Poland ~ Convergence to Europe The Challenge of Productivity Growth ...-.. .. ,- ~~.:i- ~,.. ~ I . I - wi!' - :;l . "'--. . ~ ....'; - ~. ~""'? ... ' -. J -~ ~ ~ , ~ -'-"" " ' ~ .. ~ ..., ~ - ~ ;'<0__ . - --.r-, ' ' ' -.. ft::. ~ ~.~. .JI THE WORLD BANK POLAND: CONVERGENCE TO EUROPE - THE CHALLENGE OF PRODUCTIVITY GROWTH INVESTMENT CLIMATE ASSESSMENT Europe and Central Asia Region Finance and Private Sector Department and Private Sector Vice Presidency Investment Climate Department POLAND: CONVERGENCE TO EUROPE- THE CHALLENGE OF PRODUCTIVITY GROWTH INVESTMENT CLIMATE ASSESSMENT © The International Bank For Reconstruction and Development / The World Bank, Poland, Warsaw Office Edition II Publisher The World Bank 53 Emilii Plater Str., 00-113 Warsaw tel. (48 22) 520 80 00 fax (48 22) 5208001 internet: www.worldbank.org.pl Published by Oficyna Wydawnicza "Rewasz" 05-800 Pruszk6w P.O. box 174 e-mail: rewasz@rewasz.com.pl http://www.rewasz.com.pl All rig hts reserved. Rights and Permissions This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this paper do not ne- cessarily reflect the views of the 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 judg- ment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. ISBN 83-89188-16-3 TABLE OF CONTENTS Foreword ...................................................................................... . vii Acknowledgments ............................................................................ . viii Summary of Outcomes and Policies ........................................................... . x Overview ...................................................................................... . XI I. BACKGROUND 1 A. The of the Challenge ................................................................ .. 1 B. The Eagle Slows .......................................................................... . 1 A Deteriorating Economic Environment? ................................................. . 2 D. Recovery and Challenges Ahead .......................................................... . 3 II. COMPETITIVENESS IN PERSPECTiVE ................................. .................. . 5 A. Poland's Productivity Performance ....................................................... .. 5 B. Poland Compared to the Other EU-8 ..................................................... . 7 C. The Global Context ....................................................................... . 8 D. Looking Forward: Maintaining Productivity Growth ....................................... . 9 III. DETERMINANTS OF PRODUCTIVITY GROWTH: A CONCEPTUAL FRAMEWORK. . . . . . . 11 A. Evidence from Microeconomic Empirical Work ............................................ 11 B. Lessons from the Cohesion Countries ............................................. .. .. . .. . . 11 C. A Framework for Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 IV. MICROLEVEL CONSTRAINTS ON SUSTAINED PRODUCTIVITY GROWTH ........ 15 A. Legal and Regulatory Infrastructure........................................................ 15 B. Government-Private Sector Interface....................................................... 16 Firm Creation and Operation .......................................................... 16 Regulation of Firm Entry .............................................................. 16 Regulation of Firm Operation ......................................................... 18 Labor Issues .......................................................................... 19 C. Stability of Private Sector Transactions ........................................... ......... 21 D. Private Sector Interface.................................................................... 24 Deficient Infrastructure ............................................................... 24 Access to Financial Services ........................................................... 26 E. Variables Under the Control of Firms...................................................... 27 Transparency and Corporate Governance.................................... ......... 27 State Involvement in Productive Activities. .. . .. . . .. . . .. . . . . . .. . . .. . .. .. . .. . . . . . .. . . .. . 29 Technology............................... .......................... .................. 31 V. POLICY PRIORITIES . ............. . 33 Improving the Legislative Framework .......................... ............ .............. 33 Improving the Judicial System ............................................................ . Improving Infrastructure.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Reducing the Costs of Regulatory Compliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Toward Stronger, More Competitive Enterprises ........................................... 35 Budding Institutional Capacity to Improve the Investment Climate. . . . .. . . . . . . . . . . . . . . . . . . . 36 ANNEX 43 Annex 1: Sources of Data. .... . . . .. .. . . . . . . . .. .. . . .. . .. .. . . .. . .. . . .. .. . . .. . . . . . .. .. .. . . .. . . . . . .. 43 THE WORLD BANK v Table of Contents Annex 2: Factors Behind Firm-Level Productivity Growth........................................ 45 Annex 3: Determinants of Total Factor Productivity: ............................................ 49 1.1. Estimated Productivity, 2002 ........................................................... . 1.2. Real GDP Growth, Poland, 1990-2003 ................................................. . 1.3. GDP per capita, PPp, 1992-2002 ....................................................... . 1.4. Aggregate Investment, 1992-2003 ..................................................... 2 1.5. Foreign direct investment, net, 1998-2003 ............................................. 3 2.1. Labour productivity and wages in manufacturing, Poland............................... 5 2.2. Employment in manufacturing, 1995-2002 ............................................. 6 2.3. Unit labor costs, Poland relative to other CEE-5 ......................................... 6 2.4. Unit labor costs in selected countries, 1996,2000 and 2003 ............................ 7 2.5. Sectoral productivity indicators, 2002 ................................................... 7 2.6. Unit labor costs in selected sub-sectors in the manufacturing industry.................. 7 2.7. High-skill industries..................................................................... 7 2.8. Productivity estimates in the garment sector ............................................ 9 3.1. Typology of factors affecting firms' ability to seize market opportunities................ 13 4.1. Competitiveness indicators, 2002 ....................................................... 19 4.2. Employment regulation, 2003 .......................................................... 20 4.3. Average duration of economic case in courts, 2000 ..................................... 22 4.4. Privatization proceeds, 1998-2002 ...................................................... 30 1.1. Macro and microeconomic indicators of turnaround, 1997-2003 ....................... 2 2.1. Foreign direct investment in manufacturing, 2001 ...................................... 8 2.2. Exports plus imports, 1995,2001 ....................................................... 8 3.1. GDP per capita.......................................................................... 12 3.2. Selected indicators of performances in cohesion countries and the EU-15 ............... 12 4.1. Country ranking by global competitiveness indicators, 2003 (out of 102 countries) ..... 15 4.2. Selected indicators of firm-level perceptions of the investment climate, 2003 ........... 16 4.3. Indicators on the regulation of entry, 2004 .............................................. 17 4.4. Regulatory burden and administrative delays by country, 2002 .......................... 18 4.5. Average days of inspections, 2003 ...................................................... 18 4.6. Income tax and social security contributions, 2002 ...................................... 20 4.7. Estimated size of the informal economy, 2000 .......................................... 21 4.8. Time and burden for contract enforcement of a dishonored check, 2004 ............... 22 4.9. Infrastructure indicators, 2002 .......................................................... 24 4.10. Infrastructure indicators, 2003 .......................................................... 24 4.11. Public expenditures on infrastructure, 1998-2002 ...................................... 25 4.12. Banking sector assets, 2002 ............................................................. 26 4.13. Indicators of NBFI and capital markets, 2002 ............................................ 26 4.14. Corporate governance indicators, 2003 ................................................. 27 4.15. State aid to enterprises, 1998-2002 .................................................... 30 4.16. Selected indicators on technology....................................................... 31 4.17. Technology indicators, 2002 ............................................................ 32 vi THE ·WORLD BANK FOREWORD Improving the investment climate is a key pillar of the World Bank's private sector development strategy. Without a good investment climate, firms and entrepreneurs of all types-from farmers to micro-enterprises to local manufacturing concerns and multinationals-have few opportunities and incentives to invest productively, create jobs, and expand, enter and remain in the formal economy, and thereby contribute to growth and poverty reduction. Growth and private sector development encompass a very broad agenda, but in Poland's case such a challenge boils down to the objective of reducing the convergence time to the standard of living of the EU-15 countries. Sound macroecono- mic policy, debt sustainability, open trade, security, access to finance, good governance and quality infrastructure services are all key requirements for the private sector to flourish. These conditions need to be complemented by micro-economic reforms-the policies and institutions that support efficient private economic activity-that help to unleash competitive forces leading to increased productivity and competitiveness. Produced by the World Bank in partnership with a public or private institution in each country, Investment Climate Assessments (ICA) systematically analyze the conditions-positive and negative- for private investment and enterprise growth in the manufacturing sector of the country, drawing on the experience of local firms in order to pinpoint the areas where further reform is most needed to improve the private sector's productivity and competitiveness. By providing a practical foundation for policy recommendations and involving local partners throughout the process, the assessments are designed to support policy reforms that can reduce the cost of doing business and in that way speed up private sector development, leading to faster economic growth and poverty reduction. Investment Climate Assessments are based on surveys of firm-level performance and perceptions on the quality of policies, regulatory and institutional factors. These surveys are designed to yield comparable information across countries. Benchmarking of key features of the investment climate has proven to be a particularly powerful instrument to set agendas and to encourage additional reform efforts. Findings of these surveys, combined with relevant information from other sources, provide a critical basis for identifying the most important areas for reform at improving the investment climate. The findings and policy recommendations emerging from these assessments are discussed exten- sively with the private sector and other stakeholders in the country. This broad dissemination of the findings is aimed at engaging not only policymakers but also all stakeholders, including business leaders, investors, and nongovernmental organizations in shaping the national private sector deve- lopment strategy, forging consensus on the priorities for reform of the investment climate, and laying the groundwork for concrete responses to the problems identified. The Poland Investment Climate Assessment is the first ICA piloted in the World Bank's Europe and Central region in 2004, adding to the stock of knowledge from the many other country reports prepared worldwide. The Poland ICA provides benchmark data to assess firm-level performance in other countries in the Europe and Central Asia region. The report also analyses Poland's strengths and weaknesses in the context of a regional comparison, with the EU-8 countries, which recently joined the European Union, the cohesion countries, and the other EU Member countries. Fernando Montes-Negret Director Finance and Private Sector Department Europe and Central Asia Region THE WORLD BANK vii ACKNOWLEDGMENTS The report was prepared by team led by Nancy Vandycke and comprising Robert Gourley, John Nasir, Ryszard Petru, Luis Alvaro Sanchez, Sacha Kandiyoti, and Annabel Lee. The report was prepared in consultation with the Ministry of Economy, Labor, and Social Policy of Poland. The dissemination of the report was coordinated by the World Bank's office in Warsaw, including Edgar Saravia, Jacek Wojciechowicz, Magdalena Wasik, and Natasha Kapil. Bruce Ross-Larson was the editor. The cover of the report was designed by Pauline Chin-MorL Anne John and Young Hong assisted with the production of the report. Many others inside and outside the World Bank provided helpful comments, including Fernando Montes-Negret, Axel Peuker, Andrew Stone, Ali Mansoor, Yasuo Izumi, Marie-Renee Bakker, Edgar Saravia, Henryka Bochniarz, Jacqueline Coolidge, Jan Rutkowski, Richard Symonds, Sue Rutledge, Istvan Szekely. The team also benefited comments from participants in videoconferences with sites in Warsaw, Moscow, Ankara, and Belgrade; and workshops at the World Bank Institute of the World Bank in Washington, and in Warsaw. The Report was presented at a conference on the conditions for convergence to Europe in Warsaw on June 29,2004, and was jointly organized by the World Bankand the Polish Confederation of Private Employers. Participants in these discussions, videoconferences, and workshops, included researchers, government officials, and staff of nongovernmental and private- -sector organizations. viii THE WORLD BANK ABBREVIATIONS BEEPS Business Environment and Enterprise Performance Survey CIT Corporate income tax EBRD European Bank for Reconstruction and Development European Commission ECA Europe and Central Asia Region EU European Union FDI Foreign direct investment FIAS Foreign Investment Advisory Service GDP Gross domestic product ICA Investment climate assessment ICT Information and communications technology IMF International Monetary Fund OECD Organization for Economic Cooperation and Development PAED Polish Agency for Enterprise Development PAIIZ Polish Information and Foreign Investment Agency PIT Personal income tax PLN Zloty (national currency of Poland) PPP Purchasing power parity RIA Regulatory impact analysis R&D Research and development ROSC Report on the Observance of Standards and Codes SME Small and medium enterprise SOE State-owned enterprise TFP Total factor productivity VAT Value added tax NOTE ON ANALYTICAL GROUPS For analytical purposes, this report uses the following groups of countries: Cohesion countries Greece, Ireland, Portugal, Spain CEE-5 Bulgaria, Czech Republic, Hungary, Romania, Poland EU-8 Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, Slovenia. EU-10 Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slo- vak Republic, Slovenia. EU-15 Austria, Belgium, Britain, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain, Sweden. OECD Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxemburg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States. THE WORLD BANK ix Poland Investment Climate Assessment: Summary of Outcomes and Policies ~ ------ ----~--------- ------------- STRENGTHS WEAKNESSES ------- Regained competitiveness since mid-2001, Significant loss in output potential due to high putting unit labor costs in line with the other unemployment and low incentives for labor mar- EU-8_ ket participation, including a high tax wedge. Fast growth in labor and total factor producti- Lack of competitiveness in agriculture. vity. Good location, making the country a magnet Continued dependence on traditional manufac- for foreign investment. (AT Kearney ranks Po- turing industries. land fourth in its 2003 listing of the 60 best destinations for FDI)_ Large domestic market (40 million inhabitants)_ Less openness than the other EU-8, despite si- gnificant FDI in manufacturing. Strong domestic and foreign competition in Regulation of entry ranking below the best per- most sectors, creating pressure to innovate and formers in the EU-1S. cut costs. EU-consistent legal and institutional framework. Complex and unstable tax legislation. Delays in processing of court cases and lack of alternative conflict resolution mechanisms. Poor performance relative to the other EU-8 in infrastructure (roads, transportation, telecom- munications, electricity, and lIT). Significant levels of FDI in manufacturing and Limited access to finance for small and medium- banking. Largest equity market in Central -sized enterprises. Limited bank credit to the pri- rope. Rapidly growing private pension fund as- vate sector. Limited development of non-bank fi- set base. nancial institutions (e.g., leasing, factoring, cor- porate bond markets) relative to the other EU-8 and EU-1S. Significant state ownership in key sectors, con- tributing to a reduction in social efficiency. Lag in adopting advanced technology relative to other countries in the region. Inadequate institutional capacity (PAED, PAIIZ) to monitor and improve the investment climate x THE WORLD BANK OVERVIEW Having joined the European Union, Poland faces the challenge of achieving a standard of living comparable to those of the