, and coastal areas. The country also lags behind in creating a framework with broad stakeholder ownership and institutions for water services delivery. The government did not liberalize the national uniform water supply tariffs until July 1998, when it established the Utility Regulatory Commission, giving it powers to set tariffs and determine how they would be enforced. However, even then, the tariff for many local water utilities was well below the one requested by the utilities. The coun- try continues to experience water problems not only because of outdated supply and sanitation systems but also because of sluggish progress with reforms. In Tirana, more than 50 percent of the water is drained because of leakages and illegal connections. In the urban areas, only about 40 percent of the people have sewerage connections and only about 80 percent have access to piped water. Although the privatization of the water sector has started, major efforts are needed to modernize and maintain the sector. Sources: World Bank (2003c) and European Commission (2003a). fisheries, tourism, and recreation industries and leads to loss of ecosystems; (d) threatens the well-being of local communities through poor service delivery of drinking water; (e) weakens intersectoral allocation of water supplies for irrigation, hydropower, municipal water supply, and ecosys- tem maintenance; and (f) brings about inadequate water policies, institu- tions, and pricing regimes that drain government budgets and lead to poor water resource management and service delivery. All of the SEE8 are working toward improving the regulatory side of the water sector to increase accessibility and the efficiency of the water delivery while establishing a sound, market-oriented, institutional framework for the sector. The lack of sufficient investment for mainte- nance and modernization of the water infrastructure is a common and acute problem for every country in SEE. Although pricing reform and price adjustments have been initiated in the SEE8, institutional reforms for accountable public and private organization of the water sector are needed everywhere. Bulgaria and Romania, in line with their EU acces- sion process, have adopted legislation governing water resources man- agement, but both countries face serious problems in carrying out this legislation. At the conclusion of the Thessaloniki Summit of the European Council in June 19­23, 2003, the council recommended drawing up inte- grated water resource management plans for transboundary water bodies within the western Balkans. INSTITUTIONAL REFORM PROGRESS 59 Corporate Governance Incentives and Institutions To address the corporate governance needs in the SEE8, we look at four areas: restructuring and enterprise ownership, financial disclosure and transparency, minority shareholder rights, and access to finance. RESTRUCTURING AND ENTERPRISE OWNERSHIP The slow output recovery in the SEE8 reflects the pace of enterprise restructuring and privatization in the region as well as the new ownership and corporate governance structures that are emerging. Competing meth- ods of privatization entail different anticipated outcomes with respect to control over the privatized enterprise and, in turn, "the likelihood of its extensive restructuring" (Bornstein 2001, p. 190). Djankov and Murrell (2002), in a recent empirical study, find that, across transition economies, outsider privatization is associated with larger restructuring gains than insider privatization. In the same study, they also demonstrate that the effect of privatization through sales to foreigners is on average 10 times as strong as sales to diffuse individual owners and that state ownership has the least effect on restructuring among all other types of ownership. As table 2.3 reveals, the dominant method of privatization across the SEE8 has been the management-employee buyout (MEBO)--that is, the sale or giveaway of all or substantial ownership of a company to its managers and employees. For example, observers have estimated that in Romania, by the end of 1998, over a third of all industrial firms in the State Ownership Fund had undergone MEBO privatization, with average employee ownership of 65 percent and median employee ownership of 71 percent (Earle and Telegdy 2002, p. 8). In addition, MEBO participants were the largest owner group in one-fourth of the Romanian privatized firms, which makes the MEBO technique the most important tool of state ownership divestiture in the country. Table 2.3 Primary Methods of Privatization in SEE Method of privatization Direct sales Vouchers MEBOs Albania -- Secondary Primary Bosnia and Herzegovina Secondary Primary -- Bulgaria Primary Secondary -- Croatia -- Secondary Primary Macedonia, FYR Secondary -- Primary Moldova Secondary Primary -- Romania Secondary -- Primary Serbia and Montenegro Secondary Primary -- Source: EBRD (2002). Note: The primary (secondary) methods of privatization are those that have been used most (second most) frequently since the start of transition. 60 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 2.6 Largest Shareholder's Identity in Surveyed Firms, 2002 Albania Bosnia and Herzegovina Bulgaria Croatia Macedonia, FYR Moldova Romania Serbia and Montenegro 0 20 40 60 80 100 percent individual or family domestic firm foreign firm bank or investment fund managers or employees government other Source: EBRD and World Bank (2002). BEEPS2 confirmed this finding on a cross-country basis. On average, in one-fifth of the surveyed enterprises in 2002, the largest shareholders were either the managers or the employees of the firm (see figure 2.6). According to BEEPS2, the highest proportions of insider-dominated governance structures are in Bosnia and Herzegovina and in Moldova, where 28.3 percent and 24.8 percent, respectively, of managers or employees of privatized enterprises have become the new owners of former state-owned companies. Because of the prevalence of MEBOs, enterprises in SEE are characterized by highly fragmented ownership, inadequate management skills, and insufficient fresh capital for restruc- turing and investment. Another striking feature of enterprises in the region is the limited pres- ence of foreign ownership. As presented in figure 2.6, for the region, on average approximately 8.4 percent of the surveyed firms in 2002 were for- eign owned. However, in Bosnia and Herzegovina, FYR Macedonia, and Serbia and Montenegro, the share of foreign ventures among the sur- veyed enterpriseswasbelowtheaveragefortheregionandstoodat 4.0 per- cent, 4.6 percent, and 6.7 percent, respectively. In addition, institutional INSTITUTIONAL REFORM PROGRESS 61 investors (such as privatization funds or commercial banks) and block investors are not popular types of shareholders in the region. However, they are gaining importance as key players, especially in privatization transactions that empower insiders. For example, the privatization expe- rience of FYR Macedonia illustrates an interlocking relationship between commercial banks and enterprises. Privatizing the banking sector required the privatization of dozens of enterprises and resulted in frag- mented ownership that tends to abuse credit rather than safeguard bank capital. A 2003 OECD and Stability Pact white paper on corporate governance in SEE outlines three common features that characterize the emerging ownership structures in SEE. These features, which are also reflected in the results from BEEPS1 and BEEPS2, are as follows: (i) Significant control by insiders and, more precisely, by managers who have secured control either through direct ownership or indirectly by de facto control over employee shares (ii) The importance of retaining state ownership and control, especially in large firms and utilities that are to be privatized (iii) The emergence of various forms of institutional investors, mainly for- mer privatization funds that play a significant role in the ownership structure of enterprises (OECD, South East Corporate Governance Roundtable, 2003, pp. 64­65) The experience of SEE with insider-dominated privatization tech- niques reveals that, as a whole, MEBOs have produced enterprises with weak corporate governance practices because the transformed enter- prises have a rudimentary incentive structure. For example, the culture of "social capital" in the former republics of Yugoslavia gives the employees' assembly significant decisionmaking power in firms to be privatized. Details of the enterprise's privatization and the choice of future owners are left to the employees. This type of ownership transformation creates conditions that preserve overemployment, permit low management turn- over, and limit the flow of new human capital in the firms. Consequently, little effective restructuring takes place. Moreover, insiders' privatization deals often materialize through infor- mal ties between politicians and industrial incumbents. These kinds of non- transparent relationships breed corruption and nepotism. In Croatia, for instance, the enterprise privatization program of the early 1990s combined partial sales to employees with tendering to politically related investors. The privatization attempt empowered incumbents without promoting the incentives for corporate restructuring and governance. In Romania, pow- erful insiders such as the labor unions not only influenced the choice of privatization tools but also blocked the divestiture of state firms. 62 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Mass privatization has been another widespread privatization instru- ment in SEE. Vouchers were popular because the belief was that they could empower the population equally and quickly create new private owners of state firms. Generally, vouchers have been used extensively in countries where capital for direct investment is scarce and inaccessible to the public. In Bosnia and Herzegovina, Moldova, and Serbia and Montenegro, vouchers are the primary method of privatization, and inAlbania, Bulgaria, and Croatia, they have been a secondary technique for divestiture. However, the results of mass privatization techniques in SEE are disap- pointing. Not only is the pace of privatization slow (resulting in a low per- centage of state assets being privatized), but also these techniques have failed to create market incentives in the firms with new owners. For exam- ple, in Romania, the first wave of the voucher privatization transformed only 8 percent of state assets, and the second one in 1995 proved to be exces- sively complicated, because the trading of vouchers and the formation of intermediaries were prohibited. The state retained a large ownership stake by offering only 60 percent of the shares in the firms for mass privatization. Major setbacks affected voucher privatization in Bosnia and Herzegovina, too (see box 2.6).Although the privatization process began in 1997, ownership transformation has been only partly completed, primarily among SMEs in the country, as large and strategic enterprises are priva- tized very slowly. The regulations in both the Federation of Bosnia and Box 2.6 Institutional Hurdles to Privatization in Bosnia and Herzegovina In Bosnia and Herzegovina, the privatization legislation created an entity- based scheme involving 12 privatization agencies: one for each of the two entities, the Federation of Bosnia and Herzegovina and Republika Srpska, and one for each of the 10 cantons. The key problem is that the agencies' powers often overlap or conflict because a firm with operations in more than one canton or a firm with strategic significance can fall within the purview of several cantonal agencies and the federal agency. This institu- tional and regulatory framework has enormous potential for corruption. It also has stimulated ethnic rivalry because entity governments were allowed to distribute disproportionate numbers of vouchers to war veter- ans, discriminating against citizens who had fled or had been removed from their homes during the war. Political obstruction was and still is more apparent in profitable state-owned enterprises that are enjoying either monopolies or particularly favorable market positions. The OECD assesses the potential sources of failure for the Bosnia and Herzegovina mass privatization techniques in the areas of "political uncertainties, public mistrust of vouchers, and a specific danger that privatization may become dominated by war profiteers and political insiders" (OECD 2000, p. 22) INSTITUTIONAL REFORM PROGRESS 63 Herzegovina and Republika Srpska have favored domestic holders of vouchers over foreign owners of cash, permitting the latter to acquire upto 30 percent of the shares with cash. Of the remainder, up to 55 percent of shares can be purchased with vouchers, up to 20 percent can be pur- chased with citizens' old hard-currency savings, and 15 percent is reserved for the entity. The high ratio of vouchers to cash leaves most newly privatized companies without sufficient working capital to func- tion. In addition, a rule that allows voucher investors to appoint only two members to the board of directors effectively allows the entity (the Fed- eration of Bosnia Herzegovina or Republika Srpska) to retain control over the privatized firm. For example, in the Republika Srpska, the state retains 30 percent of shares in all mass privatized firms. The state-controlled Pension and Disability Fund receives 10 percent of all shares, and the Restitution Fund gets another 5 percent. Most of the enterprises in Bosnia and Herzegovina still lack strategic owners. Similarly, in Albania and Moldova, voucher privatization has been used extensively, especially in the housing, transportation, and retail trade sectors, but it has not transformed a significant share of state assets. The mass privatization programs in both countries proceeded slowly and transformed only a negligible amount of assets. In Albania, only 97 enterprises (or 12 percent of medium-size and large state-owned enter- prises) were sold over five rounds from October 1995 through July 1996, and in Moldova, in two rounds, approximately 3 million Moldovans became shareholders in 225 firms by using their promotional bonds. Generally, voucher schemes of privatization across the region have failed to bring sound corporate governance mechanisms because they have caused ineffective corporate restructuring and a consequent decline in competitiveness.16 Enterprises that are controlled by insiders still dominate the structure of privatized firms in SEE. How does this corporate structure affect enter- prise restructuring and private sector development in the region? Insider control mirrors the poor corporate governance structure in SEE. The weak institutional framework for corporate governance, as well as the lack of financial transparency and disclosure, creates owners of cor- porate assets without also creating the proper incentives for restructuring and modernizing the newly privatized firms. When corporate gover- nance structures and incentives (namely, the rules and institutions that determine the extent to which managers act in the best interest of share- holders) are weak, then firm performance suffers, and the incentives for opportunistic behavior and corruption strengthen. This pattern is espe- cially true for firms with significant (or even complete) state ownership because in such cases, often, little effective separation between govern- ment and business has been established. In these firms, fundamental con- flicts of interest are more likely to arise because of the tension between the decisions of managers--who are appointed by the government and, thus, 64 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE are naturally more inclined to protect workers and delay the restructuring process--and the interests of shareholders. In addition, insiders rarely have the capital and know-how to bring their enterprises to the competitive edge of the market without using preferential treatment in their transactions. This conflict of interests and objectives between shareholders and managers is also present in privately held firms with widely dispersed ownership. In firms with weak checks and balances (for example, firms with ineffective boards of directors or firms that lack independent finan- cial audits), the shareholders cannot be assured that their interests are fully protected from those of the managers. Conversely, if (a) share own- ership is closely held and the main shareholder plays an active role in management (insider control) and (b) there are weak internal and exter- nal disciplines on corporate performance (for example, a banking system that does not engender strong creditors' rights or require scrupulous pay- ment of credit), then deleterious outcomes and economic distortions can arise. Unchecked insider control can lead to asset stripping, decapitaliza- tion, and corruption, all of which seriously hamper the restructuring process. This unchecked control can also create powerful interest groups against corporate governance reforms. At the end of the 1990s, the SEE8, having a poor privatization record and fearing the dangerous implications of dispersed and insider owner- ship, started to abandon mass privatization and insider techniques and shifted their strategy toward direct sales of enterprises. In both Albania and Moldova, for example, the voucher privatization programs are phas- ing out, and both governments have started to rely on direct sale methods, especially for large industrial enterprises. The Albanian government's privatization strategy of 1998 provided for an auction-based sale of all remaining SMEs, allowing the sale of shares to either local or foreign investors. The SME privatization process proved to be difficult, however, and several SMEs that could not find private investors were liquidated.17 The government of Romania started privatization in more than 1,500 state-owned enterprises in 1999, began the measures in another 700 in 2000, and continued the process in the following years, using case-by-case sales, pool sales, and sales by the State Ownership Fund. The fate of the Bulgarian MEBO and mass privatization programs was similar. These methods were abandoned in 1998. Since then, the privati- zation of state-owned enterprises has been conducted primarily by means of direct sales. In March 2002, to improve transparency in the privatiza- tion process and eliminate potential sources of red tape, the Bulgarian government enacted major amendments to the privatization law. The amendments that FYR Macedonia made to its two key privatization laws in June 2000 had similar goals and outlawed nontransparent methods of privatization that would be conducted by means of direct negotiation with politically and socially sensitive enterprises. INSTITUTIONAL REFORM PROGRESS 65 In Romania, too, legislative changes were made to overcome the slow pace of large-scale privatization.18 Yet a significant number of state- owned enterprises still remain under the Authority for Privatization and Management of State Assets, the main authority in charge of privatiza- tion in Romania. Among these enterprises are many unprofitable compa- nies that are not suitable for privatization. However, the imposition of investment and employment conditions in the amendments to the priva- tization law--a move that allows companies to be sold for a nominal price, conditional on future investment commitments--has had positive results. In September and October of 2003, some ailing state-owned com- panies (including Aro, Tractorul, Siderurgica, and Petrotub) were sold to strategic foreign investors using this method. The Sidex privatization also benefited from these conditions. Efforts to privatize and create incentive-based ownership structures have spurred further reforms in the rest of the SEE8. In Serbia, the par- liament adopted a new law on privatization at the end of June 2001. The law specifies that at least 70 percent of shares in the state and socially owned assets ought to be sold to private investors.19 However, the results of the privatization program in 2002 were mixed. Although most of the auctions for small and medium-sized companies were completed in 2002, auctions for socially owned enterprises continued into 2003, and the plan was to sell about half of those companies by the end of the year (EBRD 2003). The privatization of large companies has advanced slowly. In March 2003, the Serbian government enacted amendments to the privati- zation law that were designed to speed up sales, but only three deals to privatize large companies were finalized after those amendments--the sale of the major steel conglomerate Sartid in June 2003 and the sale of two tobacco companies in August 2003.20 Other sales have been marred by allegations of irregularities. Privatization efforts in Montenegro have also advanced, including the tender privatization of 15­20 large enterprises (with about 25,000 employ- ees in total), a mass voucher privatization program for 240 medium-size companies, a batch sale privatization of 33 companies, and the liquida- tion of about 30 companies (World Bank 2001d). The largest privatization to date is the sale of the oil company Jugopetrol, approximately 54 per- cent of which was purchased in October 2002 by Hellenic Petroleum of Greece. Other privatization initiatives under way in 2003 include the privatization of the aluminum conglomerate Kombinat Aluminijuma Podgorica, a tender for the Niksic steel mill, and 11 tenders for hotels (EBRD 2003). The tenders for hotels, surprisingly, have attracted little interest from foreign investors. FYR Macedonia dealt with large loss-making enterprises by restruc- turing 23 loss-making firms into more than 165 separate business units under a special restructuring program supported by the World Bank 66 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE that began in 1995. In the first half of 1999, significant progress was made in dealing with these firms: 108 were privatized and 8 were put in bankruptcy. Under the World Bank's Second Financial and Enter- prise Sector Adjustment Program (FESAL II), 24 companies were still awaiting sale or liquidation at mid-2003, and 8 of these were reported to have been sold by late August 2003. At the same time, the Privatiza- tion Agency relaunched the privatization program in an effort to restore momentum. A new privatization timetable was published for 22 loss- making enterprises, and in most cases, an adviser was appointed for the sale. In each case, the asset will be sold to the highest bidder, and bidders will not be required to commit either to making future invest- ments or to retaining current employees. The government intends to complete the program, at which point the Privatization Agency will be closed down. Although the SEE8 have stepped away from the insider ownership and dispersed ownership methods of privatization, the corporate gov- ernance elements of transparency and of accountability in exercising property rights are yet to emerge fully to drive market-oriented enter- prise sector development and growth in the region--a key theme of chapter 5. FINANCIAL DISCLOSURE AND TRANSPARENCY One key reason for the failure of dispersed privatization efforts to estab- lish effective corporate governance structures in the region is the inability of the SEE8 to implement financial transparency and disclosure require- ments. Without institutions to ensure that transparent financial disclosure occurs, investors make uninformed decisions with respect to their prospec- tive investments, and at the same time, shareholders and the public can- not assess the performance of the public companies or hold managers responsible for their actions. The contours on figure 2.7 represent a combination of (a) the extent to which financial audits have been carried out and (b) the extent to which IAS have been adopted in the SEE8. The score is normalized on a scale from 1 (universally carried out) to 4 (poorly carried out). The data show not only that financial disclosure and transparency vary tremendously across the countries over the observed period but also that they have gen- erally declined since 1999. For example, in 1999, the adoption of IAS was almost universal among the surveyed firms in Croatia and very high in Bosnia and Herzegovina, but it was much lower in Croatia in 2002 among surveyed firms. In interpreting these findings, however, one should bear in mind that the sample is skewed toward small enterprises, which in most countries are not legally obliged to adopt IAS or independent financial audits. Looking at a reduced sample of the larger firms that participated in INSTITUTIONAL REFORM PROGRESS 67 Figure 2.7 Financial Disclosure and Transparency Albania 4 Serbia and Bosnia and Montenegro 3 Herzegovina 2 1 Romania 0 Bulgaria Moldova Croatia Macedonia, FYR 2002 (BEEPS2) 1999 (BEEPS1) Sources: EBRD and World Bank (1999, 2002). Note: Scores are normalized on a scale from 1 (universally carried out) to 4 (poorly carried out). the survey, we find in chapter 5 a stronger pattern of adoption of IAS and financial audits in the SEE8. It is important to keep in mind, however, that adoption of IAS is a nec- essary condition only for improved corporate governance: improvements in the use of financial information depend on having sufficient numbers of well-trained accountants and auditors--an unmet condition in many of these countries. In addition, as our enterprise-level case studies show, the external auditing process often does not provide independent, accu- rate, and complete information to the shareholders of a company, and the managers from the region rarely consider it a mechanism for obtaining independent expertise. The limited disclosure of corporate information is a widespread char- acteristic of the region. Companies publish their corporate records under external pressure because most of the countries' legislation formally requires publicly held firms to disclose information. In practice, however, disclosure is not used to attract potential investors or generate economic interest; rather, it is used to fulfill a bureaucratic obligation, and in this sense, it undermines the notion of financial transparency of publicly held enterprises. Because the region demonstrates these flaws in financial transparency, it appears that only a combination of external and internal controls can ensure effective corporate governance. Internal controls are important in 68 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE minimizing the risk posed by ill-defined relationships among sharehold- ers, managers, and stakeholders, whereas external controls are effective only if the institutions that regulate corporate governance are suited to the local business environment. MINORITY SHAREHOLDER RIGHTS Enforcement of minority shareholder rights in firms with dispersed ownership structures is weak throughout the region. If the number of shareholders is large, especially in firms privatized through mass priva- tization, individual owners are often quite unaware of their rights and responsibilities. As a result, the diffused owners of these companies play a passive role in corporate governance because managers or major investors in the firms do not recognize them as true investors. Thus, there is limited recognition of small shareholders' rights and few incentives for such shareholders to exercise those rights. When compared with international corporate governance standards, the legal framework in Albania, Bosnia and Herzegovina, Moldova, and Serbia and Montenegro fares poorly.21 Often, the lack of legislation safe- guarding minority shareholders has left these shareholders (who in fact often constitute most of the shareholders in a single company) unpro- tected from decisions made by state agencies. For example, in Albania, the company law does not afford minority shareholders protection in the event that another company makes a bid for fewer than all the shares of a widely held target company. Cumulative voting for directors does not exist. Although the law in Albania points out the directors' duty to per- form their functions in good faith and their obligation to avoid self-dealing, in practice, these duties and obligations are often ignored. Similarly, in Serbia and Montenegro, the Federal Enterprise Law does not provide for a right of preemption over newly issued shares; an increase in share cap- ital could be fully allocated to a third party. In Bosnia and Herzegovina, shareholders' rights to elect board members also are relatively weak. Furthermore, minority shareholders are neither protected with respect to stock repurchase rights nor provided with derivative suit rights.22 In addition, they are not given cumulative voting rights. To strengthen minority shareholders' rights and to foster ownership consolidation, FYR Macedonia adopted an initial set of amendments to its securities law in July 2000. The amendments provide for the transfer of shareholder books from companies to the new Central Securities Depository and Central Share Registry. The government also plans fur- ther amendments to strengthen insider trading rules, to fortify listing requirements, and to protect minority shareholders, but security of minority shareholder rights is still at issue.23 According to EBRD's legal assessment, which draws on the experience of lawyers working in the field, the Bulgarian, Croatian, and Romanian INSTITUTIONAL REFORM PROGRESS 69 company laws compare reasonably well with international standards. In July 2003, amendments to the Croatian Company Law and the Law on Takeover Procedure of Joint-Stock Companies were enacted to strengthen minority shareholders' rights, to enable more transparent securities trade, to help joint-stock companies place their stocks on the stock mar- kets, and to harmonize corporate governance practices with EU rules (World Bank 2001c). With the enactment of the Public Offering of Securi- ties Act in 1999, Bulgaria took a substantial step forward in modernizing the country's corporate governance rules and, specifically, in reinforcing the minority shareholders' protection regime. Under the new act, for exam- ple, any shareholder of 5 percent or more can hold managers accountable for any action that adversely affects shareholders' interests within a year of its occurrence. In Romania, Ordinance 229 of 2000 sought to strength- en equitable treatment among shareholders. Although the ordinance has since been declared null, it drew attention to the importance of corporate governance. The government has pledged to issue new legislation to strengthen shareholder rights. Despite these developments, individual investors and entrepreneurs in the region still face difficulties in exercising property rights. ACCESS TO FINANCE Access to finance is another common bottleneck that businesses in SEE face. Among the SEE8 firms that participated in BEEPS1 in 1999, more than 54 percent indicated that financing was a major impediment to the development of their business (see figure 2.8). Although under BEEPS2 the total number of these firms decreased substantially in 2002, two-thirds Figure 2.8 Financing as an Obstacle to Enterprise Development financing (1999) cost of financing (2002) access to financing (2002) 0 10 20 30 40 50 60 70 80 90 100 share of firms (%) none minor or moderate major Sources: EBRD and World Bank (1999, 2002). 