EU-1 5. This is likely to be a lengthy task. If per capita GOP grows by 5.7 percent per year in Poland and by 2 percent per year in the EU-1 5, full convergence will take almost 30 years. To meet this timetable, Poland needs to achieve high rates of labor and total factor productivity (TFP) growth. It must also maintain its competitiveness by keeping cost increases in line with productivity growth. Poland's experience in the 1990s shows that it is possible to achieve high rates of total factor productivity growth. These high rates were achieved as a result of the government's decision to introduce the key principles of a market economy. These reforms strengthened property rights, stimulated the reallocation of resources, and redefined the role of the state. They also encouraged foreign direct investment (FDI) and greater commercial integration with the European Union (EU). Maintaining competitiveness has proven more difficult for Poland. In the late 1990s, the country's loss of competitiveness led to a marked economic slowdown and a widespread crisis of confidence. But economic growth has now returned, opening a window of opportunity to advance stalled structural reforms and fine-tune the microeconomic determinants of productivity growth. By making the most of this opportunity, the government can avoid the stop-and-go cycles of the late 1990s and maintain a steady pace of economic convergence with the EU-15. This report identifies Poland's principal strengths (see Summary Table of Outcomes and Policies above). These include its its skilled and productive labor force, its location within the EU market, and the growing credibility of its legal framework as Poland adopts the Acquis Communautaire. It also identifies weaknesses that must be addressed to unlock fast growth: · The increase in productivity has been associated with a significant decline in employment, especially in manufacturing. At 19 percent, the highest level within the OECD, unemploy- ment in Poland has reduced the economy's productive capacity. High labor costs have compounded this problem. · The manufacturing production structure remains dependent on low-skill, low-value-added, labor-intensive industries. Like Romania and Bulgaria, Poland remains locked in a traditional pattern of industrial trade and specialization. · Poland has not opened as much as the other EU-8, despite significant inflows of FDI in manufacturing. As a result, the following areas require priority action: · Enhancing the competitiveness of the tradable sector. The government should clean up the tax system, reduce the costs of regulatory compliance, and promote competition through such measures as effective implementation of anti-monopoly legislation. These reforms would facilitate the entry and operation of firms. Public policy should also promote the development of high-skill, high-value-added industries, including services. · Improving infrastructure. Public investment, including the use of EU support funds, can improve performance in transportation, power, telecommunications, and information and communications technologies. Private sector investment and participation in these sectors can also be encouraged by creating effective regulatory frameworks. · Strengthening corporate governance. Improved corporate governance can encourage in- creased investment by strengthening the protection of minority shareholders' rights. In addition, it can enable firms to respond more quickly to competitive pressures by upgra- ding management practices and absorbing new technology. THE WORLD BANK xi Overview · Accelerating privatization. The government should sell211 companies in 2004, as planned. State banking giant PKO BP, power distribution groups ENEA and G-8, power generation group PKE, chemical firm ClECH, and coal holding company KHW are all on the privatization slate. · Reforming the labor market. Labor market reforms can improve Poland's competitiveness and raise its standard of living. The top items on the reform agenda should include reducing the wedge between gross and net income. This would reduce the employment cost and increase the incentives for labor force participation. A detailed study should be conducted to clarify Poland's options in these areas. · Reforming the judicial system. Serious deficiencies in the judicial system spillover into many areas that affect the investment climate, including taxation, access to finance, incentives to innovate, and protection of minority shareholders' rights. Reform of the judicial system is a long-term effort that should be initiated as soon as possible. Since previous efforts have not produced the desired results, an in-depth Judicial Sectoral Assessment and a more focused Insolvency and Creditor Rights Assessment would help define a reform agenda. · Focusing on the microeconomic determinants of productivity growth. The government should continuously monitor the effectiveness of its policies and benchmark its performance against relevant countries. In addition, given the existence of regional discrepancies in many areas-implementation of tax laws, for example--the government should partner with local authorities to conduct regional investment climate assessments and develop region-specific plans. · Building institutional capacity. The capacity of such agencies as the Polish Information and Foreign Investment Agency (PAIIZ) and the Polish Agency for Enterprise Development (PAED) should be strengthened. In addition, the government should enhance its capacity to produce effective laws and regulations by adhering to strict procedures, such as the Regulatory Impact Analysis, which now accompanies the process of drafting new laws. xii THE WORLD BANK I. BACKGROUND As Poland joins the European Union (EU), it is time to take a broad look at the challenges facing the country as it seeks to catch up with the European "core." Poland's economic performance has been uneven since the collapse of socialism. After a quick takeoff and rapid transition, the Polish economy slowed in the late 1990s, and unemployment reached the highest levels within the EU-8 (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia). During this period of crisis, confidence in the economy was shaken, and the business environment deteriorated. The government's falling popularity and the breakup of the ruling coalition made it difficult to pursue structural reform, as well as the legislative changes needed for EU entry and beyond. These factors also led the prime minister and his cabinet to resign on May 2, 2004. By then, however, the economy had started to recover, with growth exceeding 3 percent of GDP in 2003. With the crisis coming to a close, it is time to reflect on how Poland can return to high growth. A. The Size of the Challenge Poland has a long way to go to achieve economic performance on a par with the EU average. Produc- Figure 1.1. Estimat(;d ProduCli .. it~, 2002 tivity in the EU is 66 percent higher, on average, than (GDP per hour per worker, 1999 US$) ~I II in Poland (Figure 1.1). The rate of convergence will depend on the difference between growth rates in Poland and the EU-15. According to De Broeck and Koen (2001), if per capita income grows by 5.7 per- EU II Poland II Czech II Hungary cent per year in Poland and by 2 percent per year in Source: OECD Republic the EU-15, Poland will catch up with the EU-15 in roughly 30 years. B. The Eagle Slows Poland's economic performance in the 1990s was Figure 1.2. Real GDP Growth. Poland, 1990-2003 outstanding relative to other economies in transi- tion. Poland experienced a relatively short and shal- low contraction followed by sustained and vigo- :1 2 . rous growth. From 1992 to 1998, the country had ~ 0 .... ...... TrrTTr.-''''u..,..Ju..,..Ju..,..Ju..,..J>.Q..L,-I..L,-I..L,-I''''''-.,..1,.'''-.,..1_'''-.,..1''''''-.,..1,.., seven years of uninterrupted growth at an an- ~ -2 ; ~ ~ ~ ; ~ ~ ~ ~ ~ ~ ~ -4 nual rate averaging over 5 percent (Figure 1.2). -6 -8 -7 This performance led some observers to call Po- -10 -8 land the "Soaring Eagle" or "East European Tiger." Source; IMF. ElU. CSO But after starting to slow in 1998, the economy re- Figure t.3. GDP per capila, PPP (US$), Poland =) corded its lowest rates of growth in 2001 and 2002. 1,80 After rising through 2000, Poland's per capita GDP t 11992 1,60 fell slightly relative to per capita GDP in the other 112000 t,40 112002 EU-8 in 2001 and 2002 (Figure 1.3). In 2003, Po- 1,20 land had the third-lowest per capita GDP within the C7Jlch Estonia Hungary Slovak Slovenia EU-8. Republic Republic Reasons for the economic slowdown. Slow Source: WDI growth in Western Europe and a sharp fall in de- THE WORLD BANK 1 I. Background mand in Russia and other eastern countries both help explain the economic slowdown that began in 1998. But the slowdown was more severe in Poland than in neighboring transition countries that were more open. This suggests that domestic factors played a significant role in Poland's economic downturn. Most important, perhaps, was a long slide in inve- Fi£:III'l' lA ..\~£:r{'~at{' InH'stmcnt. 1992··2(1113 (share ofGDP, %) stment growth as the torrid pace of early-transition 17,5.,------------------, investment cooled. Poland's remarkable growth in the 1990s was primarily driven by investment, which rose from 16 percent of GDP in 1993 to 25.5 percent 22.5 20 I I of GDP in 1999 (Figure 1.4). While this investment 17.5 15 '" '" S';. ;::: M ... '" ;::: '" or. 0-. ;::: 1 I '" ..... ;::: ;::: '" '" '" '" ;::: ;::: '" '" Co 0 0 :; 0 '" 0 0 ~, M 0 0 helped rebuild the country's worn-out and largely obsolete capital stock, it also created an overhang. Under the pressure of external fluctuations and a ti- '" '" N Source: IMP (2003). OEeD (20mb) ght monetary policy, the investment overhang even- tually burst and brought down the economy (De Bro- eck and Koen, 2001). The economic downturn reduced industrial and financial profitability. The number of newly re- gistered firms fell from 219,000 in 1999 to 164,000 in 2000. Also that year, the number of active small and medium-sized enterprises (SMEs) decreased for the first time since 1994. 1 The ratio of non-performing loans to total loans rose from 11.8 percent in 1998 to 20.1 percent in 2001 (Table 1 1). The rate of unemployment reached nearly 20 percent and exceeded 40 percent among the young. Tahir l.l. '\laero and '\1ierocconomic Indicators of Turnaround, 1997-2003 ---------~-----~-~-~-~-~--~ Indicators ------~---~----------------~.----------~-- 1997 1998 1999....-...- 2000 2001 2002 2003 Real GDP growth (%) 6.8 4.8 4.1 4.0 1.2 1.0 3.7 Gross fixed investment (% change) 21.7 14.2 6.8 2.7 -9.8 -5.8 -0.9 Current account (in % ofGDP) -4.2 -7.2 -6.1 -3.9 -3.6 -3.7 FDI inflows per capita ($) 78.6 128.3 164.0 211.1 168.0 Fiscal deficit (% of GDP) -3.2 -3.3 -3.5 -5.5 -6.7 -6.9 Inflation (%) ]4.0 11.8 6.7 11.4 4.2 1.5 1.9 Unemployment rate (%) 10.5 10.4 13.0 15.0 16.2 18.1 20 Industrial gross output (% change) 11.5 4.8 4.4 7.1 -0.5 Manufacturing gross output (% change) 12.8 5.1 5.3 7.3 0.0 Productivity in manufacturing (% change) 12.1 8.4 5.8 8.1 4.8 Bankruptcy cases 2100 2300 3000 4500 3000 Listed companies on stock exchange 143 198 221 225 230 209 Net profitability of commercial banks 11.7 2.9 4.2 3.4 2.4 1.4 (net earnings/total expenses, as %) loans as % of total loans 11.5 11.8 14.5 ]6.8 20.1 Source: IMF, OECD, PAED, NBP, EBRD, EIU. C. A Deteriorating Economic Environment? macroeconomic developments of the past few years-low economic growth, rising unemploy- ment, and growing debt-have hurt the government's popularity and stalled the process of structural 1 In 2000, enterprises operating in areas other than agriculture, forestry, fishery, and fishing generated 80.9 percent of the economy's gross value added (PAED, 2002). 2 THE WORLD BANK I. Background reform. In addition, some of the government's actions have increased the uncertainty facing busi- nesses. These include well-known reversals in privatization, the failure to develop and implement a policy of fiscal restraint, and the failure to reform the judicial sector. These developments have affected the perceptions of Polish entrepreneurs, according to the 2002 Business Environment and Enterprise Performance Survey (BEEPS)2. In 2002, percent of surveyed firms perceived "macroeconomic instability" as a major problem, compared to 47 percent in 1998. Similarly, percent of those surveyed perceived "policy regulatory uncertainty" as a major problem in 2002, compared to percent in 1998. These figures exceed comparable measures for any other transition economy, including Russia. In addition, the European Bank for Reconstruction and Development (EBRD) composite indices of perceived obstacles to business operations suggest that Poland made no progress at allover the past four years, even after controlling for macroeconomic performance (EBRD, 2002). Poland's scores were the worst within the EU-8. Poland is likely to remain a major destination for foreign direct investment (FDI), thanks to its skilled labor force, large population (the largest in the EU-8), and position in the middle of Europe. In 2003, AT Kearney ranked Poland as the fourth-best FDI destination in the world, after China, the US, and Mexico. (This ranking was based on a survey of top executives at the world's largest 1,000 firms.) However, the perceived quality and stability of government policies will affect the level and composition of FDI. For example, the perceived willingness of the government to reverse its commitments will undermine Poland's credibility among foreign investors if corrective measures are not taken. (As an example, in 2001, the government failed to treat as binding an agreement with the Dutch company EUREKa to sell percent of PZU, Poland's largest insurance company, to the private sector.) Poland has also recently lost three major projects to Slovakia. In 2004, in one of the year's biggest deals in the automobile sector, the South Korean manufacturing giant Hyundai picked Slovakia as the site for a new $870 million (£466 million) car plant. Scheduled to open in 2006, the factory will produce up to 200,000 vehicles a year for Hyundai's Kia brand. This is the second large car project that Poland has recently iost to Slovakia. In 2003, France's PSA Peugeot Citroen cited labor costs in explaining its choice of a site in Slovakia for a new plant of roughly the same size as Kia's. The Polish foreign investment agency, PAIIZ, esti- Figure 1.5. Foreign Direct Imestment. Net. mates that Poland needs to attract $125 billion in fo- 10 000 l 1998-2003 (in millions USSl reign investment per year to secure GDP growth of 5 80001 percent per year. But after climbing for several years, 6000 · ~. FDI flows have declined since 2000 (Figure 1.5). In--?-............~ 4000 / the 1990s, foreign investors buying state assets, in- 2000 ciuding banks, drove large investment inflows. 3 By the end of 2001, cumulative foreign direct invest- - - Czech Republic - - Hungary - - Poland - - Slovakia ment in Poland since the early 1990s reached $56.8 Note. Values for 2002 are estimates; values for 2003 are preliminary. billion. (On a per capita basis, Poland remained at SourceEBRD(2003) the low end of the EU-8, with $1,278 in per capita cumulative FDI from 1993 to 2002.) D. Recovery and Challenges Ahead Driven by an improved competitive position, the Polish economy grew at 3.7 percent in 2003. But fiscal management continues to be a matter of considerable concern. Despite repeated efforts 2 ror a full description of survey instruments, see Annex 1. 3 Since 1992, there has been a fourfold increase in the number of workers employed by foreign companies. However, the share of the foreign sector in total employment remains relatively small (4.2 percent in 2001). THE WORLD BANK 3 I. Background at fiscal reform, the government deficit was dose to 7 percent of GOP at the end of 2003. At $10 billion, Poland's public deficit already exceeds the level permitted by the Maastricht fiscal criteria for EMU membership.4 Moreover, Standard & Poor's has warned that Poland's debt to GOP ratio may rapidly rise to more than 60 percent by 2006. The government's challenge is to reduce the public sector deficit while restructuring public expen- diture to favor private sector growth. As part of this process, it must promote investment in infrastruc- ture and provide greater support for technological development. Potential EU transfers can reduce the fiscal burden, but Poland must also generate significant resources on its own to pre-finance agricultural direct payments, provide the funds needed to co-finance EU investments (typically 15 percent to 25 percent of the projects' total value), and pay membership fees for the EU and other European institutions (equivalent to 1 percent of GOP). Fiscal adjustment will not be easy. Some resources could be freed by introducing hard budget constraints for public enterprises, which are now financed either directly or indirectly by the state. (See Chapter IV.) But difficult choices concerning social transfers will also have to be made. Social security spending and transfers to extra-budgetary funds currently absorb 84 percent of the government budget. Poland's recent increase in competitiveness provides a basis for resumed economic growth. Indeed, the current IMF forecast puts expected economic growth at around 4 percent per year over the medium term. But Poland cannot rely on wage restraint or currency depreciations-the factors behind its recent improvement-to drive sustained growth and convergence with the EU. The successful pursuit of these goals requires continued increases in productivity. The next chapter presents an overview of patterns in productivity and competitiveness since Poland's move to a market economy and compares its performance with that of the other EU-8 and the EU-1S. 4 The Maastricht criteria require the general government deficit to be no more than 3 percent of GDP and general government debt to be no more than 60 percent of GDP. 4 THE WORLD BANK II. COMPETITIVENESS IN PERSPECTIVE This chapter takes stock of the microeconomic underpinnings of economic growth in Poland since the beginning of the transition. It focuses on the evolution of productivity, wages, and overall com- petitiveness and compares Poland's performance with the performance of the other EU-8, the EU cohesion countries (Greece, Ireland, Portugal, and Spain), and the global economy. Poland's remar- kable economic performance during the 1990s was sustained by a striking increase in labor and total factor productivity. 5 But in the middle of the decade, these gains were overtaken by wage increases that raised unit labor costs and reduced the economy's competitiveness. More recently, slower wage increases-due to a weak labor market-have combined with a mild currency depreciation to increase Poland's competitiveness in the region. Stili, significant differences between Poland and the other EU-8 remain. Poland's agricultural sector is less productive, the country's manufacturing production structure continues to depend on traditional industries, and despite a considerable inflow of foreign capital, Poland remains less open than other transition economies. Moreover, it faces growing competition from countries on the rim of Europe and from emerging Asian economies. In facing these challenges, Poland cannot rely on wage restraint-since EU accession will put pressure on the labor market- or on currency depreciation. Instead, it must ensure that productivity continues to rise. A. POLAND'S PRODUCTIVITY PERFORMANCES Poland has shown remarkable growth in labor productivity. .. During the 1990s, Poland's growth in per capita GDP was supported by a remarkable increase in labor productivity. The OECD estimates that in the business sector, labor productivity grew at an average rate of 6.4 percent per year between 1994 and 2001. By comparison, the OECD average for the same period was only 1.7 percent. Hungary and the Czech Republic, countries going through a similar transition process, also lagged Poland in productivity growth. According to the OECD, the comparable figures for these countries were 2.9 percent and 2.6 percent, respectively. ... especially in the manufacturing sector Labor Figure 2.1. Labour Producthit~ and Wages productivity in manufacturing increased by 250 per- in Manufacturing. Poland, (199~-10()) 350,---------------,---, cent between 1992 and 2002, with no evidence of 300 a slowdown after 2000 (Figure 2.1). (This reports 250 200 treats manufacturing, which generates most of Po- 150 land's exports, as a proxy for the tradable sector.)6 100 50r--.-.-~-.-._-.-.-_r-.__,- This rate of increase compares favorably with the 1992 1993 1994 1995 1996 1997 1998 19992000 2001 2002 .. h . I f -- Labour productivity index pe rf ormanceo f ot hercountneslnt ereglon. n act, --Averagemonthlygrosswagesindex measure d since 199 5, Iab or pro d ' " In manu fac- · uctlvlty Source: wnw dataoase turing grew faster in Poland than in all other EU-8 countries, except Hungary. t Competition has been the driving force behind the increase in productivity. In the 1990s, rapid and comprehensive liberalization exposed Polish firms to intense competitive pressure. Results from the 2003 BEEPS Extension, which are shown in Annex 2, suggest that Polish firms face much greater 5 Total factor productivity measures how capital, labor, and material inputs contribute to output, accounting for differences in labor quality and adjusting for capacity utilization. It provides a measure of how efficiently firms are using all resources, not just labor. 6 As will be seen below, productivity in agriculture is low, while productivity has been growing in parts of the service sector, For example, productivity has increased in banking, which benefited from significant foreign investment, but there is room for improvement in other services, such as la, THE WORLD BANK 5 II. Competitiveness in Perspective competition, both domestic and foreign, than firms in other countries in the region. In the 2002 BEEPS, almost 86 percent of sampled firms identified domestic competition as an important factor in the decision to develop new products, services, or markets. In addition, 81 percent of sampled firms reported that pressure from domestic competitors was a very important factor in the decision to cut costs. Figure 2.2. lmplo~mcnt in '\Ianuracturing. 1995-2002 Growth in productivity has been accompanied by (thousands) a decline in employment. The jump in Poland's labor 3.000 J productivity reflects the shedding of unneeded wor- 2,800 J ...--_.--. 2,600 i kers, as well as increases in output. Employment has declined steadily since 1998, especially in manufac- ::::1 2.000 , 1 turing (Figure 2.2). In 1992, the fall in employment could be attributed to efforts to reduce pre-transi- i i i t 1995 1996 1997 1998 1999 2000 2001 2002 Source: wnw data tion overstaffing, which was estimated to be on the order of 30 percent (de Broeck and Koen, 2001). But once this overhang was eliminated, firms continued to shed workers. 7 Combined with the restruc- turing that followed the 1998 Russian crisis, the slowdown in investment growth contributed to a radical shift from job creation to job destruction (lM~ 2003). Since 1998, Poland has lost 1.37 mil- lion jobs-roughly 8 percent-on a net basis (CSO, 2002). Between 2001 and 2002 alone, industrial employment declined by almost 11 percent. Unit labor costs increased in the 19905 ... Evaluating Poland's competitiveness requires productivity to be gauged against labor costs. As shown in Figure 2.1, wages in manufacturing increased at a faster rate than labor productivity, despite growing unemployment. As a result, unit labor costs in manufacturing increased by 19 percent from 1992 to 2001. This loss of competitiveness clearly contributed to the slowdown of the economy. Fillure 2.3. { nit Lahor Costs. Poland relathe to other CEE·S ...but began to fall in mid-2001. This latter trend (US!)). 2(H)n~ I no 110,00-,---------.,---------_ improved Poland's competitive position relative to 105.00 100,00 the other EU-8 (Figure 2.3). Wage restraint, in the 95,00 90,00 face of very high unemployment, and a mild depre- 85,00 80,00 ciation of the currency together explain the increase 75.00 70,00 in competitiveness and the resumption of economic 65,00 60,00+_~-N~M-.-.,.--r--,--;;:t--r-M .,. - .... ~ ::.t 0 "' '"" ;;:t growth. 0 0 Q ogO 0 ~ 0 0 0 ~ ~ ~ ~ 0 - g g g 0 § - g gog g goo - ~ - - g N N 8 ~ N N N N N ~~ N N N NnN N N Source: IMF data 7 In many European OECD countries, the real cost of labor increased in line with (or faster than) labor producti- vity growth, with little growth in employment. High labor costs encouraged capital-intensive production, leading to a relatively faster rise in capital-to-Iabor ratios, which in turn reduced labor demand (Cornelius and Yang, 2002). 6 THE WORLD BANK II. Competitiveness in Perspective B. POLAND COMPARED TO THE OTHER EU-8 Poland fares well in terms of unit labor costs. Me- Figure 2.4. {'nit Labor' Costs in ~e1re1(·d Countries, \996, 200n, 2003 (ad,lllsh:d Pl'l'. AustrincjOOI asuring unit labor costs within the EU in purchasing 70,---------------------------, power (PPP) terms, using Austria as the base, sug- 60 gests that the recent decrease in unit labor costs has 50 II 1996 40 brought Poland roughly within the fold of the clo- r I 2000 30 II 2003 ser EU-8 countries, with the exception of Slovakia 20 (Figure 2.4).8 10 o But competitiveness varies by sector. As shown in Czech Hungary Repubhc Poland Slovak Slovenia Republic Figure 2.5, Poland is particularly weak in agriculture. Note: Values for 2003 are preliminary, Source: wnw (2004) In this sector, Estonia and the remaining (Bul- garia, the Czech Republic, Hungary, and Romania) Figure 2.5, Svctora! Producthit) Indicators. 2002 are all at least three times more productive than Po- II. SS. Poland~ II 5,00 .,-------------------------------, land. In services, by contrast, Poland does remarkably 4.00 well, trailing only Slovenia, And in industry, Poland 3,00 falls behind Slovenia, Hungary, and Czech Republic, but not by much. Within manufacturing, labor productivity has grown at different rates in different subsectors, while wage growth has been similar across subsectors. As a result, unit labor costs have diverged significantly 2,00 1,00 0.00 Czech Republic Estonia Hungary Ju Slovak Republic Slovenia I I Related GDP per person employed in agriculture Related GDP per person employed in industry over time. For example, unit labor costs have rema- II Related GDP per person employed in services ined relatively stable in transport equipment over the Source: IMD (2004) past 10 years, but they have increased in the chemical sector. Thus, the relative competitiveness of subsec- tors within manufacturing has shifted over time (Figure 2.6),9 Figure 2.6. Cni! Labor Costs in Sdectrd Subsl'ctors in the Manufacturing Industry (n~l(ional currency. 19C)]= 1011 I Figure 2.7. High-skilllndllstries (as a Percentage of Total 500.---------------------------------, :\Ianufaclurillg bports to the EC-IS) 60,-------------------------. 400~ 300 50 40 111995 200 30 II 2001 100 - 20 10 1992 1993 1994 1995 1996 1997 1998 19992000 2001 2002 ~ DFCoke, refined petroleum products & nuclear fuel -DG Chemicals, chemical products and man-made fibres ~DL Electrical and optical equipment -DM Transport equipment Source: wnw data Source: EC (2003b) Poland remains dependent on traditional industries. When compared to the other EU-8, Poland seems "locked in" to a traditional pattern of trade and industrial specialization, While Romania and Bulgaria also remain dependent on low-skill} labor-intensive industries, the other EU-8 show a more dynamic pattern of integration into the European division of labor. Hungary, the Czech Republic, 8 These results are roughly confirmed when using EUR instead of PPP for comparison, 9 On average, the five largest industries supply about 60 percent of total manufacturing output in both the EU-8 and the EU-1S. But when measured by the share of the three largest industries (CR3), specialization remains somewhat higher in the EU-8, even though CR3 declined in the EU-8 over the 1990s while remaining stable in the EU-1S. In most of the EU-1S, the production share of the three largest industries is around 40 percent. In Poland, by contrast, CR3 in 2001 was roughly 48 percent 2003a), THE WORLD BANK 7 II. Competitiveness in Perspective Slovakia, and Estonia are catching up relatively fast in technology and more sophisticated branches of industry. Polish skill-intensive exports have also grown, but less than in the other EU-8, particularly Hungary (Figure 2.7).10 . Poland remains less open than the other EU-8 countries, despite significant FDI in manufacturing. Like most of the EU-8, Poland has received a large amount of FDI (Table 2.1). In 2001, the flow of FDI stood around 30 percent of GDP-roughly the median level for the EU-8. (The Czech Republic and Estonia are significant outliers.) Much of this investment-41 percent-went into manufacturing, making Poland's FDI stock per manufacturing employee one of the highest in the EU-8. Table 2.1. Foreign Direct Investment in :\1anufacturing, 2001 FDI stock per FDI stock FDI stock (in the manufacturing) FDI (% of GDP) (% of GDP) (in 1,000 EUR) (in percent of FDI stock) ----------------------------------------------~ ------~------------ Czech Republic 48.4 18.2 10.7 37.6 Estonia 51.1 11.0 5.2 21.5 Hungary 22.0 8.1 5.4 36.8 Latvia 29.9 5.1 2.9 17.0 Lithuania 20.5 5.9 3 28.7 Poland 29.6 12.2 10.6 41.2 Slovak Republic 23.3 10.2 6.1 43.8 17.4 6.3 5.8 36.2 Source: EC (2003b) Table 2.2. Exports plus Imports, 1995,2001 When external trade is considered, however, Po- (as a share orGDP) land remains less open than its neighbors (Table 2.2). Between 1995 and 2001, exports plus imports Country 1995 2001 Czech Republic 112 143 as a share of GDP rose from 50 percent to 60 per- Hungary 76 123 cent in Poland, while the same figure for Hungary Poland 48 59 rose from 76 percent to 123 percent. Given the Slovak Republic 113 156 gnificant flow of FDI into Polish manufacturing, it is Slovenia ll2 120 ------------ surprising that the increase in Poland's openness du- Source: WDI (2003) ring this period was relatively small. Closer inspection shows that FDI in Poland moved primarily into such traditional industries as food, wood, non-metallic minerals, and paper. The exceptions are electrical and transport equipment, where a sizeable FDI inflow has contributed to a significant increase in productivity. It is possible that FDI has been drawn into traditional sectors to supply Poland's larger domestic market. 11 C. THE GLOBAL CONTEXT Although Poland has achieved considerable growth in labor productivity, other countries-Ukraine, for example, or China and India-have also experienced high rates of growth. Therefore, Poland faces intense competition for access to EU markets, particularly in such traditional industries as textiles. This competition puts Polish firms in a double bind. Externally, they face lower prices for imports into the EU. Internally, they face rising labor costs and slow productivity growth in labor-intensive sectors. Poland's greater size may help explain this pattern. 10 The links among FDI, growth of innovation driven/skill-intensive industries, and economic openness should be 11 analyzed in greater detail. This process could identify barriers that may have a negative effect on Poland's pattern of specialization over the long run. 8 THE WORLD BANK II. Competitiveness in Perspective A recent World Bank survey suggests the scale of the challenge facing Polish businesses. 12 In the garment industry, Poland ranks second after China in terms of value added per worker (Figure 2.8).13 Poland also has the highest rate of total factor productivity. (India is used as the base.) However, when wages are factored in, Poland becomes the least competitive of the countries under study. 14 Moreover, the unit price of garment imports into the EU has been falling, putting additional pressure on firms. Figure 2.S. Prodllcti\it~ Estimates in the Garment Sector 32.---------~----------------- ------------------------------------------, 27 22 17 12 7 2 -3 -8 -13 -18~--------------------------------------------------------------------~ I, Value Added per Worker (US$ thousands), fewer than 50 workers (at Nominal ER) II Gannents Productivity Gap, India Base (Nominal ER Gap, %) II Value Added/Labor Costs (US$) Source: World Bank, BEEPs survey extension data A harbinger of things to come? In the future, the competitive pressures faced by traditional indu- stries may affect other subsectors. This highlights even more the need to focus on the determinants of productivity growth. D. LOOKING FORWARD: MAINTAINING PRODUCTIVITY GROWTH What must Poland do to maintain fast growth in labor productivity? The country's recent expe- rience points to an important lesson. The high growth rates that Poland previously achieved were not due exclusively to capital accumulation and labor shedding. Total factor productivity (TFP) also increased at an exceptional rate. From 1992 to 1998, Poland's TFP growth averaged about 4 percent ",2 The survey estimated total factor productivity for enterprises in a selected set of countries. See Annex 1 for a de- scription of data and survey instruments used in this report. 13 The garment sector is used for illustration because it is one of the best examples of a relatively homogeneous industry for which a production function can be estimated. It is also covered in a number of countries worldwide by the standard World Bank survey. In Poland, the garment sector accounts for about 2 percent of manufacturing production. Between 1998 and 2002, production in this sector fell by 2 percent. Annex 2 and Annex 3 present the results for TFP calculations in the garment and food processing industries. 14 FDI per employee in the textile industry is among the lowest (EU 1,000), in the manufacturing sector. By comparison, FDI per employee in transport equipment averaged EU 36,900 in 2001 2003a). THE WORLD BANK 9 II. Competitiveness in Perspective per year-high by international standards. Among emerging market economies, only China has achie- ved comparable TFP growth in recent years, and only two industrial countries, Finland and Ireland, registered TFP growth exceeding 3 percent in the 19905. In Poland, these productivity gains stemmed in part from the reallocation of inputs across sectors. They were also stimulated by the increasingly competitive environment faced by Polish industry, as trade expanded rapidly in the wake of the 1990 liberalization (de Broeck and Koen, 2001). The challenge is to keep these rates of TFP growth high in an increasingly open economy. 10 THE WORLD BANK III. DETERMINANTS OF PRODUCTIVITY GROWTH: A CONCEPTUAL FRAMEWORK Why do some countries grow more rapidly than others? The evidence suggests that total factor productivity accounts for most of the differences in growth performance among countries, not accu- mulation of physical and human capital. 