70 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE of the surveyed businesses in the region still viewed access to finance as an obstacle to business operations. Similarly, close to 80 percent of the firms indicated that the cost of obtaining financing presented a burden to their operations. The results from the BEEPS1 and BEEPS2 are supported generically by aggregate data for the SEE8. The low levels of domestic credit provided to the private sector confirm the difficulties firms face. Table 2.4 shows these levels as a share of gross domestic product (GDP). In 2002, the lev- els were low in all countries except Croatia, and they were especially low in Albania (4.7 percent) and Serbia and Montenegro (8.4 percent). The difficulties enterprises face accessing financial resources require policymakers to examine bank-enterprise relationships from the perspec- tive of the efficacy of governance incentives. Uncertainty with respect to actual ownership and the lack of a clear title can prevent a business from obtaining financing at attractive terms because business assets cannot be used as collateral. Banks are discouraged from lending to enterprises in which they do not have shareholdings or another relationship (Berglof and Bolton 2002). As table 2.4 reports, at the end of 2002, domestic credit to the private sector as a share of GDP stood at 18 percent on average for the SEE8, a figure considerably lower than the 27 percent average for the five most advanced Central and East European economies. Croatia is an obvious outlier in the SEE8 group, with domestic credit to the private sector comprising 45 percent of output in 2002. Institutional alternatives to bank-based financing in SEE are not well developed. The use of state insurance companies or other nonbank vehi- cles for financing has been almost negligible in the region. The equity capital market is relatively limited in size, and it mostly caters to the top corporations, which also have access to foreign sources of financing. The lack of long-term bank financing and other sources of financing has led to a situation in which corporate capital investment, outside of foreign investment, is mainly limited to internal earnings. The lack of financing is not a problem only for capital investment; its effects also extend to trade financing and make it difficult for enterprises to maintain normal commercial operations. Despite the shortage of working capital from the banking system, few enterprises offer trade credit because credit tracking and dispute settlement mechanisms are underdeveloped. Another obstacle blocking access to finance in SEE arises from inade- quate mechanisms for tradability of vouchers on the secondary market. Underdeveloped stock markets constrain the ability of voucher holders to execute market transactions, which in turn creates an adverse percep- tion of the value of the newly acquired ownership stakes in former state enterprises. The problem is especially acute in the countries that use mass privatization as the primary method of divestiture. The Tirana Stock 2002 4.7 12.0 18.0 45.0 14.4 18.7 8.4 -- -- -- 18.16 27.1 4.3 16.1 4.8 -- 24.9 10.2 1997. in . 3.8 5.9 2001 14.6 34.2 12.8 14.8 7.7 5.6 12.0 28.3 3.7 16.8 1.3 22.3 5.8 sector companies 2.9 4.7 enterprise listed 2000 1.61 Quotation. 27.8 10.5 12.6 7.2 7.6 1.01 32.2 4.8 14.5 0.2 27.2 3.4 the for to GDP 1993­2001 Dealerss of 2.1 9.8 diterc 1999 14.0 22.1 10.4 1.11 8.1 9.8 1.01 32.7 5.8 14.0 0.2 32.3 2.9 of cent per Securitie stock of 4.56 the of 0.6 e 1998 12.2 26.6 17.7 15.8 1.61 1.21 13.7 33.0 7.4 14.5 0.2 3.0 government. educedr figur Association Capitalization, a eatly give 3.9 gr Moldovan 1997 12.3 25.3 27.3 14.8 8.4 10.8 14.7 33.2 0.0 21.6 0.3 2.0 the IFC Romanian Market which and omfr the 3.9 1997, Data 1996 35.3 21.4 26.5 6.8 1.51 9.2 16.4 28.8 0.2 15.3 0.3 0.2 in banks market, Stock to crisis and edits cr securities. 3.6 1995 21.1 22.9 23.1 5.8 7.8 -- 14.0 27.1 0.5 3.1 -- 0.4 -the-counter banking a Slovenia. over Sector by excluding and government the 3.9 3.8 1994 21.2 45.3 3.7 4.3 -- 13.7 26.6 -- 3.3 -- 0.0 and followed Private enterprises, Slovakia, including was to and Exchange 1993 -- ------------ 3.7 1996 37.7 59.3 5.0 3.1 -- 21.8 28.4 ------------------ ------------------ -- -- -- ------------ -- ------------------ Poland,, and exchange, Stock est Credit 1995 individuals stock Hungary in to Buchar sector o o edits the cr Bulgaria Republic, Moldovan on GDP) private in of Domestic of to c Herzegovina FYR Montenegr Herzegovina FYR Czech listings egionr capitalization Montenegr (2003). available. comprise e edit a b d e ar survey 2.4 or cr and and and average average and not es expansion omfr centage oatia market EBRD figur oatia -- CEE5 include ce: edit ableT Albania Bosnia Bulgaria Cr Macedonia, Moldova Romania Serbia SEE8 CEE5 Albania Bosnia Bulgaria Cr Macedonia, Moldova Romania Serbia Cr The The Data Data (per Country Domestic Stock Sour Note: a. b. c. d. e. 71 72 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Exchange, for example, was established in 1996, but it is still not operat- ing.24 In addition, the capital market in Albania is in its early stage of development and involves negligible trading. Delays in the mass privati- zation resulted in only a small number of initial public offerings, despite the fact that, since 1998, the number of the listings has slightly increased. In the rest of the SEE8, stock exchanges are also unable to mobilize the sufficient level of financing that is sought by the firms. Stock exchanges are thin and illiquid, with trade concentrated in a small number of firms and with very low levels of stock market capitalization (see table 2.4). Indeed, the market does not attract many new investors, and stocks are traded between existing stakeholders and brokers. Many listed compa- nies are neither trusted nor traded, which also reflects investors' pas- sivity and low turnover. For example, in 2000, market capitalization of the Bucharest Stock Exchange (BSE) was US$363.2 million, while the turnover was only US$86.2 million. Only 114 companies were listed on the BSE as of the end of 2000 (Gupta, Kleinfeld, and Salinas 2002). Trade on the stock exchanges in Croatia, Serbia, FYR Macedonia, and Moldova has been even slower. As previously mentioned, the lack of transparency because of poor accounting and auditing standards in the listed companies alienates potential investors. Some countries are actively strengthening their corporate governance institutions. For example, in Croatia, amendments to the Law on Securi- ties Issuance and Trade were enacted in early 2003 to harmonize the law with proposals and instructions of the International Organization of Securities Commissions as well as with the EU directives. Thus, the law now enables the Croatia Security and Exchange Committee to impose substantial penalties on securities dealers who violate investors' rights, thereby allowing more effective oversight of brokerage houses. Other ben- efits of the new legislation include stronger disclosure requirements and new rules for depositories. Romania is also making an effort to improve legislation pertaining to the supervision of capital markets, despite the inefficiencies of the agencies created to monitor the stock exchanges (Gupta, Kleinfeld, and Salinas 2002). The low volumes of traded shares, capitalization, and liquidity are likely influenced by the fact that the region's stock exchanges were created in response to the dispersed methods of privatization and were intended to serve as privatization devices in the initial distribution and trading of shares. This fact has led to a notable tendency in the region: increased con- centration of ownership achieved by delisting companies from the stock exchange, especially in the postprivatization phase. Experts assess the trend as derived from "the excessive ownership dispersion that results from voucher privatization, and more generally and fundamentally from the inability or great difficulty for minority investors to have their rights respected" (OECD, South East Corporate Governance Roundtable 2003, INSTITUTIONAL REFORM PROGRESS 73 p. 65). This tendency to consolidate ownership and abandon the status of being publicly listed is especially popular among SMEs. SMEs cannot effectively access outside capital through the local stock exchanges, but they accrue administration and legal costs by being listed. Furthermore, the legal organization of a joint-stock company is not appropriate for them (OECD, South East Corporate Governance Roundtable 2003). Poor regulation of the capital and stock markets as well as weak corporate governance incentives--especially with respect to small shareholders--have made dispersed ownership a less attractive structure for divestiture of the state sector. The expected restructuring and reor- ganization do not materialize easily in an environment of small, unmo- tivated owners and inexperienced managers of investment funds. Restrictions on secondary share trading and a lack of investment funds and other mechanisms to consolidate shares in the hands of strategic investors hamper efforts to overcome the disadvantages of weak corporate governance in the region. Commercial Disputes and Contract Enforcement Problems with commercial disputes and contract enforcement are endemic to the SEE8. The business environment in most countries is char- acterized by difficulties with protecting property and contract rights, cor- ruption, an ineffective court system, a lack of security, and an ineffective means of resolving business disputes. DIFFICULTIES WITH UPHOLDING PROPERTY AND CONTRACT RIGHTS AND COMBATING CORRUPTION Results from BEEPS1 and BEEPS2 reveal that, on average, the business community perceives the judiciary and court systems in SEE as among the worst public providers of services in the region. (Other public providers included infrastructure providers, educational providers, the police, par- liament, and the central bank.) In countries where the courts and other legal institutions cannot be relied on to uphold the law and, in particular, to enforce contracts, corruption extends to the court system. The courts are perceived as weak and subject to political influence, which makes the resolution of commercial disputes and litigation lengthy and subject to uncertainty. These institutional weaknesses within the legal environment lead foreign investors and companies trading with SEE8 firms to avoid local courts to every extent possible. Yet, as will be discussed later in this chapter, the effectiveness of the judiciary systems in the region has improved slightly since 1999. This observation is reflected not only in the results of BEEPS1 and BEEPS2 but also in the experts' assessment of the legal environment of the region 74 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE (EBRD 2002; Heritage Foundation 2003; Kaufmann, Kraay, and Mastruzzi 2003). Observers saw that the 2002 indicators of legal effectiveness throughout the region had made a considerable leap forward, particularly in Albania and Bosnia and Herzegovina, but have revised downward their assessments of the extensiveness of the commercial laws in Bulgaria, Croatia, and FYR Macedonia, as shown in table 2.5. Table 2.5 Control of Corruption, Protection of Property Rights, Legal Effectiveness, and Legal Extensiveness in the SEE8 Control of Protection of Legal Legal corruptiona property rightsb effectivenessc extensivenessc Country 2002 1998 2003 1999 2002 1999 2002 1999 Albania 23.2 9.8 Low Low 3.00 1.66 3.00 2.00 Bosnia and Herzegovina 34.5 45.4 Very low Very low 3.00 1.00 3.00 2.00 Bulgaria 52.6 39.9 Moderate Moderate 4.00 3.67 3.67 4.00 Croatia 63.9 46.4 Low Low 3.30 2.67 3.30 4.00 Macedonia, FYR 29.4 48.1 Low -- 3.67 3.67 3.30 3.67 Moldova -- -- Moderate Moderate 3.67 3.00 3.67 3.67 Romania 45.4 44.3 Low Low 4.00 3.67 3.67 3.30 Serbia and Montenegro 26.3 8.2 Low -- 3.00 -- 3.00 -- Sources: For control of corruption, Kaufmann, Kraay, and Mastruzzi (2003). For protection of property rights, Heritage Foundation (2003). For legal effectiveness and legal extensive- ness, EBRD (2002). Note: -- not available. a. Percentile rank indicates the percentage of countries worldwide that rate below the selected country (subject to margin of error). For more information, see Kaufmann, Kraay, and Mastruzzi (2003). b. Rankings are defined as follows: Very high--private property is guaranteed by the gov- ernment, the court system efficiently enforces contracts, the justice system punishes those who unlawfully confiscate private property, corruption is nearly nonexistent, and expro- priation is unlikely. High--private property is guaranteed by the government, the court system suffers delays and is not always strict in enforcing contracts, corruption is possible but rare, and expropriation is unlikely. Moderate--the court system is inefficient and subject to delays, corruption may be present, the judiciary may be influenced by other branches of government, and expropriation is possible but rare. Low--property ownership is weakly protected, the court system is inefficient, corruption is present, the judiciary is influenced by other branches of government, and expropriation is possible. Very low--private property is outlawed or not protected, almost all property belongs to the state, the country is in such chaos (as might be caused by an ongoing war) that property protection is nonexis- tent, the judiciary is so corrupt that property is not effectively protected, and expropriation is frequent. c. The indexes of legal effectiveness and extensiveness refer to commercial laws (pledge, bankruptcy, and company legislation) only. Indicators range from 1 (limited in scope, unclear, and contradictory) to 4 (comprehensive, clear, and readily ascertainable). See EBRD (2002). INSTITUTIONAL REFORM PROGRESS 75 As table 2.5 shows, on average, the region has a lower score on the legal extensiveness indicator than on the legal effectiveness one.25 This finding suggests that the legal rules in the areas of pledges, bankruptcy, and com- pany law may be reasonably clear, but as their experience with the laws grows, lawyers continue to identify problems and gaps in these commer- cial laws. That the commercial legal frameworks of the SEE8 need further improvement is reflected in the countries' weak scores in protection of property rights (also presented in table 2.5). Although implementation of existing laws appears adequate (as per the legal effectiveness scores in table 2.5), there is room for improvement, particularly as the commercial legal framework continues to be expanded and advanced. Except in Bulgaria and Moldova, experts consider the protection of private property rights as being low in the region--and very low in the case of Bosnia and Herzegovina (see table 2.5). None of the SEE8 has improved its ranking since 1999 on the protection of property rights index. Although recent reforms are beginning to increase public aware- ness of corruption, particularly in Bulgaria and Croatia, the control of cor- ruption index still reflects high levels of corruption in the region. In fact, since 1998, Bosnia and Herzegovina and FYR Macedonia have ranked lower on the control of corruption index. A weak institutional environ- ment, which is characterized by rent-seeking and illicit behavior among officials, ineffective protection of property rights and contracts, and lax enforcement of the law, has created grounds for corruption in SEE. The ratings in table 2.5 reflect the imminent need to fight corruption and reform the legal and judicial system in the region. Government and cross-national initiatives are under way. A major anticorruption initiative that was launched in 1999 under the auspices of the Stability Pact is attempting to identify the main areas of corruption in the regions and to recommend measures to combat the problem. In addition, another inter- national effort--the Southeast European Legal Development Initiative-- was established to create a regionwide institutional framework for fighting corruption. Anticorruption programs and surveys are also under way on the national level throughout the region. In Bulgaria, for example, the gov- ernment has launched a comprehensive and outreaching anticorruption program, which is supported by active public-private partnerships, research and analytical work, and surveys to identify the most acute areas of corruption and to develop mechanisms to combat it (see box 2.7). In Croatia, important anticorruption measures are being taken that involve civil society, nongovernmental organizations, trade unions, and judges' associations. The Ministry of Justice appointed a high representa- tive in 2001, prepared legislation for establishing an Office for Anticor- ruption and Combat against Organized Crime, and drafted a National Anticorruption Program. 76 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 2.7 Combating Corruption in Bulgaria through Public-Private Partnerships Coalition 2000 is one of the most prominent examples of a private-public partnership in the area of anticorruption in SEE. Coalition 2000 was estab- lished in 1997 by Bulgarian nongovernmental organizations to create a cooperative platform of public and private institutions. It is an all- inclusive platform combining the input and efforts of various stakeholders irrespective of their political or institutional affiliations. The partnership has developed a Corruption Monitoring System (CMS) to serve as a spe- cial tool for diagnosing corruption. Using a set of corruption indexes, the CMS also provides regular, comprehensive summaries of public attitudes and behavior related to corruption. The methodology is based on a model of corrupt behavior (defined as a type of interaction between actors) that consists of four main elements: preconditions, practical interaction, action results, and future expectations. Corruption indexes are grouped respectively in the following categories: attitudes toward corruption, corrupt practices, assessment of the spread of corruption, and corruption expectations. Coalition 2000 also has completed a best practices initiative on a local level. The initiative was implemented in three programs from April 1999 to December 2000. The initial program focused on Transparency of Local Authorities, the second on Open Municipalities, and the third on Civil Society against Corruption. Under these programs, nongovernmental orga- nizations, managers, experts from municipal and district institutions, jour- nalists, and others have made joint efforts to fight the red tape that often shields corruption. The anticorruption initiative promotes participation by civil society in applying mechanisms of civil control over the state, espe- cially with respect to carrying out the National Anticorruption Strategy for Bulgaria for the period 2001­04. The Civil Society against Corruption pro- gram supports public awareness activities and anticorruption coalitions at the local and national levels that are based on a partnership between non- governmental organizations and state and municipal authorities in the framework of the Anticorruption Action Plan of Coalition 2000. The experience of Coalition 2000 demonstrates that a determined citizenry can demand better government and turn the tables on those who are corrupt. Sources: Anticorruption Coordination Commission (2004) and Center for International Private Enterprise (2001). To fight corruption, the government of Bosnia and Herzegovina has launched an antifraud and anti­tax avoidance strategy. The financial police of the Federation of Bosnia and Herzegovina, which are supported by the Antifraud Department, have largely concentrated on investigating corruption and financial crimes. Through their efforts, high-profile cases of INSTITUTIONAL REFORM PROGRESS 77 corruption have been brought to court, and 12 officials have been removed for corruption and abuse of office. The Republika Srpska's financial police have been less successful in fighting corruption, however. No official has been dismissed, nor has the entity brought any major corruption case to court. However, important changes were made in June 2000, when the law on judicial service amended the rules governing the appointment of judges and prosecutors in Republika Srpska and set higher salaries in both enti- ties as a hedge against bribery and corruption. The Office of the High Representative has also set up the Independent Judicial Commission, an advisory body of foreign and domestic legal experts to advise and super- vise the implementation of legal and judicial reforms.Although these mea- sures have marginally enhanced the independence of judges, the system is still vulnerable to political influence. Moreover, implementation efforts are still lagging, and contracts are often violated. Legal remedies are difficult to find, and even court cases resulting from breach of contract can take years to be resolved. Apart from widespread corruption problems in SEE, the causes of a rel- atively weak rule of law include an undertrained and understaffed judi- ciary that lacks proper resources to effectively enforce enacted legislation. For example, in Albania, the constitution of November 1998--along with the Law on Judicial Organization of 1999 (which introduced minimum academic standards for new judges and a gradual application of these standards for existing judges) and the Anticorruption Action Plan of June 1998 (an initiative supported by the World Bank's Judicial and Public Administration Reform Project)--provided a clear foundation for judicial independence. Implementation problems continue to occur, however, partly because so many new laws have been enacted so quickly that the Albanian government lacks the institutional capacity to carry out and swiftly enforce the new measures. Throughout the region, the courts are overloaded with cases, and they lack basic levels of information technology. Judges are poorly trained and are not well remunerated, which creates additional incentives for corruption. Even in countries such as Serbia and Montenegro with a strong tradi- tion of commercial law litigation, judges do not enjoy the confidence of the business community because of their excessive legalistic (rather than practical) approach to resolving disputes.26 In addition, commercial laws are numerous, excessively detailed, and not well drafted. Consequently, uncertain and unpredictable bureaucratic interpretations have become the norm. Excessive discretion is exercised in carrying out administrative procedures, particularly in cases dealing with the delivery of utility and other public services. Combating corruption and establishing a well-functioning judiciary (one that approaches Western European standards) in all of the SEE8 will require decades because small steps forward have been followed by 78 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE setbacks.27 Stability and economic growth in the region depend on build- ing strong public support for standards of integrity, exposure of corrup- tion, and advocacy reforms. EFFECTIVENESS OF THE COURT SYSTEM An important dimension of the dispute resolution regime is the extent to which the legal system can be relied on to uphold contract and property rights in resolving business disputes. The institutional environment in which the enterprises exist is a key determinant of the way firms are structured and operate. Enterprises need a business environment with some degree of policy predictability. Failure to consistently and transpar- ently enforce the law and regulations weakens general respect for them and the institutions that govern them. Across the region, a substantial proportion of enterprises consider regulations and their application to be inconsistent and unpredictable. The available evidence suggests that, over time, the lack of consistency and predictability has been tilting against private sector start-ups. Figure 2.9 presents the cross-country rankings from BEEPS1 and BEEPS2 of the effectiveness of the judiciary in the eight countries by aggregating the following attributes of the judiciary: fairness, honesty, Figure 2.9 Aggregate Effectiveness of the Judiciary Albania 4 Serbia and Bosnia and Montenegro 3 Herzegovina 2 1 Romania 0 Bulgaria Moldova Croatia Macedonia, FYR 2002 (BEEPS2) 1999 (BEEPS1) Sources: EBRD and World Bank (1999, 2002). Note: Firm managers were asked the following question: "How often do you associate the following description with the court system in resolving business disputes: fair and impar- tial; honest and uncorrupt; quick; affordable; and able to enforce its decisions?" A higher value of the indicator indicates a lower rating on a 1­4 scale (with 1 representing a "very good" assessment and 4 a "very bad" assessment). INSTITUTIONAL REFORM PROGRESS 79 speed, consistency, and enforcement. As detailed analysis in chapter 6 demonstrates, the surveyed enterprises complain about the slowness of the procedures in all eight countries, but they perceive the court system as even more unable to enforce its decisions effectively and honestly. In the case of Albania, for instance, estimates suggest that fewer than 10 per- cent of civil judgments are effectively enforced. Fairness in legal judg- ment is perceived as more problematic in Romania and Serbia and Montenegro than anywhere else in the region. Of all the countries in the region, Serbia and Montenegro has the court system least trusted by the surveyed firms to settle business disputes and protect property rights. Nonetheless, BEEPS1 and BEEPS2 indicate that, compared with the findings in 1999, the perceptions of the business community in 2002 do show a small (though not statistically significant) overall improvement in the effectiveness of the judiciary. Participating businesses in the survey assess the legal environment in 2002 slightly more favorably, especially on attributes such as fairness, honesty, and affordability. These findings suggest that governments' efforts to strengthen the institutional frame- work for protection of property rights and contracts are having an effect. The Croatian government, for example, has adopted a reform program to address the problems of the country's inefficient court system. The program involves modernizing all commercial courts with the goal to (a) improve compliance with economic and financial legislation, (b) reduce the case backlog in the largest commercial court in Zagreb and other pilot courts by 2003, and (c) speed up bankruptcy proceedings and shorten the time needed for case processing. Because of an ongoing pilot program, fast-track bankruptcy proceedings are expected to be intro- duced in a number of commercial courts. SECURITY AND ENFORCEMENT OF PROPERTY RIGHTS The uncertainty about the security of property rights and institutional arrangements for their enforcement in SEE is particularly acute in issues such as land titling and registration. In all the countries under study, it is not uncommon for several parties to claim to be the legiti- mate owner of disputed land. Unclearly defined property rights usually stem from the lack of accurate and consistent records in land registries and the cadastre, from conflicting and inconsistent efforts to carry out land-use regulation, and from unnecessary delays and overcomplication of administrative procedures as well as the intensive intermediary nature of those procedures (see box 2.8). The lack of formalized property rights prevents the use of dormant assets and their transformation into financial capital. Major difficulties in acquiring state-owned land, agricultural land, and larger plots in general exist throughout the region. For example, in Serbia, most urban land is state owned, but according to the existing land 80 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 2.8 Land Reform in Romania: Identifying and Tackling the Problems In Romania, land acquisition and registration rules vary depending on the type of land. Four types exist: private, state-owned, authority-owned, and free zone land. According to a Foreign Investment Advisory Services (FIAS) study on adminstrative barriers, the major problems in land acquisition are as fol- lows: (a) land is regulated on the local level, and each municipality has its own procedures; (b) identification of the real owners is difficult because 70 percent of the issued land titles end up in litigation; (c) so far, restitution has been made only for agricultural land outside city borders; (d) there is no legal obligation to register land, so cadastre records are incomplete; and (e) there is a lack of sufficient coordination between local courts (which register the titles) and cadastres (which keep the records). Although a sin- gle land registration system, with only one land book, was established in 1999, the unification process has been slow. Registration is done at the local level with little coordination among the cities. FIAS's recommenda- tions are directed toward removing the legal and procedural difficulties, completing the unification of land registration, and introducing a system to resolve land claims quickly and effectively. Source: FIAS (2000). regime, state-owned land cannot be acquired (FIAS 2001b). In addition, the land books in Serbia are outdated and incomplete. As a result, land titles are often not registered, and parcels are missing from the cadastre, which leads to further delays and complications in the transfer of owner- ship of private land. Insecurity of land tenure and rights limits the use and value of prop- erty in business transactions. In Bosnia and Herzegovina, for example, the court process for repossessing assets is too long, allowing owners to strip all assets of value from the property or enterprise in question. The complicated and obsolescent system of land registry poses significant problems that, together with the unresolved problems of clear ownership and the inadequate regulations governing collateral, severely restrict access to working capital. New firms in Albania and FYR Macedonia perceive very weak security of contracts and property rights. These perceptions are based in part on excessively broad legal interpretations of the principle of expropriation for public purpose, which covers construction of gas and oil pipelines, con- struction of electricity generation and distribution facilities, preservation INSTITUTIONAL REFORM PROGRESS 81 of cultural heritage, maintenance of public order and national security, and construction of public housing blocks. The reform efforts in the region are directed at overcoming the hurdles of the process through strengthening the institutional framework and introducing viable restitution policy and land laws. Initiatives to reform and modernize the cadastre system as well as to advance restitution policy reforms are under way in all countries in the region. To overcome the deficiencies in the enforcement of property rights and contracts, the FYR Macedonia has eased collateral constraints and estab- lished a system of national registries. The newly created Central Register Organization is now responsible for development and maintenance of movable and immovable collateral registers as well as a central legal entities database. Although the state still needs to resolve claims on land under the 1998 Land Restitution Law, a new rural land-use law was enacted that introduces a basis for secure property and tenancy rights. However, a workable title registry is not yet in place, which continues to make land titling difficult. RESOLUTION OF BUSINESS DISPUTES Establishing a formal system that secures and defines property rights fos- ters the resolution of commercial disputes. The countries in the region are working actively toward improving enforcement of commercial dispute resolutions--although with varying degrees of success. Progress is slow, especially in the absence of effective appeals mechanisms, which makes resolution of business disputes obsolete. The introduction of mechanisms for alternative dispute resolution (ADR)--a variety of methods for resolving disputes using out-of-court pro- cedures such as mediation, arbitration, or both--is gaining popularity in SEE.Although ratifying the major international conventions in all the SEE8 is an important and necessary step toward the use ofADR, harmonizing the national laws and establishing suitable institutions for out-of-court settle- ment of disputes requires more than the mere ratification of the interna- tional rules in this area. In fact, ADR needs to complement judicial reform in the region and must be used to foster efficiency in dispute resolution. In this vein, for example, the government of Serbia and Montenegro is currently working on a law to further modernize and expand the scope of arbitration. Independent centers for ADR have been established throughout the region. And yet, in all the SEE8, arbitration is not a com- monly used tool for dispute resolution and remains largely underdevel- oped. Given the cumbersome procedures for resolving disputes through the court system, ADR may gain importance and provide a viable alter- native to enduring the delays, inaccessibility, expenses, and unsatisfactory outcomes of the formal legal system. 82 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Conclusion: The Unresolved Institutional Problems in South Eastern Europe South Eastern Europe has made solid progress in establishing an appro- priate institutional environment for the formation and functioning of private enterprises. Initiatives include the passage of company and commercial laws, laws on collateral and secured lending, and bank- ruptcy laws. However, substantial challenges still remain throughout the region. Although most of the SEE8 have adopted policies to foster enter- prise restructuring and privatization of assets, more decisive institution- al solutions are needed to create conditions for a business environment that favors competition, respects property rights, protects creditors, and treats equally all participants in the market. Advancing these "second generation" reforms would encourage investment (both domestic and foreign) into productive ventures and would promote sustainable growth in the region. Developing these market institutions in the eight countries is not only critical to creating an investment-friendly policy framework but also necessary for their integration with Western Europe. The main messages of this chapter highlight the deficiencies in the development of the four market institutions that are explored in detail in the subsequent chapters: competition and barriers to entry and exit, reg- ulated infrastructure utilities, corporate ownership, and resolution of business disputes. First, most of the countries have adopted policies directed to remove administrative barriers (for example, streamlining business licensing and registration procedures). In many of the coun- tries, however, failure to implement the improved registration or licens- ing requirements in a predictable manner and failure to interpret laws and regulations consistently has led to discrimination among different types of investors and, thus, to deficiencies and corruption. More impor- tant, few of the countries have strengthened the fundamental market institutions that protect firms from anticompetitive structures and con- duct; although some of the countries have sound competition laws, the use of these instruments to reduce economic barriers to entry is almost universally neglected. Furthermore, key legislation has yet to be imple- mented to facilitate the restructuring or liquidation of large loss-making enterprises. Second, countries are in the process of overcoming the severe infra- structure bottlenecks caused by the conflict and inadequate maintenance that have characterized the region--though to different extents, depend- ing on the country and sector. However, the development of predictable and transparent regulatory frameworks that would ensure users' access to competitively priced, high-quality services and that would engender investment in the utility sectors (and, generally, in infrastructure) is lag- ging in all countries. Indeed, the inefficient pricing and cross-subsidies INSTITUTIONAL REFORM PROGRESS 83 embedded in many of these sectors stifle incentives for attracting investors and privatizing utilities. Third, the governments of the SEE8 have shifted away from insider techniques of state ownership divestiture and have increasingly relied on more transparent methods of privatization. However, although some countries have adopted international accounting standards and have introduced independent financial audits for enterprises, most are still in the process of doing so. In addition, adoption of these instruments needs to be supplemented with the training of managers who can properly interpret and use the improved financial information to engender improved enterprise performance. At the same time, in most countries, enforcement of commercial legislation is still ineffective in protecting minority shareholders and in imposing the needed discipline of financial disclosure and transactional transparency. As a result, there are weak checks and balances on managerial performance. Fourth, the legal frameworks help ensure the protection of property rights and the enforcement of contracts in all countries. But the function- ing of the associated institutions is limited by lengthy procedures, by the lack of qualified and independent judges, and by weak enforcement mechanisms. Alternative out-of-court administrative channels for dis- pute resolution--such as the use of arbitration--are underdeveloped in all eight countries. In addition, inefficient registration systems for land and property rights present another source of dispute and a further bar- rier to investment in most of South Eastern Europe. Endnotes 1. This improvement might be interpreted as a strong evidence of the similar- ities of the SEE8. However, it depends crucially on the level of aggregation of the indicators and hides a substantial variation in each single subcomponent, as our more detailed analysis will show. 2. Throughout the region, the ownership transformation process for most medium-size and small enterprises has been completed in just a few years. Conversely, the large-scale transformation of ownership has lagged substantially across the region, except in Bulgaria (EBRD 2002). 3. Most of the self-employed in Romania are in agriculture, operating small, family farms. 4. The budgets of both entities rely to a considerable extent on fines from inspections. Inspectors have the right to shut down a company or to seize goods. Companies are also vulnerable to inspectors discovering fictitious viola- tions of nonexistent regulations or to political opponents who make them tar- gets. For more detailed information, see FIAS (2001a) and Stability Pact and OECD (2003). 84 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE 5. These initiatives follow the recommendations of the FIAS (2001a). See also Stability Pact and OECD (2003). 6. Moldova adopted bankruptcy regulations in November 2001 that went into effect as in January 2002. 7. The information on Serbia and Montenegro in this and subsequent sections is largely based on World Bank (2001a). 8. A thorough description is contained in World Bank (2001b). 9. In March 2003, the government of FYR Macedonia adopted draft changes to the VAT law. Under the amendments, the general VAT rate will be reduced from 19 percent to 18 percent, but the tax base will be expanded because the 5 percent rate for most of the preferential products and services will be abolished. 10. These payment bureaus handled all transfers within the country, collected taxes, and reported on tax payments. They had the power to decide who was to be paid and when, as well as the power to divert tax funds to political parties and other nongovernmental institutions. Under the new system, the tax authorities are directly responsible for collecting taxes. For additional information, see also the country assessment for Bosnia and Herzegovina in EBRD (2001c). 11. For more information on KESH, see box 4.3 in chapter 4. 12. In addition, the budget would have to provide subsidies amounting to US$9 million to the budgetary and nonbudgetary entities (primarily the water and mining companies). Subsidy levels from 2002 are projected to fall by 25 per- cent annually. See also Albanian Ministry of Finance (2001). 13. The Directive on the Periods of Operating Licenses regulates the issue of licenses in the energy sector. See Stability Pact (2003a). 14. See, for example, the home page of the Trade and Transport Facilitation in Southeast Europe Program at http://www.seerecon.org/RegionalInitiatives/ TTFSE. 15. For detailed assessment of the water resource management in the Balkans, see World Bank (2003c). 16. The Czech experience with voucher privatization is particularly telling, as are cases from the Russian Federation. See, for example, Shleifer and Vishny (1997). 17. A comprehensive review of the privatization program is provided by Hashi and Xhillari (1999). 18. The Romanian legislature created several mechanisms for easing the process, including the following: (a) arrears as of December 2001 would be writ- ten off for companies that were to be privatized; (b) creditor utilities would have 90 days to decide on writing off company debts, rescheduling them, or converting them into shares; (c) regardless of the prices sought by the state, the firms would be sold at any price offered, including a nominal price of, for example, 1. 19. Employees and other eligible citizens can retain up to 30 percent of the shares, depending on the pace of the firm's privatization. 20. The privatization law amendments include measures to help ensure that company insiders cannot block a sale indefinitely and that existing owners and INSTITUTIONAL REFORM PROGRESS 85 managers cannot artificially raise the cost to buyers through social programs and redundancy packages (see EBRD 2003, p. 188). 21. The information on corporate governance legislation in this and other sec- tions is based on information provided by the EBRD Legal Transition Team. 22. Derivative suit rights are actions brought by a shareholder on behalf of a corporation to protect the company's legal rights. 23. These planned amendments are supported by FESAL 2000. 24. In March 2002, the Tirana Stock Exchange was registered as a joint-stock company with a single owner, the Ministry of Finance. As of December 2003, the stock exchange was still preparing the legal and administrative framework nec- essary for the start of operations. 25. For an extensive discussion on the EBRD legal surveys, see Ramasastry (2002). 26. There are 16 commercial courts in Serbia and Montenegro (including one in Kosovo). 27. For instance, in Albania, 2 years after the government made the decision to establish a new institution, the Judicial Inspectors' Office, it is still debating the role of this new institution. References Albanian Council of Ministers. 2001. "Strategy on Growth and Poverty Reduction." Tirana. Albanian Ministry of Finance. 2001. "Medium-Term Expenditure Framework." Tirana. Processed. Anticorruption Coordination Commission. 2004. "Anticorruption.bg." Sofia. Available online at http://www.anticorruption.bg/index_eng. php. Berglof, Erik, and Patrick Bolton. 2002. "The Great Divide and Beyond: Financial Architecture in Transition." Journal of Economic Perspectives 16(1):77­100. Bornstein, Morris. 2001. "Post-Privatisation Enterprise Restructuring." Post-Communist Economies 13(1):189­203. Center for International Private Enterprise. 2001. "Coalition 2000: A Public-Private Partnership." Washington, D.C. Available online at http://www.cipe.org/programs/corruption/c2000.htm. Djankov, Simeon, and Peter Murrell. 2002. "Enterprise Restructuring in Transition: A Quantitative Survey." Journal of Economic Literature 40(3): 739­92. 86 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Earle, John S., and Almos Telegdy. 2002. "Privatization Methods and Productivity Effects in Romanian Industrial Enterprises." W. E. Upjohn Institute Staff Working Paper 02-81. W. E Upjohn Institute for Employment Research, Kalamazoo, Mich. Available online at http:// ssrn.com/abstract=292825. EBRD (European Bank for Reconstruction and Development). 2001a. Belgrade Municipal Infrastructure Reconstruction Programme Project. London. ------. 2001b. Railways Recovery Project for Bosnia and Herzegovina. London. ------. 2001c. Transition Report 2001: Energy in Transition. London. ------. 2002. Transition Report 2002: Agriculture and Rural Transition. London. ------. 2003. Transition Report 2003: Integration and Regional Cooperation. London. EBRD and World Bank. 1999. Business Environment and Enterprise Performance Survey (BEEPS1). London and Washington, D.C. Data available online at http://info.worldbank.org/governance/beeps. ------. 2002. Business Environment and Enterprise Performance Survey (BEEPS2). London and Washington, D.C. Data available online at http://info.worldbank.org/governance/beeps2002. European Commission. 2003a. "Albania: Stabilisation and Association Report 2003." Commission Staff Working Paper. Brussels. Available at online at http://europa.eu.int/comm/external_relations/see/sap/ rep2/com03_339_en.pdf. ------. 2003b. "European Charter for Small Enterprises." Brussels. Available online at http://europa.eu.int/comm/enterprise/ enterprise_policy/charter. ------. 2003c. "Former Yugoslav Republic of Macedonia: Stabilisation and Association Report 2003." Commission Staff Working Paper. Brussels. Available online at http://europa.eu.int/comm/ external_relations/see/sap/rep2/com03_342_en.pdf. ------. 2003d. "Report from the Commission: The Stabilisation and Association Process for South East Europe. Second Annual Report." INSTITUTIONAL REFORM PROGRESS 87 Brussels. Available online at http://europa.eu.int/comm/ external_relations/see/sap/rep2/com03_139_en.pdf. FIAS (Foreign InvestmentAdvisory Services). 2000. Romania Administrative Barriers. Washington, D.C. ------. 2001a. Bosnia and Herzegovina Commercial Legal Framework and Administrative Barriers to Investment. Washington, D.C. ------. 2001b. The Climate for FDI: Serbia. Washington, D.C. Gupta, Pooman, Rachel Kleinfeld, and Gonzalo Salinas. 2002. Legal and Judicial Reform in Europe and Central Asia. Washington, D.C.: World Bank. Hashi, Iraj, and Lindita Xhillari. 1999. "Privatization and Transition in Albania." Post-Communist Economies 11(1):99­125. Heritage Foundation. 2003. "Index of Economic Freedoms Database." Available on line at http://www.heritage.org. Kaufmann, Daniel, Aart Kraay, and Massimo Mastruzzi. 2003. "Governance Matters III: Governance Indicators for 1996­2002." Policy Research Working Paper 3106. World Bank, Washington, D.C. OECD (Organisation for Economic Co-operation and Development). 2000. Country Fact Sheets: A Summary of the Current State of the Investment and Business Environment and Key Policy Reform Priorities in South East Europe. Paris. Available online at http://www.investment- compact.org/pdf/CFSxpress.pdf. OECD, South East Corporate Governance Roundtable. 2003. White Paper on Corporate Governance in South East Europe. Paris. Available online at http://www.investmentcompact.org/pdf/CGWhitePaper.pdf. Ramasastry, Anita. 2002. "What Local Lawyers Think: A Retrospective on the EBRD's Legal Indicator Surveys." Law in Transition (Autumn): 14­30 Shleifer, Andrei, and Robert W. Vishny. 1997. "A Survey of Corporate Governance." Journal of Finance 52(2):737­83. Stability Pact. 2003a. "National Measures Providing Exceptions to National Treatment in South East European Countries: Regional 88 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Overview." Submitted to the Investment Compact Project Team Meeting, Bucharest, October 13. Available online at http://www. investmentcompact.org/pdf/9thPTMtgNTOverview.pdf. ------. 2003b. "Regional Network of Foreign Investor Organisations: Summary Note on Role and Terms of Reference of the Network." Available online at http://www.investmentcompact.org/pdf/ 9thPTMtgRegionalFIC.pdf. ------. 2003c. Summary Report: Ministerial Conference on "Pushing Ahead with Reform: Removing Obstacles to FDI in SEE." Available online at http://www.investmentcompact.org/pdf/Min2003Summary.pdf. Stability Pact and OECD (Organisation for Economic Co-operation and Development). 2003. "Progress in Policy Reform in South East Europe: Monitoring Instruments." 3rd ed. Paris. Available online at http:// www.investmentcompact.org/pdf/MONITORING_2003.pdf. World Bank. 2000. Croatia: A Policy Agenda for Reform and Growth. Washington, D.C. ------. 2001a. Breaking with the Past: The Path to Stability and Growth. Volume 1: The Economic, Social, and Institutional Reform Agenda. Washington, D.C. Available online at http://www.seerecon.org/ serbiamontenegro/documents/ertp/. ------. 2001b. Croatia: Country Assistance Strategy Progress Report. Washington, D.C. ------. 2001c. "President's Report on the World Bank Structural Adjustment Loan to Croatia." World Bank Report P7490-HR, October. Washington, D.C. ------. 2001d. World Bank Country Economic Memorandum on Serbia and Montenegro. Washington, D.C. ------. 2003a. Doing Business database. Washington, D.C. Available online at http://rru.worldbank.org/DoingBusiness/. ------. 2003b. "Trade, Energy, and Infrastructure in South Eastern Europe: Concept Note for World Bank Strategy Study." Washington, D.C. ------. 