15 Researchers have emphasized "high-quality institutions" (Knack and Keefer, 1997; Acemoglu, Johnson, and Robinson, 2001), "social infrastructure" (Hall and Jones, 1999), and institutions and government policies as key determinants of growth. These indicators are, however, too aggregate to provide specific policy guidance. Hence, current efforts, including this Investment Climate Assessment (lCA), focus on identifying microlevel determinants of productivity and deriving policy recommendations to complement the emphasis on macroeconomic stability. This section reviews evidence from microeconomic empirical work. It then focuses on lessons from the cohesion countries and presents a framework for analyzing the determinants of productivity growth. A. EVIDENCE FROM MICRO ECONOMIC EMPIRICAL WORK In order to understand how poor institutions and policies affect firm performance, the World Bank has undertaken a major effort to collect firm-level data, drawing on new measures of institutional variables. As part of the Investment Climate Assessment (ICA) exercise, the Bank conducted a firm-level survey in eight countries-Poland, Moldova, Uzbekistan, Tajikistan, the Kyrgyz Republic, China, India, and Pakistan-to analyze productivity in two representative sectors (garments and food processing). In the Europe and Central Asia (ECA) region, Poland's record in TFP was used as a benchmark to assess the productivity gap in other countries. In addition, the Polish data offered insight into the determinants of Poland's remarkable TFP. As detailed in Annex 3, much of Poland's success can be explained by the quality of the investment climate, which can be proxied by variables such as access to bank credit, inspections, power outages, foreign ownership, training and worker skills, and exports. In similar work, Dollar et al. (2003) analyzed a random sample of firms, drawn from several sectors, to determine if microeconomic measures of the investment climate could explain aggregate economic performance in China, Bangladesh, and Pakistan. 16 They identified a set of five indicators that explained some of the variance in growth among these countries: the number of inspections per year, the number of days to clear customs, power losses (in terms of a percentage of sales), the number of days to connect to a phone line, and the share of firms with overdraft facilities. B. LESSONS FROM THE COHESION COUNTRIES The cohesion countries (Greece, Ireland, Portugal, and Spain). which joined the European Union 10 to 20 years ago, provide an intermediate benchmark for the EU-8. They also suggest some valuable lessons, notably that, the ability to profit from the opportunities provided by an enlarged market depends largely on the domestic business environment. Table 3.1 shows the evolution of per capita GDP in the cohesion countries, relative to the EU-1 0 (Cyprus, Malta and EU-8), from 1950 to 2002. Convergence in Ireland, which joined the EU in 1973, only took place after 1986, once the government had implemented a series of critical reforms. Following the adoption of measures to control the fiscal deficit, open the economy, and create a better investment climate, foreign 15 Hall and Jones (1999), for example, estimated that differences in productivity accounted for 68 percent of the cross-country variation in growth between 1960 and 2000. 16 These three countries had similar incomes at the beginning of the 19905, but diverged considerably thereafter. THE WORLD BANK 11 III. Determinants of Productivity Growth: a Conceptual Framework investment accelerated, with FDI growing to more than 50 percent of GDP. Private investment also rose from 16 percent of GDP in 1995 to 24 percent of GDP in 2000. Similarly, the Spanish example illustrates the importance of internal reforms. After Spain joined the in 1986, growth declined for several years before resuming in the 1990s, following progress in reform. The fiscal position also moved into balance in the 1990s, and private investment increased. Table 3.1. GOP per capita (con~tant 1990 international dollars. ELJ-I 0= 100) - ............ ~-~----------~~-.--. ................ ~-- Country or group 1950 1973 1981 1986 2002 EU-I0 100 100 100 100 100 Ireland 69 57 62 60 118 Greece 38 63 64 61 63 Portugal 42 61 58 56 70 Spain 48 72 67 66 78 Cohesion countries 47 68 65 63 77 Asian Tigers* 30 40 51 79 (*) Hong Kong, Singapore, South Korea, Taiwan Source: Kazimierz and Romisch (2003) Achieving high productivity growth. In Ireland, the most important factor was the creation of a highly competitive environment in manufacturing and in such tradable services as information and communications technologies (la) and financial services. The competitive environment induced significant restructuring in local industries and encouraged trade and foreign investment. The resulting economic expansion contributed to a significant reduction in unemployment. Moreover, together with tax reforms, it induced greater labor force participation, fueling growth. Finally, policies emphasizing human capital, including efforts to bring talent from abroad, helped make Ireland's productivity gains sustainable. Taken together, this record suggests that the EU-8 are likely to benefit from their early push to create market-friendly institutions, as well as from the fact that the 1990s was a decade of increased capital and trade integration. Table 3.2. Selected Indicators of Performances in Cohesion Countries and the Elf-15 --...---- --~-----~. Changes in Nominal FDI stocks Private Investment General Government Deficit Unit Labor Costs (% ofGDP) (% ofGDP) (% ofGDP) (%) 1987-1991 1992-1999 1995 2000 1995 2000 1995 2000 Ireland 0.5 0.9 18.0 62.0 16.0 23.8 2.8 -2.5 Greece 4.8 3.7 15.5 17.5 16.0 20.0 10.0 3.5 Portugal 7.8 2.1 15.5 23.8 21.3 23.8 4.7 2.5 Spain 8.8 0 18.5 23.8 18.5 22.2 5.9 0 EU-15 4.3 1.7 Source: Kazimierz and Romisch (2003) Maintaining competitiveness. Ireland and Spain have maintained their competitiveness during a period of high economic growth. Unit labor costs in Spain did not grow at all between 1992 and 1999. Over the same period, unit labor costs in Ireland grew at an average annual rate of 0.9 percent (Table 3.2). Despite high wage growth, Ireland has remained competitive, even with rocnO,-T to the EU-8, by keeping cost increases in line with productivity growth in the tradable sector. 12 THE WORLD BANK III. Determinants of Productivity Growth: a Conceptual Framework Different countries will find that different institutions can help them secure this objective. Ireland, for instance, has adapted a social partnership approach, which coordinates wage moderation with taxation and welfare reform. C. A FRAMEWORK FOR ANALYSIS This report distinguishes between two types of factors that can affect firm performance: those typically under a firm's control and those that define the investment climate. 17 The first category inc- ludes ownership, corporate governance, management capacity, and other internal factors that affect a firm's ability to perform in a competitive environment. This report will focus on a subset of these factors: corporate governance, ownership, and selection of technology. A complementary report- the Knowledge Economy Assessment-analyzes such additional factors as education, training, and absorption of technology (World Bank, 2004b). Government-private sector interface. 18 The government interacts with the private sector by issu- ing laws and regulations, such as measures involving business registration, licenses, permits, taxes, labor standards, customs, land titles, and the like. The government also enforces these laws through inspections, tax administration, customs administration, and other means. Enforcement and com- pliance are costly, and these costs help determine important organizational characteristics of the economy, including industrial concentration, patterns of ownership, and the degree of competition. Figure 3.1." T~ pOlOg~ of Fa('tor~ Affecting Firm,' \hili\\ ro Seil.l' .\larkN Opportunitil'" Objective: Increase I Economy's Competitiveness I I Microeconomic Capability , . - - - - - - - - - - - - - - - + I - - - - - - - - ' - - - - ' ' - - ! r - v a r i a b l e s outside the control of firms. I I _j' Variables within the control of firms (Le. Investment Climate) . · Corporate Governance 1. Government - Private Sector Interface · Ownership 1.1. Laws and Regulations (L&R) · Technology 1.2. Enforcement of L&R · Product mix 12. Stability of private sector transactions 2.1. Contract enforcement '--__________. I 2.2. Judicial and court system 13. Private Sector Interface I I I 3.1. Physical Infra s.tru_c._ture_. __~_II __ 3.2. Financial Infrastructure (*) necessary. but not sufficient condition '---------_. Stability of private sector transactions. Firms require an environment where rights are secure, con- tracts are enforced, and personnel and property are reasonably safe from criminal acts. Many resear- chers have documented the importance of secure property rights. For example, Johnson, McMillan, and Woodruff (2002) have shown that entrepreneurs who believe their property rights are secure reinvest between 14 percent and 40 percent more of their profits than entrepreneurs who do not 17 The World Development Report 2005 (World Bank, 2005) offers a useful starting point for assessing a country's investment climate. It ranks relevant issues under five broad headings: broad governance issues; security and stability; regulation, taxation, and openness; financial and physical infrastructure; and workers and labor markets. This report takes a concise approach by limiting its coverage of the investment climate. 18 The government is understood here as the legislative and executive power. THE WORLD BANK 13 III. Determinants of Productivity Growth: a Conceptual Framework share this belief. (This sample was drawn from Poland, Romania, Russia, Slovakia, and Ukraine). While many institutions can secure property and enforce contracts (Djankov, La Porta, Lopez-de-Silanes, and Shleifer, 2003), this report focuses on the courts. Private sedor interface. The government's regulatory capacity affects interactions between private agents, such as transactions giving firms access to finance and such other critical facilities as telecom- munications, electricity, roads, and ports. Ample evidence demonstrates the importance of physical and financial infrastructure for firm performance. For example, Rajan and Zingales (2002) have shown that repressed and distorted financial markets have a significant impact on firm-level productivity and economic growth. 14 THE WORLD BANK IV. MICROLEVEL CONSTRAINTS ON SUSTAINED PRODUCTIVITY GROWTH Recent assessments suggest that Poland's com- Table 4.1. Country ranking by global competitiveness petitiveness ranks at the bottom of the EU-8 group, indicators,2003 (out of 102 countries) behind even Romania and Bulgaria (IMD, 2004; WEF, Growth Business 2003) (Table 4.1). These rankings raise concern Competitiveness Competitiveness about Poland's ability to maintain rapid producti- --;;:;:_-;-;;;:--~~. Index Ranking Index Ranking Czech Republic --39 35 vity growth. Using various data sources, survey in- Estonia 22 28 struments, and results from consultations with the Greece 35 39 private sector, this chapter highlights key bottlenecks Hungary 33 38 to future growth. Ireland 30 21 Latvia 37 29 Lithuania 40 40 A. LEGAL AND REGULATORY INFRASTRUCTURE Poland 45 47 Portugal 25 36 There is ample evidence of the impact that regula- Slovak Republic 43 43 tory frameworks have on firm performance. Among Slovenia 31 30 others, Brandt (2004) has shown that complicated li- 23 25 ~~.----------------------- cense and permit systems discourage the creation of Source: WEF (2003) new enterprises. 19 Giving creditors long-lived claims to the assets of bankrupt firms can have the same effect. Klapper et al. (2004) have shown that value added per worker in "high entry" industries (retail, for example) grows more slowly in countries with onerous entry regulations. And Kaufmann et al. (2002) have shown that national income depends in part on measures of "regulatory quality" including the incidence of price controls or inadequate banking supervision, as well as the perceived burdens regulation imposes in such areas as foreign trade and business development. A regulatory framework's quality is determined by its content, complexity, and consistency. Com- plexity and inconsistency often impede implementation by making rules difficult to respect and enforce. Unfortunately, Poland's legal and regulatory infrastructure is complex and sometimes con- tradictory. In addition, it suffers from serious deficiencies in implementation. These problems affect all areas of Polish economic life. Filling the post-socialist legal vacuum. Like other transition countries, Poland had to fill the legal vacuum that followed the collapse of socialism. Throughout this process, there was a tendency to emphasize control and regulation. More recently, harmonization with the Acquis Communautaire has required considerable legislative activity. Between October 2001 and May 2003, Parliament approved or reviewed 444 acts of legislation, including 75 acts aimed at adapting Polish law to the Acquis Communautaire. Unpredictable legislative outcomes. During this period, various ministries undertook parallel legi- slative initiatives. This led to the adoption of inconsistent and contradictory pieces of legislation. For example, when the Ministry of the Economy presented the "First for All Entrepreneurship" Program to support private sector development, Parliament made significant amendments to the government's proposal. Some of these amendments ran counter to the ministry's intentions. For example, one of its goals was to alleviate the administrative burden facing small and medium-sized enterprises. Instead, 19 Brandt's study (2004) also showed that firm entry rates are significantly correlated with output and employment growth across services sectors. But this relationship is less clear-cut in manufacturing. If new firms are thought to influence output and employment growth by facilitating innovation and technology adoption, as Schumpetarian models of growth suggest, this result appears quite puzzling. THE WORLD BANK 15 IV. Microlevel constraints on Sustained Productivity Growth Regulation of Firm Operation The costs of regulatory compliance have a significant impact on firms' ability to compete, innovate, allocate resources, improve management practices, and adopt new technologies. In all these areas, businesses operating in Poland may be at a disadvantage with respect to firms in neighboring countries. Managers in Poland have less faith in the legal and regulatory framework than their counterparts in the Czech Republic, Hungary, or the Slovak Republic. They also spend more of their time-1 0 percent trying to get access to public services or dealing with the application and implementation of laws and regulations (Table 4.4). This "time tax" is virtually the same in Poland as in Russia and significantly higher than in the Czech Republic (2.8 percent) or Hungary (6.9 percent). It can have a significant impact on business performance by affecting key strategic decisions that affect productivity, such as the selection of technology. Table 4.4. Regulatory Burden and Administrathe Delays by Country, 2002 - - - - _...... Interpretation of Senior management's Unofficial Firms revenues regulation consistent time spent dealing payments reported for tax and predictable with regulations relative to sales purposes (% of total) (%) Poland 66.6 9.6 1.3 90.3 Czech Republic 56.1 2.8 0.9 90.1 Hungary 42.7 6.9 0.9 88.4 Slovak Republic 55.1 7.0 1.5 86.7 Note: Number of responses, by question: Poland (329, 492, 463,461), Czech Republic (139, 268, 248, 232), Hungary (106, 250, 218, 214), Slovak Republic (92, 161, 142, 133). Source: World BanklEBRD BEEPS 2002 survey Taxation. In the 2002 BEEPS, more firms identified taxation as a "major" obstacle to growth than any other factor. Small and large firms cited tax rates as a constraint in equal proportions, but foreign-owned firms did not place as much importance on the level of taxation as a business impediment. In fact, taxes are not significantly higher in Poland than in the DECD, although Polish taxes are higher than those in neighboring countries. 21 This suggests that the quality of the tax laws and their implementation drive perceptions more than the level of taxes. In this connection, it is worth noting that of all government inspections, visits by the tax inspectorate last the longest (Table 4.5). Table 4.5. Average Days of Inspection, 2003 Businesses face an unstable, complicated, and (number of days) nontransparent tax environment. Tax legislation has Tax Inspectorate 8.5 been subject to frequent change. Between 1992 and Labor & Social Security 2.8 Fire & Building Safety 0.8 1998, the Law on Corporate Income Tax (CIT) was SanitationiEpidemology 3.4 amended almost 40 times. In 1997 alone, it was Municipal Police 0.4 amended 10 times (Baicerowicz, 2002). The CIT pro- Environmental 0.7 _ vides for more than 70 exemptions, while the Perso- Source: World Bank, BEEPS extension nallncome Tax (PIT) legislation allows for more than 21 The nominal (statutory) corporate income tax (CIT) rate was 40 percent in 1992-96 and around 27 percent as of January 1, 2003. With the exception of the Czech Republic and Malta, all other new member states have CIT rates below the Polish level. In Hungary, for example, the CIT is 18 On average, the tax rate in the EU-8, plus Cyprus and Malta, is 23.6 percent-considerably lower than the current average tax rate of the EU-1S member states (31.7 percent). When looking at the effective average tax rate (EATR) for a subsidiary of a foreign firm, Poland has the second-highest EATR percent), following Malta (32 percent) (Ernst and Young, 2003), There are plans to reduce Poland's CIT from 27 percent to 19 percent in 2004. 