2003c. Water Resources Management in South Eastern Europe. World Bank, Washington, D.C. 3 Competition in South Eastern Europe Developing and strengthening institutions that engender vigorous inter- enterprise competition is essential to improving the investment climate and accelerating sustainable growth in South Eastern Europe (SEE). Along with key institutional reforms in three areas--greater financial trans- parency, accountability, and protection of property rights; more effective mechanisms to settle commercial disputes; and improved access of busi- nesses to better quality and efficiently priced infrastructure services1--a more competitive business environment in SEE will help capitalize on the economic reform progress made to date and further enhance peace and stability in the region. The European Union's trade-opening measures of 2001 have helped improve South Eastern European firms' access to Western European mar- kets, and intraregional trade liberalization is also high on the policy agen- das of South Eastern European authorities (World Bank 2003). However, in the absence of institutional reforms that propagate robust "behind- the-border" competition within and among countries in the region--by facilitating the entry of new firms, restructuring of noncompetitive busi- nesses, and reorganizing or liquidating commercially nonviable firms that take up "economic space"--such trade opportunities will not be effec- tively realized.2 As discussed in chapter 1, most South Eastern European countries have chronically high rates of unemployment and low rates of job creation, which reflect and exacerbate the persistently high poverty rates in the region. The experience of many other transition economies is that institutional reforms that enhance enterprise competition--even reforms that provide opportu- nities for credible threats of entry by new competitors--discipline ineffi- cient businesses to restructure and improve performance. Although there may be short-term social costs from greater enterprise competition and restructuring, particularly if social safety nets are inadequately developed,3 89 90 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE there is abundant evidence that, in the medium term, increased business rivalry and the presence of new entrants, including small and medium- size enterprises (SMEs), are the main engines of job creation, growth, and prosperity. This chapter assesses the incentives and constraints on competition in the eight South Eastern European countries (SEE8) that are the focus of this study and recommends policies for reform. In developing policy recom- mendations, the study relies on both at the aggregated level--through firm-level quantitative surveys (the two European Bank for Reconstruc- tion and Development [EBRD]­World Bank Business Environment and Enterprise Performance Surveys, BEEPS1 of 1999 and BEEPS2 of 2002)-- and at a disaggregated level--focusing on certain industry sectors through the 40 qualitative business case studies developed in the field. The chapter illuminates salient cross-country differences in the nature of competition across the eight economies and shows how South Eastern European firms both respond to and shape these differences. The chapter also highlights the evolution of cross-country changes in enterprise competition over time, focusing on changes between 1998/99 and 2002 (the two periods covered by BEEPS1 and BEEPS2). The aspirations of the South Eastern European authorities and investors (both domestic and foreign) necessi- tate progress beyond such narrow issues as administrative barriers to firm registration and licensing. To that end, the chapter focuses on the funda- mental determinants of competition.Athorough diagnosis of basic market institutions and their effect on competition is essential for the design of "second generation" medium-term structural policy reforms. In brief, our analysis concludes that many industrial firms in SEE are, in differing degrees, effectively immune to robust competitive market forces, not only because of administrative impediments, but also, more importantly, because of more entrenched institutional and structural ones. These impediments are especially found at the local level, where in many sectors horizontal and vertical market power is possessed by incumbent firms, some of which enjoy protection from both appreciable barriers to exit as well as high barriers to entry by new rivals. There is an apparent trend, however, that over the period under examination, com- petitive pressures within individual countries and the region as a whole are modestly increasing. The competition may be due to economywide structural reforms, including those in competition policy, and because of greater exposure of SEE8 firms to the international marketplace. Still, progress is considerably uneven among the countries, necessitating an extensive and ambitious set of reforms. With respect to policy recommendations, we conclude that certain competition-enhancing reforms will apply to all the SEE8. However, given the economic (and political and social) heterogeneity of the SEE8, in some countries, where the transition is more complex, more funda- mental institution-building and policy changes are required. A general COMPETITION IN SOUTH EASTERN EUROPE 91 policy theme that emerges from the contemporary history of these countries--where geographic boundaries are widely at variance with more natural economic boundaries--is the need to strike a balance, over the medium term, between policies that reduce anticompetitive structur- al conditions (such as through horizontal or vertical divestiture) and those that allow for sufficient economies of scale and scope. Conversely, policies and institutions that impede entry of new private- sector competitors should be reformed in the short run. Indeed, even if excessive horizontal and vertical structural dominance remains, facilitating free entry and exit can help make such markets contestable and can provide strong pressures to compel competitive performance from incumbents. At the country level, it is equally important in the short run to fortify rules- based institutional frameworks for implementing and enforcing competi- tion policy with a view to reducing discretion, increasing transparency and predictability, and enhancing incentives for accountability. In the medium term, a case may be made for coordination of competition policy across the region, a likely outcome of European Union (EU) accession. This chapter is organized as follows. We first assess the prospects for interenterprise competition within and among the SEE8 by examining the extent of the development of private sector businesses in the region over the past decade as well as the attributes of that development. We then analyze the competitive nature of industry in the region by assessing the horizontal and vertical dimensions of South Eastern European markets. The next section concentrates on the nature and extent of barriers to entry and exit in the SEE8 and assesses both the structural and behavioral sources of such barriers. Finally, we examine the relationship between competition, firm growth, and performance of SEE8 businesses before concluding with policy recommendations. Development of the Private Sector and Prospects for Competition in SEE International experience shows that in the transition economies the exis- tence of a substantial private sector is generally a prerequisite for the oper- ation of competitive market forces (see, for example, Djankov and Murrell 2002). The emergence of private sector businesses in the SEE8 economies has been one of the hallmarks of the countries' enterprise reform pro- grams since the transition period began. Table 3.1 examines the pattern of the development of the private sector among the SEE8. As of 2002 (the lat- est year for which comparable data are available) most of the countries had private sectors whose output values contributed to at least 50 percent of national gross domestic product (GDP). For the region as a whole, the average share of GDP accounted for by the private sector was approxi- mately 58 percent. There is, however, considerable variation across the countries: Albania and Bulgaria have private sector shares of GDP of 92 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.1 Private Sector Share of GDP in the SEE8 (percent) Country 1993 1998 2002 Albania 40.0 75.0 75.0 Bosnia and Herzegovina -- 35.0 45.0 Bulgaria 35.0 65.0 75.0 Croatia 30.0 55.0 60.0 Macedonia, FYR 35.0 55.0 60.0 Moldova 15.0 50.0 50.0 Romania 35.0 60.0 65.0 Serbia and Montenegro -- -- 45.0 SEE8 average 30.0 57.0 59.4 Source: EBRD (2003). Note: -- not available. 75 percent, while private sector businesses in Bosnia and Herzegovina and in Serbia and Montenegro contribute only 45 percent of GDP. The pattern of development of the private sector in SEE has also var- ied over time. Table 3.1 indicates that, although there was a substantial increase in private sector development in the early to mid-1990s, since 1998 the trend has slowed considerably. Many of the current SEE8 private sector firms had their origins in the privatization of state-owned or "socially owned" enterprises. However, unlike the transition economies of the Russian Federation or the Czech Republic, which engaged in mass privatization early in transition, the scale and rapidity of privatization in SEE have generally been more modest. Thus, as the individual company case studies and the BEEPS data illus- trate, a significant proportion of the number of private sector firms in SEE were established either de novo; as new private subsidiaries (or affiliates) of formerly state-owned enterprises; or as new private foreign joint ven- tures and not through the privatization process (see table 3.2).4 In inter- preting the BEEPS data, however, it is important to keep in mind that the sample of firms covered by the survey was deliberately slanted toward small- and medium-size firms. In other words, the BEEPS data do not por- tray a representative sample of the population of firms in the countries.5 Table 3.2 indicates that the smallest proportion of de novo firms exists in Bosnia and Herzegovina and in Moldova. The table also shows that in 2002, on average, the smallest proportion of current private sector firms that have their genesis in privatization existed in Albania and Serbia and Montenegro. Conversely, privatization was a more significant origin for present-day private sector firms in Bosnia and Herzegovina, Bulgaria, and Moldova. Other BEEPS data indicate that for the surveyed firms the privatizations took place earliest in Croatia and Albania, peaking in COMPETITION IN SOUTH EASTERN EUROPE 93 Table 3.2 Origin of Private Sector Firms in the SEE8, 2002 (percent) Nonprivatized firms Private subsidiary Privatized of former Other state-owned De novo state-owned Joint private Country enterprises enterprise enterprise venture firm Albania 8.78 84.46 0 3.38 3.38 Bosnia and 25.79 67.92 2.52 3.77 0 Herzegovina Bulgaria 19.71 74.52 1.92 3.37 0.48 Croatia 16.89 70.95 2.03 4.05 6.08 Macedonia, FYR 14.11 80.37 3.68 1.84 0.00 Moldova 23.97 67.81 0.68 6.85 0.68 Romania 15.28 77.78 2.78 1.85 2.31 Serbia and 13.07 82.91 0.50 2.31 1.01 Montenegro SEE8 average 17.20 75.84 1.76 3.43 1.74 Sources: EBRD and World Bank (1999, 2002). Table 3.3 Average Annual Sales Revenues of Privatized and De Novo Private Firms by Country, 2001 Privatized De novo Ratio of privatized state-owned private to de novo Country enterprises (US$) enterprises (US$) enterprises Albania 477,800 314,010 1.5 Bosnia and Herzegovina 3,293,570 536,200 6.2 Bulgaria 11,225,170 531,900 21.1 Croatia 5,673,080 1,088,900 5.2 Macedonia, FYR 4,586,360 179,760 25.5 Moldova 705,040 161,720 4.4 Romania 2,126,300 596,270 3.6 Serbia and Montenegro 3,640,090 579,370 6.3 SEE8 average 31,727,410 3,988,130 8.0 Source: EBRD and World Bank (2002). 1994­95, whereas such privatizations occurred more recently for current private sector firms in Bosnia and Herzegovina, Bulgaria, and Serbia and Montenegro, with the bulk taking place between 1998 and 2001. Table 3.3 presents data on the relative size of privatized versus de novo private firms in the SEE8, as measured by average 2001 sales revenues. As might be expected, privatized businesses are larger than their de novo 94 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE counterparts in all countries. The region shows the average size differen- tial as considerable, with privatized firms being eight times larger than de novo firms. There is, however, considerable variation across countries. The greatest differences in size are in FYR Macedonia and Bulgaria, where privatized firms are more than 20 times larger than de novo firms. In contrast, there is an almost negligible size differential among these pri- vate sector firms in Albania. Table 3.4 examines the origin of private firms in the SEE8 across sectors. The manufacturing sector accounts for the greatest proportion of firms Table 3.4 Origin of Private Sector Firms in the SEE8, by Sector, 2002 (percent) Nonprivatized firms Private subsidiary of Sector (share of Privatized former Other sector in total state-owned De novo state-owned Joint private survey sample) enterprise enterprise enterprise venture firm Mining and 2.95 0.28 0.00 2.17 4.35 quarrying (2.0 percent) Construction 9.70 7.48 16.00 2.14 13.04 (9.7 percent) Manufacturing 41.35 25.19 24.00 41.3 21.74 (30.3 percent) Transportation, 7.59 6.06 4.00 15.22 4.35 storage, and communications (7.4 percent) Wholesale and retail 22.78 39.20 40.00 30.43 21.74 trade, motor vehicle repair, and personal and household goods (30.8 percent) Real estate, rentals, 3.38 9.19 0.00 4.35 8.7 and business services (5.1 percent) Hotels and 8.86 6.63 12.00 4.35 13.04 restaurants (9.0 percent) Other services 3.38 5.97 4.00 0.00 13.04 (5.3 percent) Source: EBRD and World Bank (2002). COMPETITION IN SOUTH EASTERN EUROPE 95 that became private through the privatization process. The wholesale and retail trade sector accounts for the largest proportion of private firms that were started de novo. The mining and the transportation, storage, and communication sectors have the smallest proportion of de novo private firms; these sectors typically have higher barriers to entry--a topic we will discuss in detail below. Structural Conditions for Competition in SEE: Horizontal and Vertical Elements Generally, the industrial sectors that many of the SEE8 inherited were not competitively structured. They were often characterized by plants and firms that were disproportionately larger than actual market demand, hence resulting in diseconomies of scale and scope. The distort- ed industrial structure had resulted from central planning's emphasis on heavy industrialization at the expense of services. Socialist objectives dictated that businesses produce goods that did not always accord with market preferences. Production decisions were often dictated by state orders or military needs rather than by supply and demand. Additional- ly, the central planning system actively promoted economic autarky and self-sufficiency for some locales, and extreme regional specialization for some sectors as part of a national assembly-of-components production schema. After a decade of reform and the substantial privatization of the rela- tively large state-owned enterprises, plus the complementary establish- ment of relatively numerous (but smaller) private firms, the results of the business case studies indicate that the private sector in SEE8 industries may still be insufficient to induce commensurate competitively struc- tured markets and the competitive conduct of business operations (box 3.1). Other transition countries' experience suggests such an out- come may be due to weak incentives in the South Eastern European countries' market institutions and policy frameworks. These incentives have produced little restructuring of large state-owned firms and have engendered insufficient restructuring of privatized firms (especially if privatization led to distorted insider control). Furthermore, institutional and policy impediments have allowed firms that were dominant in their sectors to operate unchecked in a largely noncompetitive market struc- ture and have permitted inefficient businesses to continue operations without any consequences of competitive discipline. As reflected in the case studies, enterprise development in the SEE8 has been a competitively weak process. It has given rise to an industrial landscape characterized, in some cases, by dominant firms with large market shares, markets exhibiting "horizontal dominance" of either high 96 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 3.1 Is Ownership Change Enough? A relatively large firm in the construction sector, interviewed for the case studies, is typical of many of today's privatized businesses in SEE. The firm was established in 1952. Six years ago the company was privatized through a management-employee buyout. Currently, it is an insider- controlled joint-stock company that is 100 percent privately owned. The annual turnover of the firm is between US$100 million and US$150 million in revenues. Currently, it employs 3,200 people. In the mid-1990s, it had 7,400 employees. The firm's major customers are still state-owned enter- prises and other public or government entities, which account for approxi- mately 60 percent of the company's sales revenues. Although the bulk of the business is in industrial and infrastructure construction (such as roads, tunnels, bridges, dams, and sewerage systems), the firm also builds resi- dential apartments in a vertically integrated fashion. The firm buys or leases the land, builds the apartments, and then sells the residential units. It only competes with four other construction firms in the country. It also has contracts in neighboring countries, which account for about 25 percent of its sales revenues. The firm's largest overdue receivables are with the government, at both the central and local levels. Often these accounts are settled through barter. seller or high buyer concentration, and enterprises exhibiting a high degree of vertical integration or exclusive buyer-seller relationships. It has also yielded a business environment that continues to be character- ized by "duplication of facilities," artificially located industries, and geo- graphic market segmentation. Sufficiently concentrated horizontal and vertical market structures, reflected by businesses with few competitors and dominant market shares, engender not only market power but also welfare costs to an economy. These include (a) incentives for price collusion (whether tacit or explicit) and higher consumer prices; (b) reduced output; (c) diminished quality in products and service; (d) frozen, commercially unsound, verti- cal transactional relationships and the stifled participation of new sup- pliers and distributors; and (e) opportunities for rent seeking and corruption. Certainly, sizable horizontal and vertical integration can create real eco- nomic efficiencies. In certain industries the technology fundamental to the production process naturally gives rise to (horizontal) economies of scale and scope, and unit costs decline as output expands to meet market demand. In such industries it is unlikely that multiple businesses can all attain the minimum efficient scale to be commercially viable. It is, COMPETITION IN SOUTH EASTERN EUROPE 97 therefore, economically efficient to have only a few large, multiplant firms (horizontal integration) brought about through investment or mergers and acquisitions. But though there may well be significant scale economies in certain segments of an economy's infrastructure or utility sectors, in most manufacturing sectors worldwide, scale economies are unlikely to be as pronounced relative to market demand. Thus there is little economic justification for dominant firms or heavily horizontally concentrated markets. By the same token there can be vertical economies of scale and scope and a savings in transactions costs in combining successive stages of pro- duction under one corporate roof. The classic case of continuous steel- casting is well known. It would be economically inefficient to have three separate firms heating iron ore, rolling it into ingots, and then finishing the ingots into steel products. Most manufacturing processes, however, allow economic efficiencies only up to a point. Indeed, in many manu- facturing sectors throughout the world it is often cheaper for a firm to buy inputs (or sell outputs) on the open market or through arm's-length contracts rather than to produce them internally through ownership of the stages of production (vertical integration). Of course, in many transi- tion economies, pronounced commercial (and often political economy) risks associated with market transactions--for example, because effec- tively enforceable contracts are nascent or because corruption is present-- can be strong incentives for vertical integration. Thus, as we turn to review the data on horizontal and vertical features of the SEE8 markets, it should be noted that there are instances of trade- offs between efficiency and anticompetitive market power of concentrated horizontal and vertical market structures. On the other hand, when markets exhibiting concentrated horizontal and vertical structures are also characterized by the presence of high entry and exit barriers (exam- ined later in this chapter), such tradeoffs are more limited and the prospects for competition are much lower. In such cases, incumbent firms enjoying market power or operating inefficiently are protected from external discipline and thus are effectively immune to competition. The consequences include the aforementioned welfare costs as well as the fol- lowing: (a) constraints on rechanneling enterprise assets and preventing workers from engaging in more productive ways, thus reducing the flex- ibility and resiliency of the economy; (b) diminished incentives for busi- nesses to fully exploit economies of scale and scope, except in expelling rivals through predatory price reductions; (c) stifled incentives for geo- graphic market segmentation and constraints on interregional trade among the SEE8; (d) diminished incentives for innovation and manager- ial improvements; (e) and reduced new investment from domestic and foreign sources. 98 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Horizontal Dimensions of the South Eastern European Market Structure NUMBER OF COMPETITORS As elsewhere, businesses in SEE face a different number of competitors depending on their ownership, on the sector in which they operate, and on specific country attributes. This observation is well documented by the case studies (see box 3.2). The BEEPS data also shed light on these ele- ments in the region's competitive environment, including how they have changed over time. Figure 3.1 shows that, in all the SEE8 combined, the surveyed de novo private firms face a greater number of competitors than do privatized businesses or state-owned enterprises. It also indicates that this pattern Box 3.2 Variation in Number of Competitors The different sectors covered by the case studies revealed variations in the number of competitors firms face. In part, this variation was a function of the sector or the circumstances of the country itself. Most often, however, ownership type seemed to matter significantly. An examination of the tex- tile sector across the eight countries makes the point quite clearly. In Bosnia and Herzegovina, one of the interviewed companies, a state- owned textile firm, was the largest employer in its town. It was founded in the late 1970s. Although it used to sell its fabric throughout all of former Yugoslavia, its production has declined dramatically since the early 1990s-- it is currently operating at only 15 percent of capacity. The company sells 100 percent of its specialized final product and faces no effective domestic competitors. In the nonspecialized fabric it has about a 30 percent share of the domestic market. A fairly successful de novo private textile firm in Serbia and Montenegro, which was founded in the early 1990s, has a small in-house production and design unit of about 15 workers. It farms out much of its assembly operations to other firms, but virtually all of its product line is sold through its own retail stores. It extensively uses branding in advertis- ing. Competition is much more intense at the retail level, especially for products that must compete with cheaper imports. A privatized Croatian textile firm, which dates back to the late 1950s and was privatized in 1993, faces several competitors in the domestic mar- ket that import higher-end fabric or garments mostly from European coun- tries and lower-end products from Turkey and China. Maintaining cash flow from and keeping receivables current with Croatian customers has been difficult for this firm. Foreign customers, however, tend to keep cur- rent. The result has been a shift toward the export market, which now accounts for 60 percent of the firm's sales revenues. COMPETITION IN SOUTH EASTERN EUROPE 99 Figure 3.1 Number of Competitors by Ownership Type, 1999 and 2002 1999 100 none one to three more than three 80 (%) number firm 60 total of of type 40 each of proportion 20 0 de novo privatized state-owned type of ownership 2002 100 none one to three more than three 80 (%) number firm 60 total of of type 40 each of proportion 20 0 de novo privatized state-owned type of ownership Sources: EBRD and World Bank (1999, 2002). has not changed between 1999 and 2002. On the other hand, the BEEPS data show that all the surveyed firms have faced a modestly greater num- ber of competitors over this period, suggesting, all other things being equal, the evolution of a more competitive business environment in the region. These data also show that, on average in 2002, approximately 100 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE 15 percent of the surveyed firms indicated they faced three or fewer com- petitors, whereas 85 percent indicated they competed with four or more firms. However, in interpreting these findings, one must bear in mind that the sample design of the BEEPS is highly skewed toward smaller firms. Thus, the survey respondents will indicate a larger number of competitors than is representative of the actual population of firms in these economies. The variation across the SEE8 in the number of competitors firms faced in 1999 and 2002 is depicted in Figure 3.2. Although in all the countries there was a general increase between 1999 and 2002, FYR Macedonia, at both the start and end of the period, had the greatest proportion of firms reporting that they faced four or more competitors. In 2002, Albania and Moldova had the largest proportion of firms indicating they faced no competitors (3 percent and 2 percent, respectively), and Romania and Albania had the largest proportion of firms indicating three or fewer competitors (18 percent and 15 percent, respectively). Overall, surveyed firms in Albania, Moldova, and Romania indicated the least increase in competition between 1999 and 2002. Table 3.5 shows the differences across industry sectors for all the SEE8 in the number of competitors indicated by the surveyed firms in 2002. Not surprisingly, the sectors in which the surveyed firms indicated the fewest number of competitors were the infrastructure-related sectors-- transport, storage, and communications. In these sectors, where state ownership is greatest, approximately 25 percent of the firms indicated they faced three or fewer competitors. The sectors in which the firms most often indicated that they faced four or more competitors were the construction, trade, and business services. Table 3.5 Number of Competitors by Sector, 2002 (% of firms) 4 or more Sector No competitors 1­3 competitors competitors Mining 0 18.75 81.25 Construction 0 8.96 91.04 Manufacturing 0.70 20.00 79.30 Transportation, 4.65 20.16 75.19 storage, and communications Trade 0 9.37 90.63 Business services 0.75 9.02 90.23 Hotels and 0 11.97 88.03 restaurants Other 2.75 13.76 83.49 Source: EBRD and World Bank (2002). COMPETITION IN SOUTH EASTERN EUROPE 101 Figure 3.2 Number of Competitors by Country, 1999 and 2002 1999 100 none one to three more than three 80 60 competitors of 40 number 20 0 and FYR Albania Bulgaria Croatia Moldova Romania Bosnia Macedonia, Herzegovina 2002 100 80 60 competitors of 40 number 20 0 and and FYR Albania Bulgaria Croatia Moldova Romania Bosnia Macedonia, Serbia Herzegovina Montenegro none one to three more than three Sources: EBRD and World Bank (1999, 2002). 