18 THE WORLD BANK IV. Microlevel constraints on Sustained Productivity Growth 127 exemptions, plus 14 tax breaks. Since 1999, the process of managing a payroll has become so complex that it is almost impossible to do without professional help. It is estimated firms have to take into account up to 1,200 tariffs in the calculation of taxes and other public payments. As a result, tax expenditures (concessions and instances of special treatment) amount to over 9 percent of GDp, a high percentage by international standards. The tax laws are so complex that different officials or regions may provide very different interpre- tations of the same regulation. This problem is compounded by the fact that there is no centralized source of information on taxes. Moreover, interpretations change so frequently that taxpayers have no confidence that following the latest interpretation will keep them on the right side of the law (Deloitte & Touche, 2003). As a result, tax planning seems to be almost impossible in Poland. In the 2002 BEEPS, roughly two-thirds of respondents in Poland disagreed with the statement, "Interpreta- tion of regulation is consistent and predictable" (Table 4.4). This percentage was significantly higher than the corresponding figure in neighboring countries. Informal payments. The costs of regulatory compliance extend beyond the "time tax" imposed by the need to deal with public authorities. They may also include informal payments by firms seeking to maintain a good relationship with governmental officials. Anecdotal evidence suggests, for example, that firms may make informal payments to avoid a full audit. According to the 2002 BEEPS, about 18 percent of firms reported that irregular payments to public officials, otherwise known as bribes, were required at least "frequently" to get things done. 22 This percentage is substantially lower than in Slovakia or Russia but considerably higher than in Estonia. Small firms and non-exporters are much more likely than other firms to experience the need to offer bribes as a substantial constraint. Customs and trade regulations. Customs regulations can also have a significant impact on a firm's costs of operation. The percentage of firms regarding customs regulations as a major constraint increased to 23 percent of firms in 2002. At worst, it can take 6 days to clear imports in Poland and 5 days to clear exports. These are not the highest numbers in the region. In the Czech Republic, it takes 9 days to clear imports and 6 days to clear exports (2002 BEEPS). However, other countries have managed to streamline this process. In Estonia, clearing imports can be done in half the time it takes in Poland. In the future, Poland would profit by emulating the countries with the highest standards in this area, particularly since customs clearance requirements are expected to become less burdensome now that Poland has entered the EU. Labor Issues Over the 1990s, per capita income in Poland rose Figure 4.1. Comprtitiyeness Indicators, 2002 (Poland ~ I) relative to per capita income in the other EU-8, the 2.50-r------------_ cohesion countries, and the EU-1S. Despite this ad- 2.00 vance, Poland still lags its neighbors, but its relative 1.50 performance looks somewhat better when produc- 1.00 tivity is measured in terms of GDP per person-hour, rather than per capita GDP (Figure 4.1). This sug- 0.50 gests that macroeconomic factors, such as the high Czech Estonia Hungary Slovak: Slovenia level of unemployment, and microlevel incentives for Republic Republic work and labor force participation (the tax wedge, t I GOP per capita (US$) I J GOP per person employed (U8$) in other words) are lowering the country's potential II GOP per person employed per hour (US$) Source: wnw output. Labor market reform, efforts to ease the pro- cess of business entry, and measures to stimulate enterprise creation can address this problem by 22 One-fourth of respondents identified payments as associated with taxes and customs. THE WORLD BANK 19 IV. Microlevel constraints on Sustained Productivity Growth because it has a large case backlog and the arbitrators charge high fees. Moreover, once an arbi- tration award is made, the successful party must stili go to court to have the decision enforced. As a result, some legal firms have taken compulsory arbitration clauses out of their standard commercial contracts. Some Polish experts argue that alternative dispute resolution mechanisms can be effec- tive in meditation in cases involving highly technical areas. The effectiveness of alternative dispute resolution in their view continues to depend on the quality of the court system. The Polish Bankers' Association has been attempting to establish an alternative arbitration center but with little success. D. PRIVATE SECTOR INTERFACE Deficient Infrastructure The quality of infrastructure services-roads, transportation, telecommunications, electricity, and la-appears to be lower in Poland than in the other EU-S. For example, it takes much longer in Poland to get a telephone or electricity connection (Table 4.9). These indicators may reflect broader weaknesses in the country's infrastructure. Tabk 4.9. lnfrastru{'tun.' Indicators, 2002 (ill 1l11111hcr of' - . __ .. - - - .----.-~-- Indicator Slovenia Poland Hungary Czech Slovakia ------------ .... --~----------.----- --~- Frequency of power outages 1.9 2.2 2.8 2.2 2.5 Days to obtain a telephone connection 7.7 7.6 4.4 1.8 2.8 to obtain an connection 3.3 5.3 3.9 0.1 ---------- ...... 2.8 ----.--,-~ Source: World BanklEBRD BEEPS 2002 survey Table 4.10 presents information from a survey prepared for the Global Competitiveness Report. Poland scores the lowest of the EU-S and cohesion countries in adequacy of communications. The country's score on new information technology is also low, and international calis cost more in Poland than in any other country in this group. These weaknesses may stem from lack of competition and poor governance in areas (power, for example) where the state remains heavily involved. Over the long term, they can have a substantial adverse effect on productivity growth. Tabl(' ·u 0. I nfrastnH'lure I ndicators, 200~ - _ .__ ._--_.. __ ._-------_.------ Adequacy of Communications Adequacy of New Information International Fixed (from 1 to 10, with 10 highest) Technology Telephone Costs (from 1 to 10, with 10 highest) per Minute ($) Czech Republic 7.4 7.8 0.8 Estonia 7.4 8.4 0.6 Greece 7.1 6.4 0.8 Hungary 6.6 6.4 0.8 Ireland 6.4 6.9 0.9 Poland 5.2 5.6 2.6 Portugal 6.4 6.6 0.8 Slovak Republic 6.4 7.1 0.7 Slovenia 6.4 6.5 0.8 Spain 6.3 5.6 0.6 Source: IMD (2004). 24 THE WORLD BANK IV. Microlevel constraints on Sustained Productivity Growth In roads, the situation is even worse. Poland's road network remains extremely underdeveloped. Road construction has not kept pace with growth in income and traffic. Highways and fast roads cover about 406 kilometers in a country inhabited by 38 million people. Only 68 percent of the 371,000 kilometers of public roads in Poland are paved, compared with 89 percent for countries in the Commonwealth of Independent States (Brzezinski et al., 2002; WDI, 2001). There are 400 kilometers of two-lane highways (accounting for merely 0.11 percent of total public roads) and 200 kilometers of uexpressways"-two-Iane roads with a third passing lane (0.05 percent of total public roads). Only 157 kilometers of highway were constructed after 1990. increasing traffic and inadequate maintenance have caused roads to deteriorate, and their con- dition is likely to worsen following EU entry because the EU allows heavier trucks than Poland has permitted in the past. it is estimated that one-fifth of all roads are in good condition and more than one-third need urgent repair (EBRD, 2001). Poland's road accident rates are double the EU's average rates and much higher than in the other EU-8. The economic cost of road accidents in Poland amounts to about 7 percent of the state budget, or 2 percent of GDP (World Bank, 2001). Financing needs. As Poland continues to grow, major investments in transport infrastructure, including motorways, are clearly required. But financing these projects is a huge challenge. The World Bank estimates that it would cost $1 billion per year to bring Poland's road system up to EU standards. This level of investment would have to be sustained over 15 years (World Bank, 2001).29 But public investment in Poland is low, at 1.4 percent of GDP. and declining (Table 4.11). Expenditures on road infrastructure amount to 0.5 percent of GDP, including 0.2 percent of GDP for investment in new roads. The government's failure to obtain approval for a special road tax in 2003 has left the road program short of financing. This tax would have provided the co-financing needed to generate matching grant money from the EU. Table 4.11. Public Expenditures on Jnfrastructure. 1998~20()2 2001 Budget investment outlays in PLN million 9,348 7,395 7,428 6,420 7,811 as a share of GOP (%) 1.7 1.4 1.3 1.2 1.4 Public expenditures on road infrastructure in PLN million 2,921 3,218 3,684 3,811 nla as a share ofGDP (%) 0.5 0.5 0.5 0.5 nla Source: www.stat.gov.pl Access to Financial Services The depth, strength, and sophistication of a country's financial sector are among the best predic- tors of long-term economic welfare. When the financial sector intermediates efficiently between savings and investment, the process of economic transformation-including the reallocation of resources-is greatly eased. During the 1990s, Poland's banking sector grew very fast and attracted considerable FDI. Today, foreign ownership plays a significant role in the commercial banking sector, although its influence is somewhat lower than in the other EU-8. The increase in foreign owner- ship has increased competition and improved the quality of banking services in recent years. 30 But 29 A similar amount is needed to upgrade the railways. 30 A key difference between Poland and the other EU-8 is that the Polish authorities deliberately did not sell 100 percent stakes in Polish banks to foreign banks. Instead, they required a portion of each privatized bank's shares to be sold and traded on the Warsaw Stock Exchange. THE WORLD BANK 25 IV. Microlevel constraints on Sustained Productivity Growth Poland still lags its neighbors in financial development. In Poland, the assets of the banking sector represent 65 percent of GDp, the lowest level within the country's peer group (Table 4.12). Table 4.12. Banking Sector Assets. 2002 Non-banking financial services. While banks con- ( (\,) ofCi[)PI tinue to dominate the financial system, Poland ~- ... ----- . . . .- also has the largest and most successful equity mar- Czech Republic 78.8 Estonia 85.3 ket in Central Europe. This success stems from a po- Greece 121.7 licy requiring privatized banks to have publicly traded Hungary 107.2 equity. Since many enterprises remain state-owned, Ireland 397.2 only 200 or so large firms use the stock market, Poland 64.8 which remains effectively closed to smaller firms. But Portugal 242.6 some progress has been made in efforts to develop Slovak Republic 77.8 other non-banking services, such as venture capital Slovenia 99.1 and leasing (Bakker and Gross, 2004). 179.8 Access problems of SMEs. The banking sector Source: IMF data does not lend much to small and medium-sized en- terprises, and other SME financing vehicles, such as leasing, factoring, and venture capital, remain underdeveloped (Table 4.13). Consequently, SMEs must rely on retained earnings and personal investments by owner-operators. 31 SMEs frequently complain about the disadvantages they face in seeking commercial loans. But in Poland, several fac- tors combine to make this generic problem more severe (OECD, 2002b). First, problems with land and mortgage registry limit the collateral at firms' disposal. Second, SME loans tend to be relatively small, typically ranging from $2,500 to $12,500. This raises fixed costs as a share of total loan costs and forces banks to charge higher interest rates. Finally, these problems are compounded by the common practice of underdeclaring business activity in order to avoid high taxes, which means that firms do not reflect their real financial position. The upcoming World Bank report on the financial sector, "Financial Services Development Plan," will look more deeply into financial service sector issues. Tahle 4. U. Indicators of 1\1 BFI and Capital Markets, 2002 Private Annual Mutual Funds Annual Lease Venture Capital Stock Country Insurance Pension Factoring Assets Volume Investments Traded or group Penetration Assets Volume (%) (%ofGDP) (% ofGDP) (% ofGDP) (%ofGDP) (%ofGDP) (%ofGDP) EU 15 8.13 29.06 49.64 2.22 6.20 0.33 79.70 Czech Republic 4.26 3.12 4.98 5.19 2.56 0.05 8.74 Estonia 2.25 0.08 4.31 10.81 14.72 0.01 3.76 Hungary 3.87 2.79 4.73 3.55 0.92 0.03 9.02 Latvia 2.06 0.29 0.25 7.49 0.01 1.48 Lithuania 1.62 0,00 5.32 om 1.32 Poland 3.21 4.39 2.91 1.17 1.40 0.07 3.11 Slovak Republic 3.14 0.7 1.68 4.19 1.06 0.01 3.33 Slovenia 5.03 0.19 1.20 3.36 0.39 0.01 0.50 Total EU-8 3.50 3.15 3.28 2.66 1.93 0.05 Source: Bakker and Gross (2004) 31 This reliance on retained earnings helps explain the precipitous fall in investment spending in 2001. 26 THE WORLD BANK IV. Microlevel constraints on Sustained Productivity Growth Cost of financing. In 2002, 51 percent of firms identified the cost of financing as a major obstacle, and 32 percent identified access to finance as a major problem. Since then, the situation seems to have improved as a result of the government's loose monetary policy. Interest rates for 12-month corporate loans, for example, fell from 21 percent in December 2000 to 7.1 percent in April 2004. Thus, the cost of financing is less of a problem than previously. E. VARIABLES UNDER THE CONTROL OF FIRMS Transparency and Corporate Governance The literature shows that the quality of enterprise governance has a considerable impact on firms' abilityto compete, innovate, increase productivity, and modernize management. In transitional econo- mies, privatization and continued state ownership have both brought issues of corporate governance to the fore. Privatization programs that diluted enterprise ownership have often given managers the opportunity to misuse and/or appropriate resources. Similarly, in state-owned enterprises, the ten- dency to misuse resources and politicize management has remained high. This problem is particularly severe in sectors where state-owned assets have a dominant role. In these cases, poor governance is likely to have a significant impact on prospects for competition and productivity growth. Poland has developed a strong private sector, particularly in manufacturing. However, the quality of corporate governance in Poland is mixed when compared to the situation in the rest of the EU-8 (Table 4.14). On the one hand, the rights and responsibilities of shareholders, including minority shareholders, appear to be well defined. In fact, Poland's Company Law and Securities Law framework is considered about or above average when compared with counterparts in other middle-income developing countries (Claessens, Klingebiel, and Lubrano, 2002). On the other hand, Poland fares poorly when attention focuses on the adequacy of corporate boards, the credibility of managers, the adaptability of enterprises to market changes, or the efficiency of management in protecting shareholding value. In these areas, Poland posts the worst scores among the EU-8 and cohesion countries. One reason for this poor performance is that the Polish system features both weak minority shareholders' rights and high ownership concentration. Table 4.14. Corporate Governance Indicators. 2003 (Survey results. ranking 1 10 10. with 10 being the highest) Well-defined High Efficient Adequacy of Managers' shareholders enterprise management corporate board credibility widely rights and adaptability to of shareholder supervision acknowledged market value Czech Republic 5.6 4.6 4.3 5.6 4.4 Estonia 6.9 5.7 5.5 6.4 5.6 Greece 5.7 5.5 5.7 5.2 4.9 Hungary 6.9 5.1 5.4 5.5 4.8 Ireland 7.1 6.3 6.7 7.2 6.1 Poland 6.1 3.7 4.1 3.9 4.1 Portugal 5.6 5.3 5.0 4.0 4.5 Slovak Republic 5.3 4.9 4.7 5.1 4.2 Slovenia 5.7 4.2 4.9 5.7 6.1 Spain 5.5 4.9 5.4 5.5 5.3 Source: IMD (2004) THE WORLD BANK 27 IV. Microlevel constraints on Sustained Productivity Growth Judicial deficiencies weaken property rights. In Poland, the courts do not effectively enforce sha- reholders' rights. The EBRD Legal Transition Indicators Survey (1999) awarded Poland a "moderate" mark for its protection of minority shareholders. This meant that basic protection existed in principle but was poorly executed. 32 In the 2002 Legal Transition Indicators Survey, Poland scored 3 + (out of 4) for the effectiveness of its financial regulation, slipping from a score of 4 in 1999 and 2000. Ownership concentration as a response. When shareholders' rights are poorly protected, investors often respond by seeking larger ownership stakes (La Porta et aI., 1996; Shleifer and Vishny, 1996). This has happened in Poland. Between 1991 and 2000, the median size of the largest ownership block rose from 18 percent to 46 percent (Claessens, Kingebiel, and Lubrano, 2002).33 According to the Polish Securities and Exchange Commission, the median size of the largest ownership block, including both direct and indirect ownership stakes, was 45.5 percent of voting rights at the end of 2000. The median sizes of the second-, third-, and fourth-largest blocks were 10.4 percent, 5 percent, and 0 percent, respectively. This suggests that for most corporations, the largest blockholder can exercise effective control. This is even more likely when foreign strategic investors are involved. The average size of the largest block held by foreign strategic investors is 67 percent, compared to 43.5 percent for domestic companies and 40.6 percent for domestic individuals. Foreigners tend to prefer larger blocks because they are typically less familiar with the local legal system and have little confidence in its ability to enforce their rights. 34 Ownership concentration and opportunities for abuse. Investors with large ownership may be tempted to pursue private interests, rather than maximize firm value. They may expropriate other investors, managers, employees, and other stakeholders through a variety of methods, including transfer pricing, expropriation of business opportunities, preferential asset sales, and targeted share issues (Shleifer and Vishny, 1986). In Poland, Pistor (2000) and Pistor et al. (2000) have documented significant improvements in shareholder and creditor rights in Poland and other transition countries. However, some studies show that large blockholders have profited at the expense of minority sha- reholders. Postrach (1999) reports many cases of minority shareholder expropriation in Polish-listed companies. For example, there were numerous cases of self-dealing in some of the national invest- ment funds (NIF) that emerged from the mass privatization program. In one case, an NIF selected a bank that owned a large stake in its management company to organize a large issue of short-term bills. In another case, a controlling shareholder pushed through a decision to sign a management contract between the NIF and another firm he controlled. Some NIFs also planned targeted issues of shares or convertible bonds. The consequences. Although concentrated ownership and minority shareholder vulnerability are less of a problem in Poland than in many other emerging markets, they have discouraged domestic and foreign investors from participating in public securities markets. This has limited capital market development in Poland, particularly in the area of corporate debt (Claessens, Klingebiel, and Lubrano l 2002). In addition these problems may have had an impact on enterprise performance by affec- l ting firms' ability to compete adapt to changes, and introduce new technology. The World Bank/s l Corporate Governance Report on Observance of Standards and Codes (ROSC) will investigate these Issues. 32 Polish corporate law accommodates EC Directives, which represent European best practice in disclosure require- ments, particularly on the critical issue of disclosure of ownership and controlling shareholding positions. 33 Using company-level data on listed and unlisted companies, Tamowicz and Dzierzanowski (2002) found that voting control in listed companies is remarkably concentrated, with the median size of the largest block amounting to 39.5 percent. A sustainable concentration trend has been observed over the whole decade. 34 In 1996, Shleifer and Vishny reported a similar situation in Russia, where legal protection of shareholders was very poor (Shleifer and Vishny, 1996). 28 THE WORLD BANK IV. Microlevel constraints on Sustained Productivity Growth Accounting and auditing practices. Poland has recently taken steps to reduce the gap between Polish accounting regulations and International Accounting Standards. This is demonstrated in the provisions of the Accounting Act (Dz.U.No 113, Item 1186), dated November 9, 2000, and the Securities and Exchange Commission's financial reporting and disclosure requirements for publicly traded companies. But further reforms are necessary. After reviewing financial statements for 30 listed companies in the stock exchange, the ROSC Accounting and Auditing Assessment found discrepancies between accounting regulations and actual accounting practices (World Bank, 2002c). State Involvement in Productive Activities Government participation is unfavorable to productivity gains. At 25 percent, the share of GDP produced by the public sector remains higher in Poland than in other advanced transition economies. In both Hungary and the Czech Republic, the government's share of the economy is 20 percent. The evidence shows that state participation in the economy is associated with reduced growth in labor productivity. For example, in petroleum products and electricity, both sectors where state-owned enterprises playa leading role, labor productivity increased by 44 percent and 17 percent, respectively, from 1992 to 2002. By contrast, labor productivity in manufacturing rose 157 percent over the same period. State-owned enterprises (SOE) raise concerns about governance. In addition, many SOEs-for example, the state-owned bank PKO BP-enjoy quasi-monopolistic positions, which can have a nega- tive impact on the rest of the economy. Large state-owned companies remain particularly important in energy distribution and generation, railways, and heavy industry (coal, heavy chemicals, and defense). Some of these companies are money-losing ventures that rely on direct and indirect state subsidies. For example, SOEs in the coal and steel sectors suffer from overcapacity, low productivity, and high debt levels. Under EU rules, these companies must be overhauled to qualify for state aid. Problems with managing state participation. The government also holds a controlling or majority stake in more than 3,000 partially privatized companies. The value of these companies account for 17 percent of GDP (OECD, 2002). The Ministry of Treasury holds 4,952 positions on these companies' boards. While most of these directors are not Treasury employees and their qualifications are not in doubt, there is concern that Ministry appointees may not always base their decisions solely on economic and commercial grounds. On several occasions, for example, public shareholders have clashed with large private investors by refusing to support equity infusions for partially privatized firms. Their opposition has made it more difficult for these companies to implement their business and investment plans. According to the OECD, private investors have sought to increase a firm's capital in 20 cases since January 2001. The state supported this effort in 10 cases and opposed it in the other 10. It was successful in preventing a capital increase in 4 cases. Two reasons appeared to drive the government's opposition to capital injections. In some cases, it preferred to avoid diluting its equity stake. In others, social or other considerations caused government representatives to disagree with private investors over the company's strategic direction. When the state did agree to a capital increase, it typically made its contribution by transferring shares in other companies to the target firm, which was then obliged to sell shares into a thin and declining market to generate cash. Uncertainty about privatization prospects. Although private investors remain interested in many state-owned enterprises, privatization virtually ground to a halt in 2002 (Figure 4.4). The number of privatization start-ups was the lowest since the early 1990s, and receipts, at 0.3 percent of GDP, were well below target. This slowdown reflected the government's desire to screen projects initiated by its predecessor, as well as its preference for a "restructure first, privatize later" approach. In THE WORLD BANK 29 IV. Microlevel constraints on Sustained Productivity Growth addition, ministerial turnover may have slowed privatization. Between September 2001 and Apnl 2004, the previous government appointed four Ministers of State Treasury. The prime minister- -designate appointed a new Minister of State Treasury on May 2, 2004, and on May 10, 2004, the State Treasury released plans to sell 211 companies by the end of the year-at least 50 more than previously thought. At the same time, the State Treasury stressed that it will be difficult to hit the government's target of nearly PLN 9 billion in sell-off revenue, although the companies to be privatized include PKO BP (the state banking giant), ENEA and G-8 (power distribution), PKE (power generation), ClECH (chemicals), and KHW (coal). Subsidies to state-owned enterprises continue to burden the budget. Between 1998 and 2002, direct 30.000 aid to state-owned enterprises doubled to reach 1.4 25.000 4 percent of GDP (Table 4.15). In the coal and mining 20,000 3 sectors alone, direct and indirect aid to nonviable en- 15,000 10,000 2 terprises absorbed 0.2 percent of GDP. (Indirect aid 5,000 consists of tax and social contribution arrears and accounts for 60 percent of total subsidies. Direct aid accounts for the remaining 40 percent.) The current PLNmiliion -+-asashareofGDP(%) government is keen on restructuring nonviable en- Source: www.stat.gov.pl terprises, especially when the futu re of entire sectors is at stake. In late 2002, it introduced programs to restructure the tax and social contribution arre- ars of large, financially distressed companies. At the same time, the government launched regional guarantee funds for small and medium-sized enterprises. Table 4.15. Statl' .\.id to Enterprises, 1998-2002 1998 1999 2000 2001 2002 In PLN million 6,762 9,076 7,712 11,195 10,278 as a percentage of GDP (%) 1.2 1.5 1.2 1.6 1.4 as a percentage of government expenditures (%) 2.8 3.3 2.7 3.5 State Aid (by financing means): Direct (e.g.subsidies) 34.5 34.9 47.3 25.8 38.0 Indirect (e.g.reliefs) 65.5 65.1 52.7 74.2 62.2 Source: www.stat.gov.pl Example: the coal sector.35 In 2002, the coal sector received 17 percent of total state aid. There have been repeated efforts to reform this sector, which has an estimated 40,000 to 50,000 excess workers, representing 29 percent to 36 percent of total employment. Approved in November 2002, the original 2003-06 Coal Sector Reform Program called for seven mine closures and 30,000 layoffs. It also provided for the government to forgive PLN 12 billion in liabilities and reschedule PLN 2 billion in liabilities, with the aim of completing privatization of the industry by the end of the 2006. However, mine workers strongly opposed this program because, unlike the 1998-2002 Program, it involved involuntary layoffs and failed to provide special income support for laid off workers. At the time, unemployment in Silesia had risen to 20 percent. Facing protests, the government significantly amended the 2003-06 Program. For example, the targeted labor force reduction was 35 In 2004, the World Bank will support the coal sector with two loans: Hard Coal Social Mitigation ($20 million) and the Hard Coal Mine Closure Loan ($100 million to finance the cost of closing mining restructuring company SRK). The government will contribute $50 million. 30 THE WORLD BANK IV. Microlevel constraints on Sustained Productivity Growth cut from 30,000 to 22,700 jobs. (The new program is expected to cost PLN 6.17 billion.) Nonetheless, following Kompania Weglowa's decision to close four mines, the trade unions began industrial action against the government's plan. Technology Poland lags the rest of the EU-8 and the cohesion countries in developing technology-driven industries. Poland ranks next to last in per capita R&D expenditure and last in per capita business expenditure on research and development (R&D) (Table 4.16). It also lags in the per capita number of patents in use. It is likely that these indicators are biased downward by the country's size and the relative importance of agriculture. 36 Table 4.16. Selected Indicators on Technology .... -.~---. Business Total High-tech Number of expenditure on expenditure on exports, ( in % of patents in R&D per capita R&D per capita manufactured Country force (2000) ) exports, 2001 ) Republic 43.5 72.4 10.3 Estonia 10.6 28.5 31.6 22.9 Greece 21.8 49.4 76.8 9.1 Hungary 17.1 111.9 46 23.8 Ireland 222.9 618.9 306 47.7 Poland 10.9 35.8 30.7 3.2 Portugal 19.7 225.5 87.1 4.9 Slovak Republic 16.6 45.2 24.8 4.4 Slovenia 61.4 171.2 125.8 5.6 75.3 360.2 138.9 7.6 Source: IMD (2004) Other indicators point in the same direction. For example, Poland's ratio of high-tech exports to total exports (roughly 3 percent) is among the lowest in the EU-8. According to the 2002 BEEPS, Poland has fewer firms with ISO certification, as a percentage of total firms, than all its neighbors. (The incidence of ISO certification is highest among exporters and foreign enterprises and low among enterprises serving the domestic market.) And when technological innovation does occur in Poland, it is more likely to take the form of upgrading existing product lines and introducing new product lines, rather than discontinuing product lines or agreeing with a foreign partner on a new joint venture (Table 4.17). Large firms are more likely to discontinue a product line, but small enterprises and firms serving the domestic market are unlikely to take this step. This pattern seems consistent with continued reliance on traditional lines of production, as suggested in Chapter II. The World Bank's ongoing Knowledge Economy Assessment is exploring the business environ- ment's impact on incentives for innovation (World Bank, 2004b). The report shows that Poland performs poorly on major measures of innovative output-the number of patents granted by the US patenting authority and the number of scientific publications. In these areas, Poland ranks far below the average for economies with similar measures for GDp, labor force, and exports to the US. The report also identifies some of the factors behind Poland's poor showing, including a weak intellectual property regime, which fails to protect patents effectively. Polish intellectual property legislation has 36 While the manufacturing sector is not high-tech intensive, it is likely that domestic services (especially banking) use more ICT. THE WORLD BANK 31 IV. Microlevel constraints on Sustained Productivity Growth Tabl\;' 4.17. Technology Indicators. 2002 Slovenia Poland Firms with ISO Certification (% of sample) 30.3 9.4 29.6 12.6 18.8 Form of Technology innovation (% of sampled firms): (a) Firms that developed a major new product line 27.6 42.7 24.0 28.3 32.9 (b) Firms that Upgraded an existing product line 41.4 55.6 34.8 47.7 77.1 (c) Firms that discontinued at least one product (not production) line 19.6 17.8 21.6 16.4 27.1 (d) Firms that agreed a new joint venture with a foreign partner 17.0 1.2 3.6 5.9 4.7 --_......_-------_._-_......_ - - - - --......- - - - - - -..... -~-- Source: World BankJEBRD BEEPS 2002 been harmonized with international standards. But much could still be done to improve the quality of the legislation, as well as its implementation by the Polish Patent Office. 32 THE WORLD BANK v. POLICY PRIORITIES The improvement in Polish competitiveness since mid-2001 has initiated a process of economic recovery that is likely to be sustained over the medium term. This period of renewed growth provides an excellent opportunity to re-Iaunch reform and create institutions that will allow Poland to make the most of EU membership and eventually catch up with EU-1 5. As the experience of the cohesion countries demonstrates, convergence depends on more than access to EU markets. It also depends, critically, on domestic institutional reforms that allow the economy to remain competitive over time. The most important of these reforms are identified below and summarized in a Policy Matrix. Improving the Legislative Framework Legislation in Poland is uneven in quality, and many laws give public authorities excessive discretion when it comes to implementation. The government should address weaknesses as it harmonizes Polish law with the Acquis Communautaire. At the same time, it should take this opportunity to simplify legislation in areas where compatibility with EU law is not required. Some encouraging steps in this direction have already been taken. Since fall 2001/ a Regulatory Impact Analysis (RIA) has been incorporated into the process of drafting new laws. Proponents of new legislation must annex an RIA to the justification report that is required before the Council of Ministers can approve any acts. The Government Legislation Center oversees this process. It is too early to judge the effectiveness of this reform, but it is clear that strong enforcement and consistent high-level political support are essential if it is to deliver results. Improving the Judicial System Government efforts since 1996 to reform the judicial system have had little effect. The poor performance of the judicial sector continues to reduce business possibilities in all areas of economic life. It affects the structure and scope ofthe financial sector, the quality ofthe tax system, the degree of competition, the industrial structure, opportunities for SMEs, and the economy's innovative capacity. Hence, the government should: · Conduct a Judicial Sector Assessment. This assessment would explore the feasibility of: (a) re- moving administrative cases (business registrations, for example) from the courts, (b) simplifying court procedures (by, for example, introducing oral procedures, reducing notifications, simpli- fying requirements for legal justification, relaxing the statutory regulation of evidence, and not suspending enforcement upon appeal), and (c) introducing specialized courts. Extending working hours for courts, as has been done recently in Cracow and Poznan, could also lead to improved organization. · Invest in information technology. The inadequacy of information technology in the judicial system is illustrated by the process of mortgage registration in Warsaw, which takes about six months. Such examples highlight the need to improve information technology throughout the judicial system. · Ensure that courts implement the new bankruptcy law. In 1999, the government established a commission to prepare a new bankruptcy law, which would combine restructuring and liqu- idation within an insolvency framework. The commission completed its work in April 2002, the legislation was passed in October 2003. The new law emphasizes the protection of creditor rights THE WORLD BANK 33 V. Policy Priorities and seeks to maximize the value of a debtor's assets, either through restructuring or through liquidation. 