102 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Statistical tests using the BEEPS data for 2002 of the bilateral relationship between the indicated number of competitors and the firm's characteristics indicate some statistically significant correlations. As shown in table A.3.2 in the annex, there is a statistically significant positive relationship between the indicated number of competitors an SEE8 firm faces and the likelihood the firm is de novo private (as opposed to being a privatized or remaining a state-owned business). There is also a statistically significant negative correlation between the indicated number of competitors and (a) firm size, measured by number of employees or sales revenue; (b) market share; (c) extent of horizontal integration, as measured by number of establishments or plants under common ownership (discussed below); and (d) amount of subsidies received as a percentage of sales revenues. MARKET SHARE The case studies suggest that, in general, there is significant variation in the market share attained by SEE8 firms. This variation appears to be associated with the number of competitors a firm faces. Moreover, many of the attributes that are associated with firms that have a relatively lim- ited number of competitors also are associated with firms that have attained high or dominant shares in the markets in which they produce. The converse is also true. Approximately 42 percent of the businesses surveyed under the BEEPS indicated market shares greater than 5 percent, and 58 percent indicated market shares of 5 percent or less. The large proportion of firms reporting small market shares is not surprising, given that the BEEPS concentrated on the smaller firms in the region. However, it is critical to note that the BEEPS market share data do not correct for the relevant geographic boundary of the specific product or sector in question. The survey instrument implicitly assumes all products trade in a national market, even though trade may be limited to local markets for certain products (such as bricks) but may be international for others (such as textiles). Thus, the available data on market share should be seen as an approximation of the real economic span of a firm's horizontal control over a market.6 With that caveat in mind, the BEEPS data do still show important differences in firms' market shares by country, by business ownership, and by sector. Table 3.6 presents data from 2002 for the surveyed firms with market shares greater than 5 percent. On average in the SEE8, firms have attained approximately 30 percent of the share of their markets. Romanian firms enjoy the highest market share, averaging about 45 percent, whereas Croatian firms' average market share is about 22 percent--about one-half the size of their counterparts in Romania. Table 3.6 demonstrates a clear pattern among ownership types. Greater state involvement results in greater dominance of the firm. State-owned SEE8 42.95 29.07 25.93 29.94 o and 30.95 29.65 27.52 28.62 Serbia Montenegr 61.06 31.89 39.00 44.84 Romania 40.63 42.28 23.45 31.97 Moldova 2002 ype,T FYR 39.00 36.94 21.08 25.97 Macedonia, cent. per 5 oatia Cr 34.50 17.92 19.71 21.93 than Ownership eater by gr es 44.88 25.87 35.96 34.78 and Bulgaria shar and market Country 35.60 22.71 28.33 28.01 by Bosnia Herzegovina indicating (2002). Share firms Bank Albania 53.77 23.00 20.34 26.22 orld W surveyed Market and type only 3.6 EBRD cent) Covers novo ce: ableT (per Ownership State-owned Privatized De otalT Sour Note: 103 104 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE enterprises hold the greatest market shares, with an average of 43 per- cent for the region. Within the region, Romanian and state-owned enter- prises in Romania and Serbia and Montenegro register the largest and smallest market shares (61 percent and 31 percent), respectively. Privatized firms exhibit smaller market shares, with a regional average of 29 percent. Moldovan privatized firms exhibit the largest average market shares of 42 percent, whereas Croatian privatized firms registered the smallest, 18 percent. De novo private firms have the smallest market shares, with a regional average of 26 percent. The average Romanian de novo private firm registers the largest market share of 39 percent, and the average Croatian de novo firm registers the smallest market share of 20 percent. Market shares of SEE8 firms also vary significantly by sector. Table 3.7 shows that the firms in infrastructure sectors (transportation, storage, and communications) have the largest market shares--about 42 percent on average for the region. There is, however, great variance across the countries within those sectors. For example, surveyed infrastructure firms in Croatia have on average significantly smaller market shares than do their counterparts in Romania. Still, this finding is consistent with our earlier finding that firms face relatively fewer competitors in the infra- structure sectors, because in those sectors underlying technologies and high fixed costs produce large economies of scale. Conversely, in the hotel and restaurant sector and the trade sector, where competition is greater and economies of scale are small, market shares are low and, further- more, there is much smaller cross-country variance within those sectors. In general, looking across sectors and countries, Romania, Bulgaria, and Moldova are distinguishable as having the most dominant firms in the survey sample. The statistical tests using the 2002 BEEPS data of the bivariate rela- tionship between market share and the firm's characteristics indicate some important statistically significant correlations (see table A.3.2 in the annex). There is a statistically significant negative relationship between the size of a firm's market share and (a) the likelihood that the firm is a de novo private enterprise (rather than a privatized or state-owned enter- prise), (b) the firm's indicated number of competitors, and (c) the likeli- hood that the firm is in the services rather than the manufacturing sector. On the other hand, market share has a statistically significant positive relationship with (a) size, measured by sales revenue or by number of employees; (b) extent of vertical integration (discussed later in this chapter); (c) extent of horizontal integration, (d) subsidies received as a percentage of sales (also discussed below), and (e) technological prowess, measured by spending on research and development (R&D) as a percentage of sales. 1 1 SEE8 31.23 23.41 32.1 41.89 23.27 33.1 19.86 39.97 29.71 o . and or sect 52.50 25.71 26.32 29.00 26.36 44.00 16.67 21.67 28.05 Serbia Montenegr that in 32.86 43.50 58.00 35.91 40.80 25.00 90.00 44.33 surveyed Romania firms no 52.50 34.86 52.86 17.60 28.67 26.00 35.56 31.81 Moldova indicates cell 1 FYR 20.00 20.83 33.1 50.00 21.15 33.67 14.89 32.00 25.97 Empty Macedonia, cent. 2002, per oatia 5 Cr 22.00 23.83 23.00 17.67 20.56 18.43 27.50 36.67 22.03 than Country eater gr by 15.00 12.67 40.67 32.67 29.72 41.67 40.50 45.40 35.58 Bulgaria es shar and and market 30.00 13.40 33.33 25.00 23.64 20.00 19.00 36.17 28.01 Sector Bosnia Herzegovina by indicating (2002). Share firms Albania 17.75 22.19 45.20 18.65 35.00 12.67 44.00 25.60 Bank orld W surveyed Market and and only services 3.7 uction and EBRD cent) Covers ce: ableT (per Sector Mining Constr Manufacturing ransportation,T storage, communications radeT staurantser Business Hotels Other otalT Sour Note: 105 106 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.8 Horizontal Integration: Number of Establishments under Single Firm Ownership, 2002 Ownership type Average number of establishments State-owned 5.72 Privatized 4.74 De novo 2.17 Source: EBRD and World Bank (2002). HORIZONTAL INTEGRATION The effect of horizontal dominance on competition can also depend on the number of production facilities generating similar outputs under the common ownership and control of each firm. All other things being equal, the more extensive the horizontal integration attained by a firm, either within a single geographic market or across geographic markets, the greater its ability to exercise control over market outcomes. Table 3.8 depicts the varying extent of horizontal integration across ownership categories among the surveyed firms in SEE. On average, the horizontal integration of state-owned firms is greater than that of priva- tized or de novo private firms; indeed, the extent of state-owned enter- prises' horizontal integration is more than two and a half times that of de novo private firms. Table 3.9 shows that horizontal integration also varies significantly across the SEE8 and across sectors (although somewhat less so than own- ership categories). Surveyed firms in Albania exhibit the least horizontal integration, whereas firms in Serbia and Montenegro exhibit the most extensive--about three times greater than Albanian firms. Across sectors, infrastructure firms stand out as the most horizontally integrated, and hotels and restaurants, the least: a finding entirely consistent with the other aspects of our analysis. On a bivariate basis, there is a statistically significant positive correlation between horizontal integration and firm size, measured either by number of employees or by sales (table A.3.2 in the annex). Interestingly, there is also a statistically significant positive correlation between horizontal integration and a firm's capital produc- tivity. As other variables were not taken into account, this finding is not conclusive. However, it does suggest economies of scope might arise from such integration. CUSTOMER CHARACTERISTICS Assessing the characteristics of industrial firms' domestic customers sheds light on an important aspect in the way interenterprise competition is mediated in SEE. In this regard, the 2002 BEEPS focuses on (a) the size of the customer and (b) whether the customer is a governmental entity. 1 SEE8 2.47 2.40 2.97 4.53 3.44 3.03 2.12 2.55 3.1 Sector o by and 1 1.75 4.39 4.19 9.05 8.1 5.44 5.33 7.67 6.22 Serbia Montenegr Ownership 1.63 4.16 7.45 2.29 3.88 2.12 1.44 3.33 Romania Firm 1.20 2.18 2.73 1.81 2.67 1.78 1.23 1.90 Single Moldova under FYR 3.50 3.69 1.57 3.00 1.68 1.09 1.50 1.00 1.86 Macedonia, oatia 1.33 1.50 1.76 3.20 3.92 2.46 2.10 1.70 2.64 Cr Establishments of 1 4.00 2.74 4.71 2.92 4.52 2.14 1.14 2.1 3.59 . Bulgaria sector Number and that in 2.00 3.50 2.78 2.50 1.89 1.29 1.40 1.75 2.30 Bosnia Herzegovina surveyed Integration: 1 (2002). firms 1.05 1.34 2.21 1.64 1.1 1.00 1.33 1.44 Albania no 2002, Bank orld W indicate Horizontal and cells Country services 3.9 by uction and EBRD Empty ce: ableT and Sector Mining Constr Manufacturing ransportation,T storage, communications radeT staurantser Business Hotels Other otalT Sour Note: 107 108 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.10 Share of Revenue Earned from Sales to Customers of Different Size by Firms of Different Ownership Type, 2002 Ownership type Large customersa Small customers State-owned 18.4 54.9 Privatized 21.3 60.8 De novo 12.8 68.8 Source: EBRD and World Bank (2002). a. Large customers are defined as having more than 250 employees. For the region as a whole, the surveyed firms indicated that, on aver- age, 15 percent of sales are to customers that are large businesses (those with 250 or more employees) and 66 percent of sales are to customers that are small businesses, individuals, and so forth. The result is not surprising given the small-firm bias in the sample design of the survey. There is con- siderable cross-country variation, however. Albanian firms registered the smallest proportion of sales to large customers (about 4 percent), and Croatian firms the greatest (about 23 percent). Moldovan firms indicated the largest proportion of sales to small customers (about 84 percent), whereas the smallest proportion of sales to small customers was indicat- ed by firms in Serbia and Montenegro and Bosnia and Herzegovina (both approximately 50 percent). A more striking pattern emerges in compar- ing proportion of sales to customers of different size by firms of varying ownership type. As depicted in table 3.10, both privatized and state- owned firms earn a significantly greater proportion of their sales rev- enues from large firms than do de novo private firms. The converse is true with respect to the proportion of sales to small customers: de novo private firms earn a significantly greater proportion of their sales revenue from small customers than do state-owned enterprises and privatized firms. Further, on average for the overall SEE region, about 5 percent of all the surveyed firms' combined sales revenues are earned from govern- ment entities. There is, of course, variation across the countries and across ownership types. Although the average Albanian firm earns about 16 percent of sales revenues from transactions with government, the average firm from FYR Macedonia or Romania earns approximately 3 percent of sales revenues from government purchases. Figure 3.3 shows a clear trend of the heavy reliance by state-owned enterprises on sales to government in comparison with the case with de novo private firms (except in FYR Macedonia). On average state-owned enterprises' sales revenues from government transactions are about 12 percent, whereas such trans- actions account for less than 4 percent of de novo firms' sales, a difference by a factor of four. COMPETITION IN SOUTH EASTERN EUROPE 109 Figure 3.3 Sales to Governmental Entities by Ownership Type and by Country, 2002 40 state-owned privatized de novo 30 government to 20 sales 10 domestic of % 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro Source: EBRD and World Bank (2002). HORIZONTAL EXPANSION AND INTERNATIONAL EXPOSURE The extent to which SEE8 businesses have expanded into or are exposed to competition from rivals in international markets is a critical issue in assessing the competitiveness of the firms and domestic markets of the eight countries as well as the competitiveness of the region overall. Inter- national exposure may be through (a) direct or portfolio investment, licensing agreements, or other forms of partnerships and/or (b) exports. On the first score, the BEEPS assessed whether an SEE8 firm had any holdings or operations outside its home country. Figure 3.4 shows that on average for the region, 14 percent of the firms had such holdings or operations. Across the eight countries, a greater proportion of firms based in FYR Macedonia indicated that they had holdings or operations abroad than firms in any other country. Albania had the smallest pro- portion of firms with international exposure. The second factor, export intensity patterns, both across countries and across sectors, is shown in tables 3.11 and 3.12. On a regional basis, export receipts of the surveyed SEE8 firms represent about 13 percent of their total sales revenues, on average. The average Bulgarian firm indicated the greatest proportion of sales revenues from exports--almost 16 percent-- whereas the average firm in Serbia and Montenegro reported the lowest 110 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.4 Firms with Holdings or Operations outside Their Home Countries, 2002 35 30 25 firms 20 total 15 of % 10 5 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro Source: EBRD and World Bank (2002). Table 3.11 Export Intensity by Country, 2002 Country Export receipts as a percentage of sales revenue Albania 14.8 Bosnia and Herzegovina 10.6 Bulgaria 15.7 Croatia 12.4 Macedonia, FYR 14.1 Moldova 15.5 Romania 11.8 Serbia and Montenegro 6.8 SEE8 average 12.5 Source: EBRD and World Bank (2002). export intensity--roughly 7 percent of sales revenues. Across sectors, the survey data indicate that construction firms--which, as our case studies reveal (see box 3.3), tend to concentrate on their domestic markets (espe- cially public procurement contracts)--derive the least proportion of sales revenues from exports (about 3 percent). In contrast, the contribution of COMPETITION IN SOUTH EASTERN EUROPE 111 Table 3.12 Export Intensity by Sector, 2002 Sector Export receipts as a % of sales revenue Mining 21.3 Construction 3.1 Manufacturing 22.5 Transportation, storage, and 19.7 communications Trade 7.3 Business services 6.7 Hotels and restaurants 11.6 Other 4.7 Source: EBRD and World Bank (2002). Box 3.3 The "Home-Grown" Construction Sector in SEE Most of the sales of construction firms in SEE are concentrated in the domestic market and, in some cases, the municipal market, in which they are located. Bidding on government and (to a lesser extent) private contracts with neighboring or more distant countries is increasingly attempted but is not always successful. During the case studies, firms complained that they are subject to discrimination as foreign firms and that preference is shown to local companies, especially in the case of public procurement contracts. Consequently, home governments have sought to help their domestic firms win public contracts abroad through political suasion. In general, however, the construction firms that served as case studies find home government contracts quite attractive--some companies do more than 70 percent of their business with the government. However, the "competitive" selection process is not always transparent, and often the government agencies do not pay promptly, necessitating litigation. Some firms note that to be successful in the domestic public procurement construction business, they must be politically well connected. In some cases, ministries ask for pro bono construction, design or engineering advice, which the firms readily give in order to build goodwill. A few construction firms concentrate on winning construction contracts from domestic private companies or foreign private multina- tional subsidiaries located in the local market; complaints about lack of transparency in the contracting process are voiced here as well, but these complaints are more muted than in the case of domestic public procure- ment contracts. Some of these firms are interested in pursuing government contracts, but without a public procurement law in place, they are reluctant to do so. 112 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.13 Proportion of Firms Having New Export Destinations, 1998­2002 % of firms that made exports Country to new countries since 1998 Albania 11.2 Bosnia and Herzegovina 16.6 Bulgaria 25.2 Croatia 20.0 Macedonia, FYR 20.2 Moldova 50.8 Romania 32.6 Serbia and Montenegro 12.4 SEE8 average 20.2 Source: EBRD and World Bank (2002). export receipts to sales revenue is greatest for manufacturing firms (almost 23 percent). Finally, table 3.13. depicts international horizontal expansion as shown by the percentage of SEE8 firms that exported to new markets between 1998 and 2002. On average, 20 percent of the firms in the region indicat- ed that they exported to new markets during the period. Moldova had the largest proportion of firms indicating new export destinations (about 51 percent), whereas Albania registered the smallest proportion (about 11 percent). PERCEIVED MARKET POWER: PRICE AND SALES SENSITIVITY, MARKET SHARE, AND NUMBER OF COMPETITORS Firms that achieve sufficient market dominance as a result of facing fewer competitors and attaining appreciable market share should, all other things being equal, have greater discretion in price setting. Consequently, the sensitivity of such firms in changing output--and in expected sales-- in response to changes in prices should be less than that of firms facing a greater number of competitors but exhibiting large market shares. Box 3.4 illustrates the point with an example of price wars in one of the sectors in which the case studies were carried out. Tables 3.14 and 3.15, both based on BEEPS2 data, present interesting data on SEE8 firms' perceptions of their market power. The survey posed a hypothetical question to the respondents about how their firms' sales would be affected by a 10 percent increase in the market price of their principal output. Across the SEE8, on average, a significantly smaller proportion of Moldovan firms, relative to the other eight countries, indi- cated that their sales would not decrease. Bulgaria registered the largest COMPETITION IN SOUTH EASTERN EUROPE 113 Box 3.4 Market Dominance and Anticompetitive Pricing in SEE The market structure in a sector represented in the case studies is best characterized as a core of a few large, dominant firms and a competitive fringe of more numerous small- and medium-sized firms. The combined market share of the three dominant firms--which are either privatized or de novo private enterprises--is approximately 45 percent. About seven other firms--all of medium size, mostly state-owned enterprises but also some private businesses--have a combined market share of 15 to 20 per- cent. The remaining share of the market comprises many small private firms. One of the private medium-size firms, which is affiliated with a major local bank, has been an aggressive marketer and has tried to break into the dominant core. Its market share in 2001 was 2.6 percent, but a year later its share had increased to 4.5 percent. The senior manager of this firm voiced great concern that his company was suffering from "unfair competition." In particular, pricing behavior in this market is often predatory, with the dominant firms lowering prices to try to drive out competitors. The result has been frequent price wars. One of the price wars was so destructive to the involved firms' bottom lines that this senior manager invited the two other chief executive officers over for lunch. In a discussion that lasted almost 5 hours, they agreed to fix prices on certain key products. One of the participants agreed to stop selling at a lower price for 2 months, another for 4 months, and the third for 1 month. Because they had the same or similar suppliers, they also agreed on markup margins. The margins were fixed at 25 to 30 percent for one firm, 22 to 23 percent for another, and 13 to 18 percent for the third. It is likely that the participants accepted the pricing deal in part because they were seeking credits from the firm affiliated with the bank. After 4 months, the predatory pricing resumed. proportion of firms that perceived losing all their sales to rivals, although the proportion of Moldovan firms was only slightly smaller. This finding suggests that Moldovan firms--and to a lesser extent Bulgarian firms--perceive themselves as relatively less able to exercise market power than surveyed firms in the other countries. At the other end of the spectrum, firms in Serbia and Montenegro, and to a lesser extent, firms in Romania, perceive themselves as relatively better able to exercise market power. Across firm ownership categories, a greater proportion of state-owned enterprises clearly perceive themselves as being able to exercise greater market power than do privatized or de novo private firms. Interestingly, 114 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.14 Expected Sales Change after a 10 Percent Price Increase, by Country, 2002 (percent) Sales would All sales would Country not decrease accrue to rivals Albania 13.0 29.0 Bosnia and Herzegovina 13.4 29.1 Bulgaria 16.1 38.8 Croatia 16.7 23.1 Macedonia, FYR 16.0 28.4 Moldova 8.6 37.4 Romania 25.5 26.3 Serbia and Montenegro 24.4 18.8 SEE8 average 17.5 28.6 Source: EBRD and World Bank (2002). Note: Table shows the percentage of surveyed firms indicating that sales would not decrease or that all sales would accrue to rivals. Percentages do not sum to 100 because intermediate outcomes are not shown. Table 3.15 Expected Sales Change after a 10 Percent Price Increase, by Ownership Type, 2002 (percent) Ownership type Sales would not decrease All sales would accrue to rivals State-owned 23.6 23.6 Privatized 12.7 30.9 De novo 17.6 29.3 Source: EBRD and World Bank (2002). Note: Table shows the percentage of surveyed firms indicating that sales would not decrease or that all sales would accrue to rivals. Percentages do not sum to 100 because intermediate outcomes are not shown. the proportion of de novo private firms that perceive themselves as being able to exercise market power is larger than the proportion of privatized businesses that do so. Figures 3.5 and 3.6 deepen the analysis by examining how such per- ceptions of market power in fact relate to a firm's market share and the number of competitors it faces. The results are consistent with the hypoth- esis articulated above. In figure 3.5, there is a clear inverse relationship between the size of market share and the degree to which a firm's conduct would result in a loss of sales in the event of a 10 percent increase in mar- ket prices (its sales sensitivity). Figure 3.6 yields the same conclusion but is based on the number of competitors faced by the firm. COMPETITION IN SOUTH EASTERN EUROPE 115 Figure 3.5 Expected Sales Sensitivity after a 10 Percent Price Increase, by Firm Market Share, 2002 20 (%) 15 share 10 market 5 average 0 not somewhat moderately very sensitive sensitive sensitive sensitive Source: EBRD and World Bank (2002). Figure 3.6 Expected Sales Sensitivity after a 10 Percent Price Increase, by Number of Competitors, 2002 50 none one to three of 40 more than three number (%) 30 by firms 20 of competitors share 10 0 not somewhat moderately very sensitive sensitive sensitive sensitive Source: EBRD and World Bank (2002). 116 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Vertical Dimensions of the South Eastern European Market Structure EXTENT OF VERTICAL UPSTREAM AND DOWNSTREAM INTEGRATION Our case studies suggest that the degree of vertical integration by SEE8 firms--whether upstream (producing inputs internally rather than pur- chasing them from unrelated parties) or downstream (distributing or selling outputs directly to end users rather than through an intermediary)--varies across sectors, across firms of different ownership types, and across countries. Box 3.5 illustrates these differences in the case of vertical upstream integration. The BEEPS data shed light on differences among firms in terms of ver- tical downstream integration (see table 3.16). The data show that for the Box 3.5 Vertical Integration in the South Eastern European Food Processing and Retailing Sector A number of firms in the food processing and retail sector in SEE are both vertically integrated upstream to the food growing or supply portion of the market and vertically integrated downstream to distribution and retail sales. Typical of this pattern is a de novo private firm interviewed during the case studies that started out as a small retail salami and cheese busi- ness. The firm started in 1992 as a small retail shop selling salami and cheese. A family outfit, the firm was run by the founder and his wife. At the time, the founder was a sports teacher, but he decided to go into busi- ness with an initial investment of US$1,000. In 1993, he managed to expand his retail store, and two and a half years later, he started a small factory for sausages. In 2000, he opened a second factory. Today the firm has two factories for salami, its own distribution network, 10 warehouses, and 14 retail shops. A third factory for salami was scheduled to open in 2003. In the spring of 2002, the firm purchased land and some fish-lakes. Breeding and selling fish proved to be quite lucrative, so the firm also began to raise its own cows, sheep, and pigs. A milk factory was set to open in 2003. The average sales per day equal 45 tons of processed meat. Today there are 1,400 employees, and since the early 1990s, the company has significantly increased production, employees, and profits. It not only sells its produce through its own retail outlets but also supplies its prod- ucts to supermarkets. In all, it has 3,750 clients and issues some 1,200 invoices per day. The structure of the client-base is about 17 percent super- markets; 35 percent direct distributors, including the firm's own retail shops; and 50 percent independent warehouses. Turnover for the first half of 2002 was US$38 million. COMPETITION IN SOUTH EASTERN EUROPE 117 Table 3.16 Downstream Integration by Country, by Sector, and by Ownership Type, 2002 (average percentage of an enterprise's sales made to parent firm or affiliated subsidiary) Average Average Ownership Average Country share (%) Sector share (%) type share (%) Albania 3.8 Mining 7.3 State-owned 10.8 Bosnia and 28.2 Construction 7.6 Privatized 7.6 Herzegovina Manufacturing 13.5 De novo 11.7 Bulgaria 2.7 Transportation, 11.5 Croatia 4.5 storage, and Macedonia, FYR 22.7 communications Moldova 2.1 Trade 11.6 Romania 2.3 Business 10.4 Serbia and 23.3 services Montenegro Hotels and 5.6 SEE8 average 11.0 restaurants Other 7.8 Source: EBRD and World Bank (2002). region as a whole, on average about 11 percent of the surveyed firms' sales transactions are conducted internally or are made to related parties. How- ever, the case studies suggest a higher level for upstream integration. By country, downstream integration is lowest for firms in Bulgaria, Moldova, and Romania, and it is highest for firms in Bosnia and Herzegovina, FYR Macedonia, and Serbia and Montenegro. As might be expected, manufac- turing firms appear to exhibit the greatest degree of downstream integra- tion, whereas hotels and restaurants register the least. A curious finding is that, although state-owned enterprises indicate a greater degree of down- stream integration than their privatized counterparts, de novo private firms indicate a degree of downstream integration that is even higher than that of state-owned enterprises. In part, this finding may be a statistical artifact insofar as the category of de novo firms includes joint venture enterprises. STRUCTURAL CONDITIONS FOR COMPETITION IN UPSTREAM AND DOWNSTREAM TRANSACTIONS About two-thirds of the SEE8 firms covered by the BEEPS2 indicated that on average they had at least four suppliers for their "main material inputs." Although this finding may suggest that the average firm in the entire South Eastern European region enjoys structurally competitive 118 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.7 Number of Material Input Suppliers by Country, 2002 100 80 60 percent 40 20 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro three or fewer more than three Source: EBRD and World Bank (2002). upstream markets, no conclusion is possible without knowing the size dis- tribution of the firm's market shares and the number of a firm's suppliers. Amore informative picture emerges by looking at the competitive struc- ture of supply markets across countries, across ownership types, and across sectors. Figure 3.7 indicates that the proportion of surveyed Albanian and FYR Macedonian firms that buy inputs in relatively less competitive sup- ply markets is greater than that of surveyed firms in Moldova and Serbia and Montenegro. In Figure 3.8, the BEEPS data indicate that there is a clear trend across the region of proportionately more de novo private firms, versus privatized or state-owned firms, buying their inputs in mar- kets with more suppliers. This finding suggests that, all other things being equal, new business start-ups are most able to benefit from upstream competition. Across sectors, there is great variation in the number of input suppliers. The construction sector registers the greatest proportion of firms with at least four suppliers (81 percent), and the business sector indicates the smallest proportion with at least four suppliers (45 percent). BEEPS2 also contains significant data on the competitive structure of firms' downstream markets. Table 3.17 shows that, in the case of surveyed COMPETITION IN SOUTH EASTERN EUROPE 119 Figure 3.8 Firms with More Than Three Material Input Suppliers, by Ownership Type and by Country, 2002 100 80 firms 60 total of 40 % 20 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro state-owned privatized de novo Source: EBRD and World Bank (2002). Table 3.17 Size Distribution of Downstream Sales by Country and Ownership Type, 2001­02 (average share of enterprises' sales to their three largest customers) Country Average share (%) Ownership type Average share (%) Albania 59 State-owned 51.4 Bosnia and 57 Privatized 57.4 Herzegovina De novo 49.1 Bulgaria 49 Croatia 60 Macedonia, FYR 63 Moldova 37 Romania 44 Serbia and 46 Montenegro SEE8 average 52 Source: EBRD and World Bank (2002). Note: Table only covers firms that sell more than 20 percent of their output to their three largest customers. 