37 Improving the Infrastructure Poland lags most of the EU-8 on key performance indicators-access, prices, and quality- in such areas as power, transportation, telecommunications, and la. Many institutions, including the government, the EU Commission, the OECD, and the World Bank, have already identified necessary reforms. In the transportation sector, fuel excise taxes, EU resources, and complementary budgetary finance will not suffice to finance an ambitious program of road reconstruction, given the government's tight fiscal stance. So, the government should design a strategy for incorporating private sector participation into a multiyear plan for infrastructure investment. It should also restructure the Polish State Railway (PDP), a state monopoly. This restructuring should include sharp employment cuts to counter foreign competition and attract private investment. In the electricity sector, much of the legal framework for a competitive market is in place, as are some of the necessary institutions, including an energy regulator. But effective competition will not emerge until the government limits the power of the Polish Power Grid Company, PSE. At present, there is very little competition, although a power exchange has started to operate. To promote competition, the government should continue to maintain substantial separation of generation and distribution while pursuing privatization. In the telecommunications sector, where performance is very weak, the government has taken only modest steps toward liberalization. The original monopoly incumbent, TPSA, continues to dominate the fixed line telephony market. Increasing competition in this sector will require the adoption of strong, fair, and cost-based regulation for interconnection charges. Reducing the Costs of Regulatory Compliance By reducing the costs of regulatory compliance, the government can facilitate the entry and operation of enterprises. Mangers will have more time to focus on innovating and improving business methods. They will also be able to respond more effectively to competitive pressures. Facilitating enterprise creation. Poland should emulate the EU-15 standard-setters by reducing the costs of setting up a firm. These reforms should stimulate an increase in enterprise creation, increasing competition and reducing unemployment as a result. The FIAS report will provide precise recommendations on how to reduce the costs of enterprise creation. Facilitating tax compliance. Among efforts to reduce the regulatory costs of operation, plans to simplify the tax system and improve enforcement should have the highest priority. The goal should be a tax system that depends primarily on voluntary compliance, not burdensome administration. Toward this end, the government should reduce the number of tax exemptions, eliminate legislative inconsistencies, and adopt structured procedures for changing tax laws and regulations. In addition, it should simplify tax reporting requirements, reduce the number of inspections, and ensure regional consistency in the interpretation of tax laws-all topics that the FIAS Administrative Barriers study will explore. In the short term, reforms should focus on such critical issues as reducing harassment by tax officials and assuring compatibility between Polish and EU law. While Poland has brought its 37 Creditors will be able to petition to open a bankruptcy case in a much broader number of caseS-including those concerning major state-owned enterprises-than at present. The law will also allow them to petition to convert a restructuring plan into a liquidation plan at any time. In addition, it will benefit secured creditors by changing the way in which they are treated. 34 THE WORLD BANK V. Policy Priorities value-added tax (VAT) legislation more closely in line with the Acquis Communautaire, the European Commission recommends to reduce the level of tax expenditures, particularly in the VAT (EC, 2003b). In addition, the government should quickly abolish value-added taxes that discriminate between domestic and imported products, extend its tax legislation to deal with assignments of tangible property, introduce special schemes for taxation of travel agents and second- hand goods, and adopt provisions for intra-Community tra nsactions. Facilitating work and employment. In Poland, high unemployment and disincentives to participate in the labor market reduce competitiveness and lower output considerably below its potential. Recent changes in labor legislation reduce the barriers to job creation and introduce special norms for small enterprises, but the system of labor taxation still needs reform. The government's top priority should be reducing the combined marginal social security and tax rates, specially at low income levels. One solution would be to increase the flat deduction on personal income tax for low-income families with one working adult. In addition, the government could vary the minimum wage by region, enabling it to be set lower in regions with lower average wages, high unemployment, and less skilled labor. This strategy could foster job creation in economically depressed regions. More broadly, the government should approach the task of lowering the tax wedge in the context of broad public expenditure reform, which better target social transfers to rovide adequate social protection. Experience in Ireland shows that this type of reform can be implemented when all stakeholders are adequately involved. A detailed study should be undertaken to clarify Poland's options. Toward Stronger, More Competitive Enterprises Increasing transparency in corporate governance. The concentration of ownership has weakened the property rights of minority shareholders and consequently, the development and governance of capital markets. Part of the solution to this problem lies in reform of the judicial system, especially in matters concerning commercial law. The upcoming update of the 2000 Corporate Governance ROSC assessment should help identify detailed policy recommendations in this area. 38 Accelerating privatization. Past stalling on privatization has slowed the process of economic re- structuring. But on May 10,2004, the State Treasury released plans to sell 211 companies in 2004-at least 50 companies more than previously thought. State banking giant PKO BP, power distribution groups ENEA and G-8, power generation group PKE, chemical firm ClECH, and coal holding company KHW are all on the privatization slate. 39 The renewed emphasis on privatization is encouraging and should include full privatization of the 3,000 partially privatized companies. Promoting technology. Poland lags the other EU-8 when it comes to adopting new technologies and management practices. This problem reflects weaknesses in corporate governance and in public policy for R&D. The World Bank's Knowledge Economy Assessment is currently reviewing these issues in greater depth (World Bank, 2004b). Among other recommendations, the report urges that the government strengthen intellectual property rights protection and the effectiveness of the Polish Patent Office. In addition, the report suggests a national campaign to promote understanding of intellectual property rights among SMEs. To create incentives for innovation, questions involving the allocation of intellectual property rights between researchers and their employers, whether corporate or non-profit, need to be resolved. 38 The ROSe Accounting and Auditing Assessment also provides valuable recommendations (World Bank, 2002c). 39 In cost-benefit terms, creating a new job in the service industry is cheaper than subsidizing a job in the mining or steel industry. In this sense, structural reforms in the fiscal system-accelerating privatization, for example, or eliminating hidden subsidies (see below)-can help reduce unemployment. THE WORLD BANK 35 V. Policy Priorities Building Institutional Capacity to Improve the Investment Climate Polish authorities should continuously monitor the quality of the business environment and prac- tice self-benchmarking. In this way, they can create a culture focused on promoting continuous improvement in the investment climate. The monitoring process may rely on surveys, focus groups, or consultations and should involve all relevant stakeholders. Self-benchmarking should focus on global best practices, rather than exclusive comparisons with the other EU-8 or even the EU-1S. This is particularly important because Poland faces increasing competition from other emerging markets, such as China and India. Concern for the quality of the investment climate should extend to the highest level of government, but the executing agencies should be responsible for monitoring. The government should establish appropriate policy directions, assign the corresponding responsibilities, and update its strategy based on periodic reports by the respective agencies, as well as external evaluations. The areas to monitor could include: · The costs of regulatory compliance, with a focus on issues affecting the entry and operation of enterprises. The quality of the tax administration should be the subject of separate and detailed monitoring. · Court performance-to identify advances in reducing the case backlog and processing times, as well as to gauge citizen satisfaction. · The quality of infrastructure services. This task should be part of the culture of individual service providers, but independent monitoring may be required in sectors with quasi- -monopolistic operators. There are significant discrepancies across regions in implementation of the labor code and tax laws and regulations. The efficiency of the judicial system also varies from region to region. Consequently, the government should work with local authorities to assess the quality of the investment climate in each region and implement region-specific plans. Finally, the government should review the performance of the agencies responsible for implemen- ting policy in areas related to fostering a good investment climate. In some cases, this review may highlight the need for institutional changes. For example, the Polish Information and Foreign Invest- ment Agency (PAIIZ) and the Polish Agency for Enterprise Development (PAED) should be significantly upgraded. PAIIZ needs to have a clearer political mandate and more precise responsibilities to become more effective. It would also benefit from greater autonomy and the capacity to put together an experienced and committed team. And it must have the ability to coordinate effectively with other government bodies that influence the development of the investment climate in Poland. PAED has a broad mandate including oversight over many issues that affect the investment climate. These include SME development, regional development, modern technology utilization, exports, and job creation,. The agency also manages European Union and state budgetary funds earmarked for enterprise development. This provides PAED with considerable power. An institutional audit of PAED could determine its strengths and weaknesses and set concrete targets for further improvement in the business environment. 36 THE WORLD BANK POL\~D - POLICY \LUR IX TO I\lPRO\E THE 1:\ \ ESr\IL\T CLI\I.HE I ---------.------------.-- -. --- --.--------- . -.~-----.----~-----------~ I Mea. r., Improvem,nt : R",nt and Oog__:g_Rd.nn~_ R".mm,nd,d M,... ", I ~Strengthening the Institutional Framework --J i · Legislative and regulatory : Adoption of the EU-compatible !. Effective implementation of RIA I I uncertainty legislative framework I. High-level political support to I I · Fair and expeditious Regulatory Impact Analysis ensure implementation of RIA. 1 i : implementation of the law i (RIA~___________ l _______________. ___________. _____ .___ ~ 2. Improving the Judicial and the~,'I' ourt System -~----'-'-~".- '1 1 · Perception that the judiciary · Creation of "reJerendarz" Assessment of the judicial sector, is of poor quality, not meeting (court clerk) positions to II with a focus on the feasibility of: the standards ofa modem handle routine proceedings (a) removing administrative cases society, not in line with EU · Appointment of new judges (for example, business registrations) requirements. (230 positions created in 2002). from the courts, (b) simplifying · Delays in contract enforcement. · Separation of court court procedures (by, for example, · Inadequate enforcement powers administration from judicial introducing oral procedures, for the courts. functions. reducing notifications, simplifying · Lack of training and · Approval by Parliament requirements for legal justification, well- functioning IT systems. of the Bankruptcy Law. relaxing the statutory regulation of evidence, and not suspending enforcement upon appeal), and (c) introducing specialized courts. i · Investment in investment and communication technology. · Training of new clerks (reJerendarz). · Enforcement of the Bankruptcy I I---~~~~ __ ~ __ ~ _____ ~ __L _________________ -----~ Law. ~ .-.----··· ._-----------_._ _ . _ - - - - - - - - - _ . ~ j 3. Improving the Infrastructure - - - - - - - - - - - - j - _ .__.._- - · Underdeveloped network, WhiCh!- Approval of a higher excise tax i. Major highway expansion program contributes to regional ' on fuel to finance highway ! to enhance regional and unemployment and low income construction. I interregional connections levels. I. Regular repair and maintenance · Poor quality of existing roads: only 68% of total public roads are paved I. i I of roads Design and implementation of a multiyear strategy for private · Failure to build roads as sector participation in infrastructure required by growing traffic. investment · Inadequate maintenance · Modernization of the Polish State of roads. Railway !. Stronger regulatory environment for power and telecommunications and increased competitiveness and private sector participation I in these areas L.~ ,· Pursue privatization ofPSE. · Adoption of cost-based regulation for interconnection charges. THE WORLD BANK 37 Poland-Policy Matrix to Improve the Investment Climate 4. Reducing the Costs of Regulatory Compliance r-------------------i · Entry barriers to enterprise i . Continued reduction in the i · Reduction of the cost of setting up creation I number of licenses and permits a firm to the lowest level · A complex, unstable, and poorly i · New tax bill proposing to lower in the EU-15 administered tax system i the corporate income tax rate to · Implementation of proposals to · Barriers to employment and ! 19 percent facilitate tax compliance from the labor force participation · Public Sector Reform Package upcoming FIAS Administrative (October 2003) Barriers Study · Introduction of amendments · Development of a strategy, in to the Labor Code in matters consultation with stakeholders, of overtime work, leaves of to reduce the tax wedge in the absence, fixed-term employment, context of broad public sector workplace safety, and other reform I benefits · Assessment of the impact of regional differences in I the minimum wag_e_____ -J 5. Towards Stronger, More Competitive Enterpr_i_se_s_ __ 1 · Concentration of ownership, · 2003 privatization plan · Implementation of with a negative impact (not fully implemented) recommendations from the on the protection of minority · Announcement of plans upcoming World Bank update shareholders' rights to sell 211 firms in 2004 of the 2000 Corporate Governance · Significant public (including PKO, power ROSC Assessment ownership/influence in the distribution groups ENEA · Implementation of productive sector, hidden and G-8, power generation recommendations from the ROSC subsidies to certain industries group PKE, chemical firm Accounting and Auditing · Slow adoption of new CIECH, and coal holding Assessment technologies and management company KHW) · Implementation of the current i practices privatization program I · Upgrading of intellectual property III rights protection and the - effectiveness of the Polish Patent Office · j" ______ ~ ___________________ ~ _ _ _ L- _______________ ~ I _ _ _ _ ...l._ _ _ _ _ _ ----J 6. Building Institutional Capacity to Improve the Investment Climate , I · Lack of self-benchmarking · PAIIZ charged with attracting ! · Continuous monitoring of: vis-a.-vis EU-8, EU-15, and foreign investors I a) the costs of regulatory global competitors (China · PAED charged with oversight I compliance, b) court performance, and India, for example) over SME development, regional ! and c) infrastructure quality · Limited ability to monitor development, modem technology, I · Regional assessments of the and implement changes exports, and job creation ' investment climate, in partnership in the quality of the investment with local authorities, with climate region-specific implementati on plans · Measured to improve the effectiveness ofPAIIZ (by, for example, giving it a clearer political mandate and more precise responsibilities) · Institutional audit ofPAED -_._-------.-- --- - - - - - - - ----------~--.- -----~.------ 38 THE WORLD BANK REFERENCES Acemoglu, Daron, Simon Johnson, and James Robinson, 2001. "The Colonial Origins of Compa- rative Development: An Empirical Investigation, " American Economic Review, 91, 1369-1401. Alesina, Alberto, Silvia Ardagna, Guiseppe Nicoletti, and Fabio Schiantarelli, 2003. "Regulation and Investment." OECD Economics Department Working Paper No. 352. ECO/WPK (2003) 6. Bakker, Marie-Renee and Alexandra Gross, 2004. "Development of Non-Bank Financial Institutions and Capital Markets in European Union Accession Countries." World Bank Working Paper No. 28. Berglof, Erik, and Bolton Patrick, 2002. "The Great Divide and Beyond-Financial Architecture in Transition.", Journal of Economic Perspectives, 16:1,77-100. Brandt, Nicola, 2004. "Business Dynamics, Regulation and Performance." STI Working Paper 2004/3. Brzezinski, Andrzej, Wojciech Suchorzewski, and Piotr Szagala, 2002. "Financing Roads in Poland- Present Status and Future Options." Background paperforfuture World Bank involvement in the Polish road sector. Central Statistical Office, 2002. "2002 Statistical Yearbook." Warsaw. Claessens, Stijn, Daniela Klingebiel, and Mike Lubrano, 2002. "Capital Market Development and Corporate Governance in Poland: The Way Forward." Draft, the World Bank. Council of Ministries, 2003. Poland National Development Plan, 2004-2006. Warsaw. Cornelius, Peter K, and Zhang Yong, 2002. "Labor Markets in Europe: Performance, Reform, and Perception." World Economic Forum. De Broeck, Mark and Vincent Koen, 2001. "The 'Soaring Eagle': Anatomy of the Polish Take-off in the 1990s." Comparative Economic Studies, XIIII:2, 1-33. Djankov, Simeon, 2003. "Labor Regulations." Working paper, Doing Business. Djankov, Simeon, Edward Glaeser, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, 2003 "The New Comparative Economomics" World Bank 2003. Dollar, David, Mary Hallward-Driemeier, and Taye Mengistae, 2003. "Investment Climate and Firm Performance in Developing Countries." Mimeo, Development Research Group, the World Bank, Dyck, Alexander and Luigi Zingales, 2002. "Private Benefits of Control: An International Compari- son," Draft. Forthcoming in the Journal of Finance. Economic Intelligence Unit, 2002. "Poland Country Report." Ernst and Young, 2003. "Company Taxation in the new Ell Member States. Survey of the Tax Regimes and Effective Tax Burdens for Multinational Investors." Frankfurt, EY Law. European Bank for Reconstruction and Development, 2000. "Transition Report 2000: Employment, Skills, and Transition." European Bank for Reconstruction and Development, 2001, "Poland Investment Profile 2001." European Bank for Reconstruction and Development. 