120 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE firms that sold more than 20 percent of their output to their three largest customers, on average such firms sold slightly more than half of their output to those customers. Firms in FYR Macedonia and Croatia indicat- ed the most concentrated downstream market structure, whereas Moldovan firms indicated the least concentrated downstream market structure. Across ownership categories, although de novo private and state-owned firms indicated approximately the same proportion of downstream sales to their three largest customers--close to the regional average--privatized firms indicated a more concentrated downstream market structure. TENURE OF VERTICAL RELATIONSHIPS Another perspective on the competitiveness of vertical market structure is provided by the tenure of the relationships between the firm and (a) the suppliers of its principal inputs and (b) the distributors and customers of its principal outputs. Notwithstanding the risk factors inherent in such transactions--which are likely to be appreciable, especially in transition economies--one might expect greater fluidity in firms' relationships with suppliers in more competitive supply markets. Figure 3.9 indicates that, on average, slightly over 80 percent of the firms in the region maintained Figure 3.9 Tenure of Supply Relationships: Firms with at Least 20 percent of Material Inputs from Suppliers Maintained for at Least 3 Years, 2002 100 80 firms 60 total of 40 % 20 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro Source: EBRD and World Bank (2002). COMPETITION IN SOUTH EASTERN EUROPE 121 the same suppliers for 3 or more years for at least 20 percent of their mate- rial inputs. Although there is not a great deal of cross-country variance, Moldova indicated the smallest proportion (68 percent) and Albania the largest proportion (91 percent) of firms with those attributes. This finding suggests that, all other things being equal, Moldovan firms tend to have a relatively short tenure of supply relationships, and Albanian firms tend to have a relatively long one. Interestingly, with respect to differences across ownership types, the survey data indicate that for the overall region, a smaller proportion of state-owned enterprises (74 percent), relative to both privatized and de novo private firms (both 83 percent), maintain the same suppliers for 3 or more years for at least 20 percent of their material inputs. On the output side, as depicted in table 3.18, the proportion of enter- prises in the region that on average sold at least 20 percent of their out- put to the same distributors or customers for 3 or more years is 62 percent--appreciably below the counterpart upstream attribute just discussed. There is also more cross-country variation. Yet, once again the survey concluded that Moldova has the smallest proportion of firms indi- cating such a tenured--but this time, downstream--relationship. By the same token, Albania registered a large proportion of surveyed firms indi- cating this result. However, the proportion of surveyed Croatian firms indicating such a tenured downstream relationship is the largest. Across ownership categories, the results on the downstream portion of the market contrast with those of the upstream portion. This time state- owned enterprises registered the largest proportion of firms maintaining a relationship of at least 3 years with the same parties for the distribution or Table 3.18 Tenure of Distribution and Sales Relationships, 2002 (average share of enterprises that sold at least 20 percent of output to the same distributors and customers for 3 or more years) Country Average share (%) Ownership type Average share (%) Albania 70 State-owned 65 Bosnia and 59 Privatized 64 Herzegovina De novo 61 Bulgaria 65 Croatia 77 Macedonia, FYR 63 Moldova 47 Romania 62 Serbia and 55 Montenegro SEE8 average 62 Source: EBRD and World Bank (2002). 122 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE sale of at least 20 percent of the firms' outputs. Moreover, the proportion of state-owned enterprises indicating that they met this criterion was larger than that of privatized firms, which, in turn, was larger than that of de novo private firms. In view of the above findings, all other things being equal, this result suggests that, although privatized or private firms shop around for distributors and customers more than state-owned enterprises, state- owned enterprises tend to shop around more when purchasing inputs. USE OF IMPORTED INPUTS Another dimension of the competitiveness of vertical market structure is the extent to which firms purchase inputs from domestic sources instead of international ones. Firms in SEE rely to varying degrees on imported inputs (see figure 3.10). For the region as a whole, imports account on aver- ageforabout38percentoftotalinputpurchases.SurveyedfirmsinAlbania indicate the largest portion of input imports--about 51 percent of total purchased inputs. But the import content of total input purchases by firms in Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegroisalsosubstantial--allabove40percent.Incontrast,Romania, and to a lesser extent Bulgaria, purchase the vast majority of their inputs from domestic suppliers--79 percent and 72 percent, respectively. Figure 3.10 Reliance on Imported Inputs, 2002 100 (%) 80 inputs 60 material 40 of 20 origin 0 and and FYR Albania Bulgaria Croatia Moldova Romania average Bosnia Macedonia, Serbia SEE Herzegovina Montenegro foreign domestic Source: EBRD and World Bank (2002). COMPETITION IN SOUTH EASTERN EUROPE 123 PERCEIVED UPSTREAM MARKET POWER Finally, a key issue regarding the competitiveness of South Eastern European vertical market structures is the extent to which firms perceive that they can exercise market power vis-à-vis their suppliers. Once again, the BEEPS instrument asked the SEE8 firms how they would respond to a 10 percent price increase charged by their suppliers. Table 3.19 describes the results. On a regionwide basis, on average, though 19 percent of the firms would not alter their input purchases with their incumbent suppli- ers, a larger portion--28 percent--would switch to purchase all of the input from an alternative supplier. Across countries, Moldova's surveyed firms indicated that they would be most sensitive to such a price change. Moldova (with FYR Macedonia) had the smallest proportion of firms that would continue purchases with existing suppliers and the second largest proportion of firms that would switch completely to a new supplier. Firms in Bulgaria were somewhat less sensitive. In contrast, Romanian firms indicated that they would be the least sensitive to such a price change. Across ownership types, the surveyed state-owned enterprises indi- cated that they would be the most sensitive to the change in input prices. In contrast, de novo private firms indicated they would be the least sen- sitive to such a change. Table 3.19 Expected Input Purchase Change after a 10 Percent Price Increase, by Country and Ownership, 2002 (percent) Input All input Input All input purchases purchases purchases purchases would not would be would not would be decrease made with an decrease made with an from existing alternative Ownership from existing alternative Country supplier supplier type supplier supplier Albania 23 23 State-owned 18 34 Bosnia and 16 23 Privatized 18 29 Herzegovina De novo 20 27 Bulgaria 18 36 Croatia 16 32 Macedonia, 12 24 FYR Moldova 12 34 Romania 28 25 Serbia and 24 24 Montenegro SEE8 average 19 28 Source: EBRD and World Bank (2002). Note: Table shows the percentage of surveyed firms indicating the two outcomes. Percentages do not sum to 100 because intermediate outcomes are not shown. 124 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Assessment of Entry and Exit Barriers The benefits a firm accrues by exploiting anticompetitive horizontal and vertical elements of market structure are not sustainable. Such exploita- tion is usually reflected in excessive profits or in excessive costs incurred from inefficient conduct (perhaps in the form of "gold-plating" or the payment of high salaries to senior management). The exercise of market power can be sustained only to the extent that (a) business rivals are restrained from entry to the market or (b) claimants of the firm (banks, shareholders, tax collectors, and so forth) cannot effectively demand changes that render a more efficient use of the firm's resources (such as changes in senior management, restructuring of operations, or liquidation of assets). Over the past decade, as the SEE8 proceeded to move to a market sys- tem, case studies show that in some instances various types of entry bar- riers, especially economic and institutional factors, have helped insulate incumbent dominant firms from new competitors. At the same time, inef- ficient, value-subtracting firms have been protected from market exit or competitive restructuring through soft budget constraints (weak fiscal and financial discipline such as tax or loan payment forbearance). These firms are being propped up through subsidies by political economy inter- ests (see box 3.6). Before examining these entry and exit barriers in greater detail, let us first assess the extent of fluidity in enterprise turnover and restructuring in the region. Business Turnover and Restructuring in South Eastern Europe Table 3.20 shows data on changes in the number of registered firms and full-time employees in the industrial sector in the SEE8 economies between 1999 and 2002. For the region overall, there was, on average, a 35 percent increase in the number of registered firms (with all countries indicating an increase) and a 6 percent decrease in the number of full-time employees (with all countries registering a decrease). Even though these data on firm registration may include (a) re-registered firms and (b) reg- istered firms that are inactive, the rough picture that emerges is one of modest restructuring of existing firms--as reflected in the employment turnover numbers--and perhaps substantial creation of smaller firms. Table 3.21 explores this proposition in more detail by focusing on turnover in the number of active firms (rather than registered firms) and by comparing firms of different sizes. Again, there are potential cross- country inconsistencies in these data, as, for instance, not all countries define an active firm in the same way. Still, these data suggest a sizable increase (12 percent) in the number of active small firms, on average, for COMPETITION IN SOUTH EASTERN EUROPE 125 Box 3.6 Weak Financial Discipline Delays the Exit of Loss-Makers and Distorts the Use of Capital One case study concerns a firm that was founded in 1937 as an iron and steel foundry and machine shop. In 1945, it became a state-owned compa- ny, and it is still state owned today. In 1965, the factory was restructured, and its manufacturing capabilities were brought to 4,000 metric tons per year. In 1978, its manufacturing capabilities reached 8,500 metric tons per year. In 1983, because of a modernization effort, the factory's manufactur- ing capabilities reached 12,000 metric tons per year. Currently, however, the firm operates at only 20 percent of its capacity. Total employees have been reduced to 420 from 1,380 in the early 1990s. Management believes that the company still carries an excess of 150 to 200 workers on its payroll. The firm is the largest employer in the area, and it faces only two other competitors in the country. Its chief executive officer (CEO) has expressed concern that many social burdens that should fall on the state are being carried out by the firm. However, the state has been useful on several occasions. Several years ago, for example, the firm was being charged what it thought were exces- sively high land-use and property taxes by the local authorities. The CEO wrote a letter to the government proposing the company pay only a por- tion of those taxes and that the portion be tied to the capacity utilization of the plants. The government supported the proposal, and the taxes were reduced accordingly. The management board of the firm consists of five people, all members of political parties. No financial audits are performed on the firm's accounts because the enterprise is a strategic state-owned enterprise. The company's debts are to other state enterprises, the state budget, and one commercial bank. The CEO acknowledged that, if the firm were to pay off all its loans, "We would be bankrupt. We would need to give up 1 month of production to repay the loans and would stop paying budget contribu- tions, wages, etc. Once we explained this situation to our creditor [the bank], they agreed to allow us to continue to defer loan payments." In another example, in the winter of 2001 the company was 1 month late pay- ing for electricity, and the CEO wrote to the electric utility indicating that if the electrical company stopped the power supply, the enterprise would shut down. He advised in the letter that the utility check with the prime minister before cutting off the supply. As a result, the utility was not cut, and the firm paid its power bill late. the SEE8; a very modest increase (3 percent) in the number of active medium-size firms; and a modest decrease (6 percent) in the number of active large firms. In each size category, there are instances of two coun- tries that exhibit reverse trends to the SEE8 average. Overall the pattern suggests that, though there was modest restructuring of existing firms 126 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.20 Turnover of Number of Registered Firms and of Full-Time Employees in South Eastern European Industry, 1999 and 2002 Number of registered Total number of full-time firms in industry employees in industrial firms Country 2002a 1999 2002b 1999 Albania 10,195 9,302 53,965 55,068 Bosnia and Herzegovina 14,491 12,334 216,993 227,930 Bulgaria 72,359 64,372 812,963 891,164 Croatia 31,415 29,410 325,600 346,776 Macedonia, FYR 24,536 15,585 185,774 199,010 Moldova 13,992 11,597 143,068 154,765 Romania 57,753 -- 2,210,000 2,300,000 Serbiac -- -- 678,758 725,401 SEE8 average 32,106 23,767 578,390 612,514 Sources: Official statistics and World Bank staff estimates. Note: -- not available. Industry includes mining, manufacturing, and construction. a. Data for Albania, Bosnia and Herzegovina, Bulgaria, and Romania are for 2001. b. Data for Albania, Bosnia and Herzegovina, Bulgaria, FYR Macedonia, and Romania are for 2001; data for Croatia are for 2000. c. Data do not include Montenegro. (a small increase in medium-size firms and a small decrease in large firms), the entry that occurred in the SEE8 was overwhelmingly by small firms. This picture is generally consistent with the findings of other recent studies of enterprise restructuring in Central and Eastern Europe (see, for example, World Bank 2002). Constraints on New Entrants Economists distinguish between two different types of entry barriers: those that are economic in nature (these barriers are principally deter- mined by technology or underlying market forces) and those that are institutionally determined, policy driven, or administratively induced. The need for policy intervention to deal with economic barriers generally arises only when such barriers are chronically high or in markets where there is already significant horizontal or vertical dominance. Intervention is best decided on a case-by-case basis. For institutionally determined entry barriers, the case for policy intervention is more clear cut. ECONOMIC BARRIERS TO ENTRY In certain industries, the technology fundamental to the production process naturally gives rise to economies of scale, in which unit costs COMPETITION IN SOUTH EASTERN EUROPE 127 Table 3.21 Turnover of Number of Active Firms in South Eastern European Industry by Size, 1999 and 2002 Total number of Total number of Total number active active medium- of active small firms size firms large firms Country 2002a 1999b 2002a 1999b 2002a 1999b Albania 32,616 33,029 1,697 1,448 1,208 1,202 Bosnia and -- -- -- -- -- -- Herzegovina Bulgaria 43,867 23,128 1,775 1,695 527 563 Croatia 56,173 57,323 2,044 2,075 556 574 Macedonia, FYR 54,320 52,222 533 532 510 473 Moldovac 15,320 12,086 1,308 1,559 -- -- Romaniad 44,532 39,860 10,579 10,163 2,642 2,846 Serbiae 44,131 42,010 1,226 1,218 2,029 2,304 SEE8 average 41,566 37,090 2,737 2,670 1,245 1,327 Sources: Official statistics and World Bank staff estimates. Note: -- not available. Industry includes mining, manufacturing, and construction. Unless otherwise noted, small firms are those with 49 employees or fewer, medium-size firms are those with between 50 and 249 employees, and large firms are those with 250 or more employees. a. Data for Albania, Bulgaria, FYR Macedonia, Romania, and Serbia are for 2001. Data for Croatia are for 2000. b. Data for FYR Macedonia are for 2000. c. Data for medium-size firms also include large firms. d. Data do not include Montenegro. Data include all active economic and social units, including regies autonomies (large state-owned enterprises). e. Estimates are as of June 2002. Small firms are those with 49 employees or fewer, medium-size firms are those with between 50 and 100 employees, and large firms are those with more than 100 employees. decline as output expands to meet market demand. In such industries, those scale economies are a barrier to entry because it is unlikely that multiple businesses can all attain the minimum efficient scale to be com- mercially viable. As noted earlier, there may be significant scale economies in certain segments of the infrastructure sectors in the SEE8. However, in most of the industrial sector in the region and worldwide, scale economies are unlikely to be as pronounced relative to market demand, and thus, absent other types of constraints, such economic bar- riers to entry are likely to be relatively modest. When incumbent firms enjoy brand loyalty among consumers, prod- uct differentiation becomes an entry barrier. Potential rivals must then invest heavily in advertising to become commercially viable. As in many other transition countries, brand loyalty among the products of firms in the SEE8 was not strong at the beginning of the transition and, thus, was 128 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Box 3.7 Brand Loyalty as a Barrier to Entry: The Case of Food Processing and Retailing Of all the sectors covered by the case studies, firms in food processing and retailing rely most heavily on marketing, advertising, and brand loyalty to increase and maintain market share. In virtually all of the eight countries, this sector tends to be dominated by three to five firms that are largely supermarkets. Weekly advertising by the firms is extensive, including use of sales, discounts, and coupons. While competition is mediated largely by pricing among the dominant firms, smaller firms and potential entrants have difficulty reaching a higher level of market penetration as customers have developed loyalties to the large incumbents. The incumbents have built name recognition not only through advertising, but also through uni- formity in store layouts, issuance of store credit cards, and consistency in product quality. The heavy investment newcomers must make to challenge the incumbents has kept entry modest. Generally, when there is entry, it is in the form of horizontal expansion across neighboring countries and often involves foreign joint venture investors. not a potent constraint on entry. In the past decade, advertising and mar- keting have become more sophisticated, and product differentiation can well be used as an entry barrier (see box 3.7 for an illustration from the case studies). The advantages that accrue from innovation can also prevent new entry. Much depends on the embedded technological prowess of firms and whether the country has a patent system in place to protect and rein- force that capability by granting exclusive production and marketing rights. As in most transition economies to date, there is no effective patent- ing system in the SEE8 economies. Thus, technological innovation may be only a modest impediment to entry in these countries' industrial sectors. Finally, natural resource endowment may act as an entry barrier. Dur- ing an industry's development, firms that are first to locate and exploit such deposits will have a strategic market advantage over those seeking entry later (unless new resource deposits are discovered or the initial firms decide to license access rights). Mining or petroleum firms may be able to exploit this type of barrier to entry. INSTITUTIONAL, POLICY-BASED, AND ADMINISTRATIVE BARRIERS TO ENTRY Evidence from the case studies and from the BEEPS suggests several institutional, policy-based, or administrative factors that constrain the entry and growth of new firms in the SEE8. The BEEPS asked respon- dents to rank in terms of severity the importance of a variety of such fac- tors. A summary of the results is contained in table 3.22. COMPETITION IN SOUTH EASTERN EUROPE 129 Table 3.22 Comparative Severity of Potential Barriers to the Operation and Growth of Businesses in the SEE8, 2002 (percentage of responses) Minor Moderate Major Barrier No obstacle obstacle obstacle obstacle Access to financing 32.62 17.42 24.85 25.11 (such as collateral required or financing unavailable from banks) Cost of financing 20.56 20.62 27.20 31.63 (such as interest rates and charges) Access to 66.73 18.00 8.50 6.77 telecommunications Access to electricity 59.64 18.23 10.75 11.37 Access to transportation 63.08 18.46 10.58 7.88 Access to land 68.35 15.18 9.93 6.53 Tax rates 17.39 15.59 31.61 35.41 Tax administration 27.55 22.48 26.47 23.50 Customs and trade 42.54 19.99 20.45 17.03 regulations Business licensing 38.35 21.69 23.94 16.02 and permits Labor regulations 53.09 25.23 14.80 6.89 Skills and education 48.99 24.37 17.28 9.37 of available workers Economic policy 12.68 14.08 26.89 46.35 uncertainty Macroeconomic 16.12 15.93 24.87 43.08 instability (inflation or exchange rate problems) Functioning of 28.40 25.18 24.98 21.44 the judiciary Corruption 28.26 19.32 23.10 29.32 Street crime, theft, 42.11 24.95 16.44 16.50 and disorder Organized crime 47.11 18.05 15.97 18.86 Anticompetitive 27.98 21.37 24.78 25.87 practices of other producers Contract violations 31.26 24.22 24.92 19.60 by customers and suppliers Title or leasing of land 66.83 15.77 10.01 7.39 Overall average 39.98 19.82 19.92 20.28 Source: EBRD and World Bank (2002). 130 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Table 3.22 suggests several insights, bearing in mind that the BEEPS measures firm managers' perceptions of the business environment rather than making a factual assessment of business conditions based on firms' actions and decisions (the methodology used in the case studies). First, generic economic policy uncertainty--unanticipated or unilateral changes in the rules of the game--and macroeconomic instability are seen as the most pernicious obstacles to business development and operations in SEE. This finding is important because it means that governments in the region can, in fact, proactively carry out policy reforms to reduce barriers to entry. Moreover it suggests that there are important constraints on investment that are economywide (probably even regionwide) in nature and are not rooted solely in the natural underlying technology or economic character- istics of a specific sector. Second, the data in table 3.22 suggest that other key entry barriers are (a) high tax rates, (b) high financing costs, (c) cor- ruption, and (d) anticompetitive practices of other businesses. Those bar- riers are generally institutionally or policy driven.7 Finally, the data lend less credence to the conventional wisdom that administrative barriers are the major impediments to business development. Access to land, titling or leasing of land, business licensing and permits, and tax administration are not perceived by SEE8 businesses as major impediments. This finding is consistent with recent microeconomic studies of barriers to investment in other transition countries (see, for example, Broadman 2002). Figure 3.11 and table 3.23 systematically illustrate how perceived key entry barriers vary across the eight countries. Using the BEEPS ranking of severity for obstacles, surveyed firms in Bulgaria and Moldova indicated a greater severity in financial cost and economic policy uncertainty than did firms in the other six countries. Albanian, Moldovan, and Romanian firms ranked macroeconomic instability as a more severe barrier than their counterparts in the other five countries. Firms in Albania ranked both corruption and anticompetitive practices as more problematic than did firms in any of the other surveyed countries. Finally, Moldovan firms complained more about high tax rates than firms in the other countries. Overall, the picture that emerges is one in which Moldovan firms are more adversely affected by entry obstacles than the other countries, fol- lowed closely by firms in Albania. Barriers in Bulgaria and Romania are comparably less severe but are still appreciable. Dealing with corruption and obtaining business licenses and permits are perhaps the most often cited barriers in the literature on transition economies. Let us look in greater detail, by firm ownership and by coun- try, at these barriers to assess the variance in their incidence. Figure 3.12 depicts the "bribe tax" or direct costs to firms from corruption for 2002 according to BEEPS2. The data show clearly that de novo private firms are burdened by the heaviest bribe tax, followed by privatized firms and then state-owned enterprises. Comparing these data with those from BEEPS1, we find this pattern has been roughly maintained over the COMPETITION IN SOUTH EASTERN EUROPE 131 Figure 3.11 Key Barriers to Entry in SEE, 2002 Albania 4 Serbia and Bosnia and Montenegro Herzegovina 3 2 Romania 1 Bulgaria Moldova Croatia Macedonia, FYR cost of financing economic policy uncertainty macroeconomic instability corruption anticompetitive practices high taxes Source: EBRD and World Bank (2002). Note: Survey respondents ranked each category on a scale 1 to 4, with 1 representing no obstacle and 4 representing a major obstacle. Table 3.23 Key Barriers to Entry in SEE, 2002 Economic Cost of policy Macroeconomic Anticompetitive High Country financing uncertainty instability Corruption practices taxes Albania 2.59 3.12 3.28 3.10 2.91 2.92 Bosnia and 2.79 2.82 2.52 2.65 2.52 2.67 Herzegovina Bulgaria 2.88 3.34 2.96 2.53 2.59 2.76 Croatia 2.27 2.87 2.53 2.29 2.40 2.62 Macedonia, FYR 2.38 2.79 2.77 2.45 2.34 2.41 Moldova 2.95 3.30 3.48 2.65 2.25 3.19 Romania 2.80 3.03 3.29 2.70 2.56 3.17 Serbia and 2.78 3.14 2.71 2.02 2.30 2.92 Montenegro Source: EBRD and World Bank (2002). Note: Survey respondents ranked each category on a scale 1 to 4, with 1 representing no obstacle and 4 representing a major obstacle. 1999­2002 period. Among the sample of firms that indicate that they paid such a tax in 2002, the average amount paid in all ownership categories was above 3.5 percent of the firms' sales revenues. Table 3.24 shows the cross-country disparity in the incidence of barri- ers emanating from the business licensing and permitting process. (For 132 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.12 Average "Bribe Tax" Paid in SEE, by Firm Ownership, 2002 2.5 2.0 sales firm 1.5 annual 1.0 total of %0.5 0.0 de novo privatized state-owned Source: EBRD and World Bank (2002). Table 3.24 Incidence of the Burden of Business Licensing and Permitting in SEE, 2002 Country No obstacle Major obstacle Albania 42.5 22.9 Bosnia and Herzegovina 42.3 11.9 Bulgaria 44.5 15.1 Croatia 38.0 9.2 Macedonia, FYR 34.8 17.4 Moldova 24.0 22.2 Romania 34.2 23.2 Serbia and Montenegro 44.0 7.8 Source: EBRD and World Bank (2002). Note: Table shows the average percentage of surveyed firms responding in this category. Percentages do not sum to 100 because intermediate outcomes are not shown. simplicity, we include only the two extreme measures of obstacles.) The surveyed firms in Albania, Moldova, and Romania registered the great- est severity of business licensing and permitting barriers, with more than 20 percent of the respondents in those countries indicating such barriers were major obstacles. In contrast, the largest proportions (approximately 45 percent) of surveyed firms indicating that these barriers were not obstacles to business operations and growth were in Bulgaria and Serbia and Montenegro. COMPETITION IN SOUTH EASTERN EUROPE 133 Barriers to Exit In any economy, to create space for new entrants and to rechannel pro- ductive assets away from inefficient firms to new ventures that expand employment and create new products, governments must ensure that exit barriers are low. This action calls for hard budget constraints to engender improved corporate competitiveness from viable firms and to expose firms that are no longer commercially viable. The case studies show that in many of the SEE8, budget constraints are soft and barriers to exit are, in some cases, appreciable. The BEEPS data also shed light on the number of business exits and the softness of budget constraints in SEE--with respect to plant closures, subsidies, and tax arrears. PLANT CLOSURES The BEEPS survey asked respondents two questions: had they (a) opened at least one plant and (b) closed at least one plant between 1998 and 2002? The extent to which surveyed businesses indicated they closed at least one plant during this period is set out in table 3.25 by country, by sector, and by firm ownership. We also show the percentage of firms with net closures. On average for the region, 11 percent of the firms indicated that they closed at least one plant during this period--a rather low share by international standards, given that many SEE8 firms are not commercially viable. Indeed, on a net basis, about 9 percent of the firms indicated open- ing at least one plant. Across the eight countries, Croatia registered the largest proportion of firms indicating plant closures. Albania and FYR Macedonia recorded the smallest proportions. On a net basis, however, only Albanian firms indi- cated plant closures; Romania and Serbia and Montenegro registered firms with the greatest percentage of net plant openings. Looking at sec- toral variation, we find that the infrastructure sector (transportation, stor- age, and communications) had the largest percentage of firms reporting plant closures and had very few new plant openings on a net basis. The mining sector had the second largest percentage of firms indicating plant closures and also reported net closures. Across ownership types, there is a clear and consistent pattern: state-owned enterprises reported the great- est proportion of plant closures and also registered closures on a net basis. In contrast, de novo private firms had the smallest proportion of plant closures and, in fact, indicated the largest share of plant openings on a net basis. SUBSIDIES FROM GOVERNMENT The BEEPS2 data suggest that there is great variation in subsidies received by respondent firms from all levels of government (national, e 3.2) 5.4) 12.9) centage firms of closur ( ( ( entheses Per indicating 20.6 17.3 7.6 arp in Numbers 1998­2002 type novo Ownership 2002. ype,T State-owned Privatized De and 1998 e openings. 0.1) 15.9) 13.3) 1.6) 7.0) 6.7) 6.9) 10.3) centage firms ( ( ( ( ( ( ( ( between of closur plant Ownership Per indicating 17.7 6.8 12.0 18.3 12.7 6.8 .87 6.4 net plant by one and, indicates least at sign storage, Sector closed estaurantsr minus by, a Sector services they e, uction communications and that efor Mining Constr Manufacturing ransportation,T and radeT ther Country Business Hotels Other es; by indicating closur e 1.8) 6.8) 4.4) 10.9) .2)11 firms 9.2) 15.7) 14.0) 9.3) plant Closure centage firms ( ( ( ( ( ( ( ( ( net of closur Per indicating 3.6 9.0 10.0 15.6 3.5 8.4 15.3 12.3 .211 surveyed of Plant (2002). indicating of o Bank centage firms per orld of Extent W the Herzegovina FYR Montenegr and centage shows 3.25 per and and average EBRD cent) ableT the ce: ableT oatia (per Country Albania Bosnia Bulgaria Cr Macedonia, Moldova Romania Serbia SEE8 Sour Note: show 134 COMPETITION IN SOUTH EASTERN EUROPE 135 regional, and local). For all of the SEE8 combined, the average surveyed firm indicated that it received subsidies from the national government amounting to 9.5 percent of sales revenues and subsidies from regional and local governments equaling 17.7 percent of sales revenues (the per- centages are annual averages for 1998­2002). Thus, the survey suggests that, on average, subsidies received from local and regional governments are almost twice as large as those received from the national government. According to the survey respondents, the average amount of total gov- ernment subsidies (that is, the sum of local, regional, and national subsi- dies) as a proportion of sales revenues is greatest in Croatia (43 percent), followed by Moldova (29 percent). Surveyed firms in Albania responded that they receive the lowest amount of subsidies as a percentage of sales revenues (9 percent). Figures 3.13 and 3.14 depict how total government subsidies as a per- cent of average annual sales revenues between 1998 and 2002 vary across the SEE8 by firm ownership and by sector. For the region, state-owned enterprises received the greatest amount of subsidies as a proportion of sales revenues, followed by privatized firms and then by de novo private firms. This pattern is consistent across all countries except FYR Macedonia Figure 3.13 Government Subsidies by Firm Ownership Type, 2002 18 17 16.77 16 de novo privatized 15 state-owned 14 13 12 11 sales 10 9 8 annual 7 of 6 5.21 % 5 4.11 4.02 4 3 2.42 2.46 2 1.67 1.95 1 0.12 0 0 0.17 0.38 0 0.18 0.39 0 0.4 0 0 0 0.22 0.13 0.19 0.22 0.14 0.47 0 and FYR and Albania Bulgaria Croatia Moldova Romania average Bosnia Serbia SEE Herzegovina Montenegro Macedonia, Source: EBRD and World Bank (2002). Note: Figure shows total government subsidies as a percentage of average annual sales rev- enues for 1998­2002. 136 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.14 Government Subsidies by Sector, 2002 5.0 4.57 4.5 4.0 3.5 sales 3.0 2.5 2.18 annual 2.0 of % 1.5 1.38 1.12 1.0 0.52 0.5 0.15 0.14 0.01 0.01 0.0 and and services average quarrying personalgoods services construction storage, restaurants SEE and and renting, manufacturing other and communicationhousehold estate,business mining repairs, and hotels real transportation, trade, Source: EBRD and World Bank (2002). Note: Figure shows total government subsidies as a percentage of average annual sales revenues for 1998­2002. and Moldova (where privatized firms received the largest share of subsi- dies as a percentage of sales revenues). Across sectors, the largest recipi- ents of subsidies were firms in the services and infrastructure sectors. Firms in the trade, mining, and hotel and restaurant sectors were the smallest recipients of subsidies. TAX ARREARS TO GOVERNMENT As discussed in chapter 2, the government's forbearance on tax payment also contributes to soft budget constraints and provides disincentives for restructuring or bankruptcy of otherwise value-subtracting or insolvent firms. Table 3.26 contains BEEPS data on tax arrears by country, sector, and firm ownership type (arrears is defined as payments at least 90 days overdue). For the surveyed firms, the regional average level of tax arrears is 12 percent of sales revenues, which is not an insignificant amount. Across countries, Albania and Romania stand out as having the highest amount of tax arrears per sales revenues, 14 percent and 20 percent, COMPETITION IN SOUTH EASTERN EUROPE 137 Table 3.26 Extent of Tax Arrears to Government by Country, by Sector, and by Ownership Type, 2002 Annual Annual Annual average average Ownership average Country (%) Sector (%) type (%) Albania 14.0 Mining 10.0 State-owned 14.7 Bosnia and 7.8 Construction 12.3 Privatized 9.1 Herzegovina Manufacturing 11.5 De novo 12.9 Bulgaria 11.0 Transportation, 12.3 Croatia 8.1 storage, and Macedonia, 8.0 communications FYR Trade 13.6 Moldova 5.3 Business services 12.4 Romania 19.7 Hotels and restaurants 6.6 Serbia and 10.4 Other 13.5 Montenegro SEE8 average 12.0 Source: EBRD and World Bank (2002). Note: Arrears are defined as payments at least 90 days overdue to government. respectively. Moldovan firms indicated the lowest level of tax arrears (5 percent). With one exception, there is much less variation across sec- tors, with average tax arrears between 10 and 14 percent of sales rev- enues. The hotels and restaurants sector's average tax arrears, however, amounted to 7 percent of sales revenues. The survey on the incidence of tax arrears by firm ownership type reveals a curious finding: although state-owned enterprises in the SEE8 indicated that they have the highest incidence of tax arrears among ownership groups--almost 15 percent of sales revenues--de novo private firms indicated tax arrears at approxi- mately 13 percent of sales revenues, a figure that is not significantly lower. Business Performance and Competition To assess the competitive performance of firms within SEE, we consider several dimensions across countries, across sectors, and across firm own- ership types. We also assess how these performance indicators have changed over time. We then examine profitability, a key element of busi- ness performance and econometrically analyze the importance of key factors that determine the observed differentials in firm profitability in the SEE8. In so doing, we evaluate how the competitiveness of market structure accounts for variance in profitability among firms. 138 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Business Performance Differences across Countries, Sectors, and Firm Ownership Types BUSINESS PERFORMANCE ACROSS THE SEE8 Figures 3.15 and 3.16 depict average annual changes in sales revenues, exports, employment, investment in fixed assets, and profit margins (measured by the difference between a business's domestic sales price and its operating costs) among the South Eastern European firms partic- ipating in the BEEPS.8 For the period 1995­98, the firms in these coun- tries performed in a generally consistent manner, except that Bulgarian firms, on average, had a lower profit margin for 1998, firms in Bulgaria and Croatia had larger amounts invested in fixed assets, and employ- ment and sales growth in Bosnia and Herzegovina were above average (figure 3.15). In the more recent period, 1998­2001, however, there has been consid- erably less uniformity among the countries in almost all performance dimensions except for 2001 average profit margins (figure 3.16). Employ- ment growth jumped in Albania and Moldova, while firms in Albania, Figure 3.15 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Country, 1995­98 (percent) Albania 20 Bosnia and Romania Herzegovina 10 0 10 Moldova Bulgaria Macedonia, FYR Croatia sales revenues investments in fixed assets exports employment profit margins Source: EBRD and World Bank (1999). Note: Profit margins pertain only to 1998. COMPETITION IN SOUTH EASTERN EUROPE 139 Figure 3.16 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Country, 1998­2001 (percent) Albania 30 Serbia and Bosnia and Montenegro Herzegovina 20 10 Romania 0 Bulgaria Moldova Croatia Macedonia, FYR sales revenues investments in fixed assets exports employment profit margins Source: EBRD and World Bank (2002). Note: Profit margins pertain only to 2001. Croatia, and Romania exhibited sizable spurts in sales revenues. Albania and Croatia also experienced above-average growth in investments in fixed assets. Compared with 1995­1998, growth in exports indicated by the surveyed firms diminished significantly in 1998­2001. CROSS-SECTORAL CHANGES IN BUSINESS PERFORMANCE Figures 3.17 and 3.18 show performance comparisons across sectors.9 In 1995­98, growth in investments in fixed assets was particularly high in the various service sectors and in transportation and manufacturing (figure 3.17). Generally, firms indicated high growth rates of employ- ment in these same sectors in the later period (figure 3.18). In fact, there was a general surge in employment in 1998­2001, a key difference from the earlier period. Although the firms in the service sectors and, to a lesser extent, power generation, registered significantly higher profit margins than those in other sectors in 1998, there was more uniformity in profit margins across sectors in 2001. Compared with 1995­98, growth in exports indicated by the firms diminished significantly in 1998­2001. 140 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.17 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Sector, 1995­98 (percent) farming, fishing, and forestry business mining and services 30 quarrying 20 personal 10 services 0 manufacturing 10 financial building and services construction transportation power generation trade sales revenues investments in fixed assets exports employment profit margins Source: EBRD and World Bank (1999). Note: Profit margins pertain only to 1998. PERFORMANCE ACROSS OWNERSHIP TYPES Figures 3.19 and 3.20 illustrate that, for almost all the dimensions of perfor- mance, the variation across firm ownership types is striking. As expected, the surveyed de novo private firms indicated that they outperformed pri- vatized and state-owned enterprises in all dimensions in 1995­98 (fig- ure 3.19). Curiously, while growth in investments in fixed assets and the profit margins between state-owned enterprises and privatized firms were not significantly different for this period, state-owned enterprises indicated more rapid growth in sales revenues and employment than did privatized firms. In contrast, privatized firms indicated more rapid export growth. In 1998­2001, again, de novo private firms generally outperformed the two other ownership types (figure 3.20). However, performance differ- ences between privatized firms and state-owned enterprises narrowed considerably along all dimensions. The gap in employment growth rates between de novo private firms and privatized and state-owned firms con- siderably widened, but the margin in employment growth indicated by state-owned enterprises increased relative to the 1995­98 period. COMPETITION IN SOUTH EASTERN EUROPE 141 Figure 3.18 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Sector, 1998­2001 (percent) mining 30 other services construction 20 10 hotels and 0 manufacturing restaurants business transportation services trade sales revenues investments in fixed assets exports employment profit margins Source: EBRD and World Bank (2002). Note: Profit margins pertain only to 2001. Figure 3.19 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Ownership, 1995­98 (percent) sales revenues 20 15 10 5 profit margins exports 0 5 investments in employment fixed assets de novo privatized state-owned Source: EBRD and World Bank (1999). Note: Profit margin pertains only to 1998. 142 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.20 Annual Changes in Sales Revenues, Exports, Employment, Investments in Fixed Assets, and Profit Margins, by Ownership, 1998­2001 (percent) sales revenues 20 15 10 profit margins exports 5 0 investments in employment fixed assets de novo privatized state-owned Source: EBRD and World Bank (2002). Note: Profit margins pertain only to 2001. Analysis of the Relationship between Firm Profitability and Market Competitiveness DISPERSION OF FIRM-LEVEL PROFITABILITY To begin our analysis of profitability among businesses in SEE, we exam- ine the frequency distribution of corporate profitability by country, by sector, and by firm ownership type. The measure of profitability we use is the ratio of reported profits to sales revenues in 2001, as indicated by each firm covered by the BEEPS.10 The ratio is measured as a categorical variable in the survey, as described in the key to the set of profitability- distribution histograms in figure 3.21. Figure 3.21 offers several important insights. First, in all eight coun- tries, there are loss-making firms; the greatest shares of those firms are in Bosnia and Herzegovina (about 11 percent), Bulgaria (about 8 percent), and Croatia (about 4 percent). Moreover, a substantial share of surveyed firms in virtually all the countries (except Romania and Albania) indicat- ed that their profits were zero. Together with the number of firms that indicated losses, this finding shows that business conditions can be diffi- cult for some of the surveyed firms. In every country, the profitability cat- egory that contains the greatest proportion of firms indicating a positive profit-to-sales ratio is the 1 to 10 percent range. The distribution of firms COMPETITION IN SOUTH EASTERN EUROPE 143 in the profitability categories above 10 percent varies significantly among the countries. Some exhibit a relatively smooth downward distribution (for example, Albania, Croatia, Romania, and Serbia and Montenegro), whereas others exhibit a more uneven pattern. Across most sectors, there is a bit more uniformity in the distribution of firm profitability than across countries. However, the mining and the hotel and restaurant sectors are notable. In the mining sector, a significant proportion of the surveyed firms indicated relatively high profitability, and those indicating negative or zero profits constituted an almost equal proportion. In the hotel and restaurant sector, there is not only a signifi- cant share of firms indicating 1 to 10 percent profitability, but also an almost equal share indicating 11 to 20 percent profitability. In the distribution of profitability across firm ownership types, loss- makers and those earning zero profits are most heavily represented in the Figure 3.21 Distribution of Profit-to-Sales Ratio by Country, by Sector, and by Ownership Type Albania Bosnia and Herzegovina Bulgaria 0.5 0.5 0.5 0.4 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0 0 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 n Croatia Macedonia, FYR Moldova o i 0.5 0.5 0.5 t 0.4 0.4 0.4 c 0.3 0.3 0.3 0.2 0.2 0.2 a 0.1 0.1 0.1 r 0 0 0 f 1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Romania Serbia and Montenegro 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 c a t e g o r y Profit-to-sales ratio categories: 1 negative. 2­7 (zero to positive): 2 0%; 3 1­10%; 4 11­20%; 5 21­30%; 6 31­40%; 7 more than 41% (Figure continues on the following page.) 144 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Figure 3.21 (continued) Mining Construction Manufacturing 0.5 0.5 0.5 0.4 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0 0 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Transportation, storage, n and communications Trade Business services o i 0.5 0.5 0.5 t 0.4 0.4 0.4 c 0.3 0.3 0.3 0.2 0.2 0.2 a 0.1 0.1 0.1 r 0 0 0 f 1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Hotels and restaurants Other services 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 c a t e g o r y Profit-to-sales ratio categories: 1 negative. 2­7 (zero to positive): 2 0%; 3 1­10%; 4 11­20%; 5 21­30%; 6 31­40%; 7 more than 41% n State-owned Privatized De novo o i 0.5 0.5 0.5 t 0.4 0.4 0.4 c 0.3 0.3 0.3 0.2 0.2 0.2 a 0.1 0.1 0.1 r 0 0 0 f 1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 c a t e g o r y Profit-to-sales ratio categories: 1 negative. 2­7 (zero to positive): 2 0%; 3 1­10%; 4 11­20%; 5 21­30%; 6 31­40%; 7 more than 41% Source: EBRD and World Bank (2002). COMPETITION IN SOUTH EASTERN EUROPE 145 state-owned enterprise category. Privatized firms have the next largest proportion of firms in those two categories. Beyond that, the distribution of profitability for all ownership types has a declining distribution as profitability rises. De novo private firms exhibit the smoothest down- ward distribution in this respect. DETERMINANTS OF FIRM PROFITABILITY The literature on industrial organization suggests a formulaic model of a set of variables that determine differentials in observed firm profitability. Empirical application of the model can provide insights into the extent to which, when we control for other factors, higher levels of observed profitability are associated with elements of market structure and firm conduct that reflect the potential to exercise market power.11 Equation 3.1, which draws on this literature, describes the broad com- ponents of the basic model we use, which is designed to assess these relationships on a cross-country basis and to account for the economic and institutional features characteristic of transition economies, including the SEE8: (3.1) Profitability f (horizontal market dominance, extent of integration, barriers to entry, barriers to exit, firm size, ownership type, sector, country- specific characteristics) Using the firm-level BEEPS data, which cover approximately 1,600 firms across the eight countries, we econometrically estimate several variants of the basic model in which we construct specific variables to represent the broadly defined factors in equation 3.1. In particular, the models we estimate are variants of equation 3.2: (3.2) Profit-to-sales ratio f (market share, horizontal integration, vertical integration, ratio of advertising expenditures to sales, ratio of R&D expenditures to sales, ratio of total fiscal subsidies received to sales, number of employees, sales revenues, ownership cat- egory, sector category, country location) Table A.3.1 in the annex to this chapter presents descriptive statistics for the core variables we use (as well as other variables that were con- structed and tried in different variants). Generally, the data are for 2001. Before estimating the multivariate models, we performed simple bivariate correlations between the variables. The complete results of those statistical correlations are contained in table A.3.2 in the annex. In general, the results show statistically significant bivariate correlations between 146 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE profitability and many of the variables of interest. The results also indi- cate that there are statistically significant bivariate correlations among the variables that are being posited as the determinants of profitability. Of course, neither set of results can be interpreted to suggest causal relationships; by their nature, bivariate correlations do not take into account any other factors that may explain differences in the value of a variable. Nonetheless, they do indicate that the basic model we have posited may well be appropriate. They also indicate, however, that because of the correlations among the determinant variables, discerning the statistical effect of a particular variable on profitability may be diffi- cult, due to the collinearity among some of the variables will bias the esti- mates of their individual explanatory power.12 Table 3.27 shows simple multivariate regression results for four vari- ants of equation 3.2.13 (We estimate both linear and nonlinear natural log- arithm forms.) Although the models explain only approximately 10 percent of the variation in profits as a percentage of sales, the results for some of the individual variables are surprisingly strong. In all cases, the estimated coefficient on market share is positive and statistically sig- nificant, thus suggesting that, for this sample of South Eastern European businesses, the greater a firm's horizontal dominance in the market, the greater its ability to exercise market power and increase its profits, all other things being equal. Specifically, market share appears to be a robust determinant of profitability after controlling for firm size (whether mea- sured by number of employees or by total sales revenues) and the extent of horizontal integration. Neither firm size nor horizontal integration, however, appears to play a statistically significant role in explaining the firms' indicated profits independent of market share or the other included variables. The estimated positive and statistically significant coefficients on verti- cal integration and R&D expenditures as a percentage of sales--as a proxy for technological prowess--also suggest that these factors are important elements of market structure that account for differentials in profitability among the sample of SEE8 firms. In contrast, product differentiation or brand loyalty--as proxied by advertising expenditures as a percentage of sales--does not appear to play a statistically significant role in explaining firms' indicated profits. The estimated coefficients on subsidies--a proxy for hardness of budget constraints--are statistically significant in the non- linear models. Their negative sign suggests that firms that receive greater levels of subsidies (that is, those that face softer budget constraints) tend to be the less profitable, although the direction of this relationship is not easily discernible from these variables or these models.14 The estimated coefficients on the ownership variables are statistically significant and have the expected positive signs. They suggest that de novo private firms register a higher profitability rate than privatized COMPETITION IN SOUTH EASTERN EUROPE 147 Table 3.27 Estimated Determinants of Profitability: Multivariate Ordinary Least Squares Regressions (3) (4) Natural Natural (1) (2) logarithm of logarithm of Profit-to- Profit-to- profit-to- profit-to- sales ratio sales ratio sales ratio sales ratio Constant 3.3 3.302 1.129 1.111 (25.06)*** (22.19)*** (23.48)*** (26.95)*** Bosnia and ­0.654 ­0.705 ­0.254 ­0.228 Herzegovina (4.91)*** (4.54)*** (5.20)*** (5.47)*** Bulgaria ­0.387 ­0.463 ­0.163 ­0.133 (3.40)*** (3.55)*** (3.97)*** (3.74)*** Croatia ­0.502 ­0.603 ­0.194 ­0.15 (3.84)*** (3.95)*** (4.04)*** (3.66)*** Macedonia, FYR ­0.267 ­0.431 ­0.137 ­0.1 (2.08)** (2.59)*** (2.61)*** (2.50)** Moldova ­0.382 ­0.572 ­0.15 ­0.093 (3.09)*** (4.05)*** (3.37)*** (2.40)** Romania ­0.206 ­0.27 ­0.076 ­0.058 (1.83)* (2.10)** (1.89)* (1.65)* Serbia and ­0.429 ­0.67 ­0.183 ­0.123 Montenegro (3.63)*** (4.02)*** (3.50)*** (3.33)*** Employees 0.005 0.015 (0.07) (0.61) Sales revenue ­0.003 ­0.0003 (US$ millions, 2001) (0.72) (0.25) Privatized 0.271 0.298 0.122 0.113 (2.46)** (2.38)** (3.09)*** (3.27)*** De novo 0.625 0.606 0.216 0.223 (6.61)*** (5.66)*** (6.44)*** (7.52)*** Services ­0.071 ­0.016 ­0.019 (1.14) (0.69) (0.98) Vertical integration 0.003 0.006 0.002 0.001 (3.01)*** (3.39)*** (3.59)*** (3.14)*** Horizontal integration ­0.001 0.008 0.002 ­0.001 (0.35) (1.48) (1.04) (1.13) Subsidies ­0.007 ­0.01 ­0.003 ­0.003 (1.26) (1.60) (1.69)* (1.85)* Market share 0.005 0.005 0.001 0.001 (2.93)*** (2.53)** (2.43)** (2.85)*** Advertising 0.006 0.002 0.001 0.003 (1.07) (0.31) (0.54) (1.49) R&D 0.019 0.023 0.006 0.005 (3.16)*** (3.29)*** (2.73)*** (2.71)*** Observations 1337 885 885 1337 R-squared 0.09 0.11 0.13 0.10 Source: Author's estimates using data from EBRD and World Bank (2002). Note: Absolute value of t-statistics in parentheses. * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. 148 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE businesses, which, in turn, register higher profitability rates than state- owned enterprises. However, sector category does not appear to play a statistically significant role in explaining the differences in indicated prof- itability among this sample of firms independent of the other included variables. Interestingly, the results suggest that there are country-specific factors that explain the variance in firm profitability across the region. In other words, there is intercountry variation in the overall determinants of firm profitability. Policies to Enhance Competition in South Eastern Europe Need for a Two-Pronged Reform Approach The emergence of the private sector in the SEE8, although variable across both the countries and the different sectors and still very much in an evo- lutionary phase, creates the prospects for increased interenterprise com- petition in the region. Yet incentives for robust competition in SEE generally remain weak, partly because the countries have not yet under- taken or completed sufficient fundamental, economywide institutional and structural reforms that are integral to market economies. Certainly, as these economywide reforms mature and budget constraints continue to harden--thus ensuring that the prices firms pay for inputs and charge for outputs are in cash, timely, and free of subsidies--the inefficient, large incumbent enterprises will likely decline in importance. Proactive policies--both basic economywide institutional and structural reforms as well as competition policy reforms--are needed in SEE to both foster the horizontal and vertical restructuring of such incumbent firms and to facilitate the entry of new businesses. Indeed, this two-pronged approach provides a roadmap for reform that encourages greater interenterprise competition in the region. The portion of the reform program that focuses on incumbents would include a stronger institutional competition policy to enforce de-monopolization and disintegration of dominant firms. It would prohibit mergers and acquisitions that reduce the number of sellers and increase structural dominance. It would penalize restrictive business practices, such as col- lusion, price fixing, and predatory pricing to drive out competitors or deter entrants. Finally, it would protect consumers from unfair trade and false advertising practices. Worldwide, effective implementation of such competition policies has proved difficult. Implementing these policies is particularly challenging in transition economies, especially in those that have also undergone civil strife. Despite the improvements already made in the competition policy regimes of the SEE8 (see chapter 2) and the additional reforms that are suggested below, implementation of reforms in the incumbent firms will take some time. The slow pace of reform is COMPETITION IN SOUTH EASTERN EUROPE 149 dictated by the significant political economy and social costs that large restructurings entail, especially when potent vested interests are challenged or transition costs for workers are perceived to be large. The other main component of the reform program for greater compe- tition is reducing structural, institutional, policy, and administrative bar- riers to entry. This effort can be completed sooner. New entrants increase pressure on privatized companies and on the remaining state-owned enterprise; indeed, they increase pressure on de novo private firms as well. Even when incumbent firms have attained dominance, facilitating entry (or facilitating credible threats of entry) can help instill competitive performance, especially in markets in which sunk costs are relatively small and newcomers can exit relatively cheaply should demand soften. Improving the conditions for entry can thus help make otherwise struc- turally dominant markets contestable. Entrants are also a source of mar- ket expansion and economic growth. They create employment, not only by developing new businesses, but also by providing the absorption capacity as restructured firms shed redundant or underused labor and other resources. New entrants engender other benefits. They offer modern manage- ment techniques and entrepreneurial skills, they usually use new plant and equipment technologies, and they increasingly employ incentive structures that provide for market-oriented corporate governance prac- tices. Reducing entry barriers through greater openness to imports and foreign direct investment (FDI) is especially critical. Yet, though liberal- ization toward imports and FDI can be the primary tool of competition policy in small open economies, for the larger transition economies, including some of those in SEE, trade and FDI policy reform must be cou- pled with other policies to enhance structural competition within the domestic market. In fact, empirical evidence bears this observation out even in the tradable sectors. The effect of import competition is signifi- cantly muted without competitively structured distribution networks, because distribution services are location specific. Thus, trade and FDI become segmented by geography and transportation costs. Overall, there is accumulating evidence in many transition economies--from small open economies such as the Baltic states to large heterogeneous economies such as China and Russia--that the policy emphasis should be on encouraging entry.15 This finding is instructive for the eight economies of SEE. Reform of the SEE8 Competition Policy Regimes As we have suggested, greater interenterprise competition in SEE will be achieved, not only from deeper basic structural and institutional reforms, but also from more effective implementation of competition policies. 150 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE Chapter 2 indicated that the eight economies, like many Eastern European and former Soviet countries, have modeled (or are modeling) their com- petition statutes on those found in industrial market economies, includ- ing the European Union and the United States. In addition, like most Eastern European and former Soviet countries, the SEE8 have tried to encourage new entry through programs that provide financial support for the development of SMEs. However, SEE8 economies have paid less attention to formulating systematic policies that remove structural, insti- tutional, and policy barriers to entry. Furthermore, they have generally made only modest efforts to confront dominant (and often politically important) firms that are in a position to exercise market power or firms that should exit the market. Table 3.28 systematically assesses and compares implementation of competition policy in the eight countries between 1997 and 2002 (as part of an assessment of a larger group of approximately 27 transition coun- tries). Although such rankings are affected by subjective judgments and perceptions and, thus, are imperfect, they do convey the relative magni- tude of the development of competition policy regimes in the countries. The data in the table suggest a number of insights. First, all of the SEE8 have made only limited progress in developing and implementing com- petition policies during the 1997­2002 period. Second, the data also suggest that, though most of the countries either improved their imple- mentation records slightly or maintained the same level, the effectiveness Table 3.28 Ranking Effectiveness of Competition Policy Implementation in SEE Country 2002 1997 Albania 2 2 Bosnia and Herzegovina 1 -- Bulgaria 2 2 Croatia 2 2 Macedonia, FYR 2 1 Moldova 2 2 Romania 2 2 Serbia and Montenegro 1 -- Sources: EBRD (1997, 2002). Note: -- not available; 1 no competition legislation and institutions; 2 competition policy legislation and institutions set up; some reduction of entry restrictions or enforce- ment action on dominant firms; 3 some enforcement actions to reduce abuse of market power and to promote a competitive environment, including breakups of dominant con- glomerates; substantial reduction of entry restrictions; 4 significant enforcement actions to reduce abuse of market power and to promote a competitive environment; and 4 standards and performance typical of advanced industrial economies; effective enforce- ment of competition policy; unrestricted entry to most markets. COMPETITION IN SOUTH EASTERN EUROPE 151 of Albania's implementation actually declined. Finally, the table suggests that Bulgaria, Croatia, and Romania have the most effective regimes when compared with the other countries. Principles for a Reform Agenda The general experience of the SEE8 in developing competitive policies parallels that of most transition countries. Competition policy has focused more on deterring anticompetitive conduct (for example, through establishing price controls) than on dealing with imperfections in market structure. It is not surprising that progress has been slow. Establishing an effective requisite policy regime can involve institution building, public administration reform, training of government person- nel in specialized skills, and, most importantly, creating the political will to take on vested interests and rent seekers. Countries that have made progress in implementing competition policy--especially industrial economies such as the EU member states and the United States--have emphasized (a) dismantling excessive horizontal and vertical dominance; (b) implementing clearly defined and widely publicized pro-competitive merger guidelines to prevent anticompetitive mergers; (c) establishing credible and sizable sanctions against collusion and price fixing; (d) reducing significantly the structural, institutional, and policy-induced impediments to new entry; and (e) bolstering rules-based competition policy agencies with effective enforcement authority, ample resources, and a well-trained staff. Like many transition economies, the SEE8 generally have given special attention to SMEs. Although there is little economic rationale for policy to favor a particular business ownership form or size, at a minimum a policy of neutrality is called for. Thus, a reorientation of the countries' policy regimes is needed to reduce the bias against SMEs and to eliminate bar- riers to entry. Conversely, in the SEE8, where market failures are often pronounced, SMEs generate singular positive externalities that can address some market failures. As noted earlier, because of their size and their ability to easily fill market niches, SMEs offer a source of flexibility in business development. Flexibility is especially needed in the transition process, in which experimentation is critical. Evidence from a number of transition countries suggests that, whereas initially SMEs tend to occupy the retail or services sectors, over time they can become significant play- ers in manufacturing. Also, SMEs represent employment outlets for a rational downsizing of state-owned enterprises; thus, they increase sta- bility. Finally, growth in the SME sector is characterized less in terms of expansion of incumbent firms (which is typical for growth in the large- firm sector) and more in terms of de novo entry and the introduction of new products and processes. 152 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE It is on these grounds that a regime's financial support of SME develop- ment can be justified. However, such a regime should have limited objec- tives, be transitory, and be implemented transparently with minimal opportunities for rent seeking and corruption. It should also be seen as a supplement to other structural reform policies that eliminate barriers to entry and deal with the anticompetitive conduct and structure of incum- bent firms. The regime should also promote reform and development of a commercial banking sector. International experience is replete with cau- tionary examples of promotional programs for small business that often create new bureaucracies that outlive their use. Policy Recommendations MAKE STRUCTURALLY DOMINANT MARKETS CONTESTABLE FOR NEW ENTRANTS The case studies and survey data suggest that one area of emphasis in competition policy in SEE should be on dealing with horizontal and ver- tical structural market imperfections in incumbent industrial firms. Redressing the situation would create economic space for new entrants. The markets with significant concentration and structural dominance should receive priority attention and resources; other markets can be dealt with subsequently. Moreover, the SEE8 should direct resources at preventing further hori- zontal and vertical consolidation in markets where concentration and structural dominance are already excessive. In this regard, they should develop more explicit and well-defined merger guidelines that establish general policy parameters for distinguishing between pro-competitive and anti-competitive mergers. These guidelines should be based on simi- lar guidelines used in industrial countries such as the EU member states and the United States. Public announcement of the guidelines is critical to maximize transparency, credibility, and predictability of the policy for mergers and acquisition so that a "market for corporate control" is not hindered (see below). Merger applicants should know ex ante that they must prove that a merger will enhance efficiency and not result in a sig- nificant loss of competition. However, a balance must be achieved between, on the one hand, prohibiting excessive enterprise integration and subsequent exercise of market power and, on the other, fostering suf- ficient integration that permits the technical economies of scale and scope. FOSTER PROACTIVE COMPETITIVE RESTRUCTURING OR EXIT OF VALUE-SUBTRACTING INCUMBENTS In the SEE8, as in other transition economies, relatively little policy emphasis has been directed toward the restructuring, reorganization, COMPETITION IN SOUTH EASTERN EUROPE 153 bankruptcy or--where necessary--liquidation of insolvent firms. The concerns about the potential social costs of such actions are understand- able. Yet with adequate social safety nets in place, such costs can be sub- stantially reduced. International experience provides important lessons about the benefits of hardening budget constraints to engender improved corporate competitiveness from viable firms and to expose firms that are no longer commercially viable. Indeed, viewed from the broader struc- tural reform perspective, the bankruptcy process engenders important benefits. It allows the rechanneling of productive assets to new ventures so that employment can be expanded and new products can be created. Significantly, facilitating the bankruptcy process should not be seen as the sole purview of the government; on the contrary, the main focus should be on strengthening the legal rights of creditors. Hence, the SEE8 must accelerate reform of their banking systems to create one in which banks can make credit, lending, and debt-collection decisions scrupulously on the basis of commercial and risk criteria. Exacting external discipline from firms in the real sector will go far in fostering the competitive restructuring of industry in SEE. STRENGTHEN RULES-BASED COMPETITION POLICY INSTITUTIONS Experience in SEE shows that if a competition policy regime is poorly implemented (that is, as a new source of discretionary authority), it may be distorted into an industry promotion regime that selects certain sectors for preferential treatment. Although competition laws in SEE are, for the most part, beginning to approximate international standards, the institu- tional incentive framework and infrastructure for their implementation remain weak and discretionary. The dominant role of local governments in promoting industrial policy may be the barrier to successful competi- tive policy. Several remedial steps can be taken. The SEE8 governments should review, at the highest levels, the mission of their current competi- tion policy agencies and should consult international experts to develop recommendations that strengthen their rules-based incentive structures. These agencies can be institutionally strengthened if they are matched with their counterparts in member countries of the Organisation for Eco- nomic Co-operation and Development to carry out a series of appraisals on sector competitiveness. INTRODUCE PROMOTIONAL POLICIES FOR SMES Support for SMEs is critical in engendering new entry and competition in the region. However, in some countries, current preferences (such as tax concessions) for SMEs are creating widespread distortions by encourag- ing firms to remain at relatively small levels so that they may enjoy such benefits. Existing firms that are below the minimum efficient scale should 154 BUILDING MARKET INSTITUTIONS IN SOUTH EASTERN EUROPE be encouraged to integrate. SME preferences may be considered along a sliding and less graduated scale. However, systems of targeted SME support through subsidized lines of credit can be counterproductive. In the long run, such regimes may undermine market-based reforms of the banking sector and the commercial intermediation role of banks (see chapter 5). The credit lines in some of the countries can breed corruption, particularly in the context of weak property rights. Nongovernmental support programs (sponsored by commercial banks or international donors) can assist by (a) providing equity participation in venture capital and investment funds, (b) funding local banks that provide commercial- ly based credit to SMEs, and (c) cofinancing SME projects with local banks. ESTABLISH INDEPENDENT MONITORING SYSTEMS AS A CHECK ON REFORM IMPLEMENTATION International experience suggests that a reform program to reduce insti- tutional barriers to business operations and growth is most effective when there is independent public monitoring of the program's imple- mentation with strong support at the highest political levels. A special- ized unit should be entrusted to monitor and oversee reforms. There should also be widely publicized and anonymous feedback channels that enterprises can use to report violations. For example, monitoring mecha- nisms in the area of business inspections could include (a) quarterly pub- lic reporting by inspection or supervisory agencies, (b) introduction of inspection logs at enterprises and organizations, and (c) establishment of coordinating boards to organize inspection activities (these boards would monitor and sum up the results of all inspections and maintain a database of them). STRENGTHEN "BEHIND-THE-BORDER" COMPETITION REFORMS TO FACILITATE REGIONAL TRADE AND FOREIGN DIRECT INVESTMENT While all but two of the SEE8 (Bosnia and Herzegovina and Serbia and Montenegro) are members of the World Trade Organization, more progress is needed on liberalizing tariff and other nontariff barriers on imported goods and services in the region (see World Bank 2003). Especially impor- tant in enhancing trade flows are the "behind-the-border" competition policy reforms that we have analyzed. For example, greater competition in the internal distribution networks within one of the eight countries will facilitate cross-border trade flows, from countries outside the region and among the SEE8 themselves, where discriminatory and preferential arrangements hinder neighborhood trade. Furthermore, to facilitate cross-border flows of FDI, the SEE8 governments should also continue to COMPETITION IN SOUTH EASTERN EUROPE 155 align their FDI policy regimes with international best practice in the fol- lowing ways: (a) national treatment for foreign investors; (b) binding international arbitration for investor-state disputes; (c) substantial reduc- tion in restricted sectors and limitations on FDI in other sectors; (d) free- dom for profit remittances; (e) expropriation only for a bona fide public purpose and with prompt, adequate compensation; and (f) an absence of trade-related investment measures. Again, this effort will help encourage FDI not only from countries outside the region, but among the SEE8 themselves. COMPETE FOR REFORM PROGRESS IN THE REGION Documenting the progress of competition policy reform among the SEE8 could help create pressure for more effective implementation in the region as a whole. Comparable information on the incidence of policy- based barriers to entry and expansion (such as the average number of days and cost to acquire a specific license or register a new business) would identify countries with a more favorable investment climate to investors domiciled in the region as well as to foreign investors. Such benchmarks of reform, if appropriately disseminated, could allow local enterprises to advocate for more rapid reforms in areas in which their governments are resisting change. They could also permit governments to implement further reform so that the countries can attract more invest- ment and, hence, greater employment and growth. In response to the con- clusions of the European Council meeting held in Lisbon in March 2000, the European Commission has launched a "Benchmarking Scoreboard" to include indicators on constraints in starting new enterprises and the average time and costs involved in setting up a company. The intention is to provide an assessment of relative effort, performance, and progress in EU member states and the community as a whole vis-à-vis a number of other countries. This effort will allow member states to act on the basis of shared learning and good practices. In order to jumpstart this type of vir- tuous reform competition among South Eastern European countries, gov- ernments could play an important role in proposing appropriate metrics and a simple survey methodology to assess progress in reform. ENHANCE PUBLIC EDUCATION EFFORTS TO FOSTER A CULTURE OF COMPETITION As part of their competition advocacy mandate, SEE8 governments should undertake public relations and educational initiatives aimed at ensuring that consumers and enterprises, especially start-ups, are aware of the importance of the competitive process and the objectives and con- tent of competition law. cent, cent, e per per mor or cent, 4 privatized, 1­201 31­40 cent 6: Notes 3: 1: per 4: per services 0 40 1­3, 2:, 2: cent, cent, 2: owned, novo per per than e de none, state 2: industry negative, 1­10 21­30 mor 1: 0: 1: 1: 3: 5: 7: of 786 1,625 1,591 1,510 1,638 1,638 1,591 1,638 1,573 1,638 1,403 1,047 1,583 1,051 1,638 1,541 Number Observations 0.43 0.38 20.3 27.6 8.7 5.9 5.1 19.8 5.1 10.02 0.724 9.9 0.5 1.1 Standard Deviation 127.9 20.8 SEE8 Annex the on 5.5 3 100 100 99 100 50 100 70 80 2 2 7 200 250 2,300 Maximum Statistical Data BEEPS 0.002 1.000 2.500 0.000 1.000 0.000 0.000 15.000 0.000 1.000 0.008 0.167 0.000 0.001 1.000 1 of Minimum 0.14 2.8 Mean 13.3 10.4 3.1 0.75 2.7 80.5 1.8 18.1 24.6 16.6 1.6 1.9 1.6 3.5 Statistics ratio (2002). Bank Summary millions) sales sales of marketing orld % average W a gin (US$ employees competitors e company establishments and average of % type and of of of (as of A.3.1 mar oductivity shar domestic sales) sales) a sales) ent % pr oductivity ofit-to-total of pr pr EBRD e par a (as evenuer ce: ableT riableaV (thousands) to annual (as annual annual oss Number Number Market Shar Number Subsidies Advertising Utilization R&D Price-cost Capital Labor Ownership Sales Sector Gr Sour 156 oss ofit- Gr pr sales ratio to-total page.) Sector following Sales the evenuer (US$ millions) on type Ownership continues able (T Labor oductivity pr Capital oductivityrp gin Price- cost mar of R&D (% average annual sales) SEE8 Utilization 1 1,573 the of sales) on (% expenses average Advertising annual 1 1,638 0.0428*** 0.0896 1,573 Data of (% Subsidies annual sales) 0.0022 1 1,591 0.0014 0.9559 1,591 0.9327 1,534 BEEPS of of Number establishments 1 1,638 0.0068 0.785 1,591 0.036 0.1448 1,638 0.0267 0.2903 1,573 ofe to ent 102* Shar domestic sales par company 1 1,638 0.0403 0.1029 1,638 0.0365 0.1451 1,591 0.0075 0.7605 1,638 0.1 0 1,573 e Market shar 0.0037 Correlations 1 1,510 0.0457*** 0.076 1,510 0.1229* 0 1,510 0.0841* 0.0013 1,468 0.0378 0.1418 1,510 0.8875 1,450 of 1* 0.4761* 0.0929* 0.071 0.0174 Number competitors 1 1,591 0 1,509 0.0363 0.148 1,591 0.0002 1,591 0.0052 1,545 0.0101 0.6868 1,591 0.4964 1,527 of Bivariate Number employees 0.2457* 0.0175 (thousands) 1 1,625 0 1,579 0.2966* 0 1,499 0.0057 0.8194 1,625 0.4059* 0 1,625 0.0790* 0.0017 1,579 0.0069 0.7804 1,625 0.4887 1,565 A.3.2 of of of sales) sales) e to average of e ent of of ableT employees (thousands) competitors shar domestic sales par company establishments (% annual and marketing (% annual Number Number Market Shar Number Subsidies Advertising Utilization 157 oss ofit- Gr pr sales ratio to-total 1 1,541 0.034 Sector 1 1,638 0.1821 1,541 Sales evenuer (US$ millions) 0.0527*** 0.0232 1 1,051 0.0875 1,051 0.463 1,005 type 0.1852* Ownership 1 1,583 0.0000 1,013 0.0806* 0.0013 1,583 0.2313*