2002. "Transition Report 2002: Agriculture and Rural Transition." European Bank for Reconstruction and Development, 2003. "Transition Report 2003: Integration and Regional Cooperation", London, U,K. . European Commission, 2002. "Poland: Annual Report." THE WORLD BANK 39 References Vandycke, Nancy, 2004. "Economic Development and Private Sector Growth in the Low-Income CIS-7 Countries: Challenges and Policy Implications." In The Low-income Countries of the Common- wealth of Independent States: Progress and Challenges in Transition. Eds. Clinton R. Schiells and Sarosh Sattar. Washington, DC: International Monetary Fund. World Bank, 2001. "Poland: Labor Market Study: The Challenge of Job Creation." Report No. 22490-POL. PREM, ECA. World Bank, 2001. "Poland: Strategy for Energy, Transport, Water and Urban Development." ECSIE. World Bank, 2002a. "Trade Union Strength in Six CEE Accession Countries." Transition, July- -Aug ust-Septem ber. World Bank, 2002b. "Creating More Jobs in Central and Eastern Europe: Analysis of the Economic Intelligence Unit." Transition, July-August-September. World Bank, 2002e. "Poland. Report on the Observance of Standards and Codes. Accounting and Auditing." July 25. World Bank, 2003. "Poland. Toward a Fiscal Framework for Growth. A Public Expenditure and Institutional Review." Report No. 25033-POL. PREM, ECA World Bank, 2004a. "Poland. Knowledge Economy Assessment." Public Consultations Draft. World Bank, 2004b. "Foreign Investment and Adisory Serveces: Back-to-office Report: Poland-- Administrative Barriers to Investment". World Bank, 2005. "World Development Report 2005. A Better Investment Climate for Everyone". World Economic Forum, 2003. Global Competitiveness Report 2002-2003. London: Oxford Uni- versity Press. 42 THE WORLD BANK ANNEX 1: SOURCES OF DATA WIIW Industrial Database Eastern Europe. This database contains more than 8,000 series on industry in the Central and East European countries (CEECs). It currently covers 11 countries: Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia. The data are from the period 1989-2002 and are arranged according to NACE rev. 1 . sections of industry and 14 sub-sections of manufacturing. For Poland, the data also include more disaggregated data on manufacturing at the level of NACE rev. 1 divisions comprising 23 industries. Information is presented by country, year, and industry. More than 20 economic indicators are covered, focusing on production, employment, wages, and trade. Industry data are taken from national statistical sources. BEEPS (Business Environment and Enterprise Performance Survey). BEEPS, which was developed jointly by the World Bank and the European Bank for Reconstruction and Development, was originally carried out in late 1998 and early 1999 as a survey of more than 4,000 firms in 22 transition economies, also referred as BEEPS I. The survey examined a wide range of interactions between firms and the state. The BEEPS began as the Transition Europe/Central Asia version of the World Business Environment Survey (WBES), which was a World Bank Group initiative. The EBRD substantially enhanced coverage of governance and industrial structure issues. Based on face-to- -face interviews with firm managers and owners, BEEPS was designed to generate comparable measurements in such areas as corruption, state capture, lobbying, and the quality of the business environment, which could then be related to specific firm characteristics and firm performance. BEEPS provided the empirical basis for the 1999 Transition Report. In 2002, the EBRD and the World Bank launched a second round of BEEPS-also referred as BEEPS II or 2002 BEEPS-largely to track how conditions had changed over time. The survey was implemented in more countries (27) and interviewed some 6,000 firms. Under a Memorandum of Understanding with the World Bank, the survey uses a substantial amount of the World Bank's new core productivity and investment climate survey (PICS). However, it does not include questions on firm-level financial performance C,productivity data") from the core PICS. The 2002 BEEPS omits certain core investment climate surVey questions and does not include questions on firm-level finances (costs, assets, liabilities, employment) that would allow productivity to be calculated. Sample distribution of 2002 BEEPs (Table 1). The Polish sample of the survey was composed predominantly of SMEs. Two-thirds of the firms were classified as "small" (2 to 49 fulltime employees), 20 percent were classified as "medium" (50 to 249 employees), and 12 percent were classified as "large" (250 or more employees). About 29 percent of the firms were in manufacturing; 43 percent were in commerce (wholesale/retail trade); 3 percent were in construction; and the remaining quarter were in services. Most firms were private, with only 7.5 percent identifying themselves as government or state-owned, but more than one-fourth had "mixed capital." One-third of the firms were exporters. Finally, 41 percent of the firms were in Warsaw, with the remainder in other cities. BEEPs Extension or Enhanced BEEPS. In order to increase comparability with the growing set of surveys conducted under the World Bank's global investment climate assessment (lCA) initiative, a small supplement to BEEPS was carried out for 100 manufacturing firms (generally in two sectors, garments and food processing) in 5 countries of the Europe and Central Asia region (the Kyrgyz Republic, Moldova, Poland, Tajikistan, and Uzbekistan). This small-scale supplement to 2002 provides both the basis for comparing firm performances in two sectors (garments and food proces- THE WORLD BANK 43 Annex 1: Sources of Data Table l. Sample Distribution of 2002 BEEPS Firm Ownership (%) Sample Size (%) Private foreign 4.0 Small (2-49 Employees) 67.8 Private domestic 48.3 Medium (50-249 Employees) 20.1 Government / State 7.5 Large (250-9999 Employees) 12.1 Other 13.8 Mixed Capital 26.4 Main Activity (%) Construction 2.9 Market Orientation (%) Manufacturing 28.7 Exporter 33.3 Transport, storage and communication 6.3 Non-Exporter 66.7 Wholesale and retail trade 42.5 City or Town size (%) Real estate, renting and business services 1.7 Capital 41.4 Hotels and restaurants 5.2 Other Cities, 50,000-250,000 pop. 23.0 Other services 12.6 Cities with under 50,000 pop. 35.6 sing) to that in other ECA countries and India and China. It also makes it possible to relate performance to the costs and constraints imposed by a particular country's investment climate conditions. Polish Agency for Enterprise Development Survey. In 2001 the PAED conducted a survey 1 of 124 entrepreneurs (PAED, 2002). Of the respondents, 34 percent worked in small firms (2 to 9 employees), 34 percent in medium firms (10 to 49 employees), and 32 percent in large firms (50 to 250 employees). The firms were based in five cities: Warsaw (30 percent)l Szczecin (10 percent)l Poznan (9 percent), Cracow (7 percent), and Lublin (6 percent). The survey assessed entrepreneurs' opinions of the of the court system. IBnGR. The PAED commissioned the Market Research Center II\lDICATORI a survey of 500 small and medium-sized high tech firms in November 2001, 1 Doing Business. This World Bank database provides indicators of the cost of doing business by identifying specific regulations that enhance or constrain business investment productivitYI and growth. The principal data collection methods are study of the existing laws and regulations in each economy, targeted interviews with regulators or private sector professionals on each topic, and cooperative arrangements with other departments of the World Bank, other donor agencies, private consulting firms and business and law associations. In each area, the project establishes a network of 1 informants who can identify the procedures and costs encountered by a firm or transaction of specific characteristics in the leading city. The project team prepares a set of templates or questionnaires that can be used by staff of the World Bank Group, or other agencies, in their work on business environment issues. The topics covered to date are: credit markets, bankruptcy, business licensing, contract enforcement, entry regulations and labor regulations. More topics will be added over the 1 next two years. Once published, each topic will be updated annually. The database covers 24 countries in Transition Europe and Central Asia. Complete descriptions of the indicators and methodology, as well as the database itself, can be found at: 44 THE WORLD BANK ANNEX 2: FACTORS BEHIND FIRM-LEVEL PRODUCTIVITY GROWTH Poland's Productivity in Perspective Poland appears to have much higher labor pro- Figure I. \'alne Added per Worker ("(J00 of USD) (Valued at \lominal ER) ductivity than world competitors in the garment and 12,00.----------------, 10,29 food processing industries (Figure 1). 40 This is ad- 10,00 7.81 vantage is particularly strong in the aggregate sam- 8.00 ple, which includes small and large enterprises. But 6.00 4,00 3,16 2,68 Poland's comparative advantage diminishes when 2.00 the sample is restricted to firms with fewer than 50 employees. Poland II Garments II Food Observing labor productivity is helpful. But for a true picture of efficiency, it is more important to look at total factor productivity (TFP). TFP measu- Figure 2. Food Produclj\jty Gap India Ra\c 70,00,------------r-;;:-;;;;;----, res the contribution of capital, labor, and material 60.00 inputs to output accounting for differences in la- 50,00 40,00 bor quality and adjusting for capacity utilization. It 30.00 provides a measure of how efficiently firms use all 20,00 resources, not just labor. Total factor productivity is 10,00 0.00 +----"'L __La_~.&-' estimated for Poland and measured against TFP in Bangladesh Pakistan Poland a base country (India) by using nominal exchange I I Nmninal Exchange Rate Gap (%) I I PPP Gap (%) rates to convert values in all countries to comparable USD figures. Chapter II shows results for the garment sector. Figure 2 here shows results for the food processing industry. In this industry, Poland's firms are more efficient in both nominal and PPP terms. On average, TFP for the Polish sample is 63 percent higher than TFP for the Indian sample in nominal terms and 11 percent higher in PPP terms. Clearly, Poland's efforts to improve its business environment have paid off. Factors Driving Productivity Growth "Right" Macroeconomic and Microeconomic Policy Choices Poland's robust performance reflects macroeconomic and reform policies that are largely sound. Poland made significant progress toward price and trade liberalization during the 1990s. Rapid price and trade liberalization, along with the imposition of hard budget constraints, led to a prompt change in the way most economic resources were allocated. Rapid privatization shifted assets under more productive private sector management and exposed firms to greater competitive pressure. Between 1995 and 2001, the public sector fell from 37,2 percent to 25.2 percent of total employment. Among others, the policy ingredients of the Polish success story included: a) an early political window of opportunity opening in 1989 (the so-called period of "extra- ordinary politics," characterized by a broad political consensus on the reform strategy and public willingness to accept difficult and radical measures); 40 Why Bangladesh, China, India and Pakistan? While these countries may not seem to be natural comparators for Poland~and some GECD countries and Central European transition economies of would be-they account, by their sheer for a large share of world trade. The competitiveness of these countries is largely achieved through very low labor costs (bolstered, in some cases, by an undervalued currency, as in China), In other words, they represent a low-cost benchmark for Poland in a globally competitive world. In the medium term, it is expected that the database of comparator countries will be extended, THE WORLD BANK 45 Annex 2: Factors Behind Firm-level Productivity Growth b) low entry barriers for new firms, facilitating a redistribution of labor from state-owned to new enterprises; c) the establishment of a commercial banking sector and securities markets subject to strict regulation and supervision, and the implementation of a financial restructuring program providing incentives to banks and enterprises to resolve non-performing loans; d) extensive legal and institutional reform in support of market and private sector activity; and e) a substantial reduction in external debt, which opened the door to large-scale inflows of foreign direct investment. Poland's performance is also related to favorable initial conditions. At the outset of the transition, the share of private sector activities was sizeable, particularly in agriculture. The quality of the country's public sector institutions and legal system was relatively high, and indicators of educational attainment and the quality of schooling suggested high levels of human capital. Moreover, Poland enjoys close proximity to the European Union countries and offers a sizeable domestic market of 40 million inhabitants. High Levels of Investment Fixed Capital Formation. High levels of investment are an important factor driving productivity increases. As shown in Figure 1 investment boomed in the mid-1990s as firms sought to rebuild worn and largely obsolescent capital stocks. In 1999, foreign capital accounted for 17.6 percent of the total capital stock, and FDI accounted for 4 percent of GDP. The largest share was in the industrial sector, with about 40 percent going to manufacturing. The entry of foreign firms improved productivity by increasing competitive pressures on incumbent firms. Foreign firms also introduced new technologies and served as an important source of training for labor and management, which then disseminated throughout the economy. All these factors were at work in the productivity growth experienced by Poland in the last decade. 41 But by 2000, investment began to fall off markedly. High interest rates, combined with a slowdown in demand for Polish exports, contributed to the decline. Also, the very high levels of investment during the 1990s may suggest that firms had overinvested. This hypothesis is consistent with evidence showing that labor productivity continued to increase during the period of declining investment. rahk L Sun t;. uflnH'stmenl by :\ lanufaduring and Transport Firms (f'l\?iTel1l:t",c 111 2U02 \ erSl!'> ]99:-\ f -~----------.-~-------.-.-.-------- --- .-----------. -.----------- Firms reporting Avg. annual inv. Avg. Annual increase in fixed Median Increase in in equipment and Expenditures on assets since 1998 fixed assets since euildings R&D (% of sampled firms) 1998 (% of sales) (% of sales) .- -,-~,,- .. ---------~- ...._-------- ... ~~-----.---.-.--~. Poland 35.0 o 5.5 1.9 Czech Republic 44.4 o 8.3 1.1 Hungary 63.6 10 6.4 1.3 Slovak Republic ::_--_._-----_._--------_. _ 42.2 . .- o 6.5 1.8 Source: World BanklEBRD BEEPS 2002 survey Investment since 1998. The fact that investment has fallen off, possibly due to overinvestment, is borne out by the 2002 Business Environment and Enterprise Performance Survey (BEEPS)42 This 41 See among other papers Malgorzata Jakubiak, "Transmission of Knowledge and Innovation into Poland: Role of Trade and Foreign Investment," unpublished working paper, CASE. 42 See Annex 1 for a detailed description of surveys and administrative data used in this report. 46 THE WORLD BANK Annex 2: Factors Behind Firm-level Productivity Growth survey of about 500 firms provides some insight into the operational obstacles facing firms. In Poland, about 35 percent of the manufacturing and transportation firms in the sample reported increases in the value of fixed assets since 1998 (Table 1). Only 67 percent said that they had invested in new equipment or buildings. The average expenditure on new buildings and equipment during this period was low--5.5 percent of sales, similar to rates for neighboring countries in the survey. This suggests that most investment between the two surveys has gone to make up for depreciation, not to increase the capital stock. Competitive Pressures on Firms The rapid and comprehensive liberalization in early 1990s exposed Polish firms to enormous competitive pressure. Polish firms report a much higher level of pressure from both foreign and domestic competitors than companies in other countries in the ECA region (Table 2). Garment firms, as expected given the global nature of the garment trade, felt more competitive pressure than food processing firms. Food processing Garment Country Domestic .. F'''.r~igl1 Domestic .'-Kyrgyz 'Republic .-.- 51 Moldova 74 51 43 32 Poland 84 55 87 81 Tajikistan 64 37 64 39 Uzbekistan 36 10 69 48 Source: World Bank, BEEPS extension Pressures to Innovate In the 2002 BEEPS, almost 86 percent of sampled firms identified domestic competition as impor- tant in the decision to develop new products, services, or markets (2002 BEEPS). Almost 61 percent of the manufacturing firms reported developing a new product line since 1998 (Tabie 3). Close to 72 percent of the sample upgraded existing product lines, and 48 percent introduced new techno- logies that substantially changed the way their main product was produced (2002 BEEPS). This rate of innovation is higher than in any of the neighboring countries, except the Slovak Republic, and reflects the openness of the Polish economy and the competitive pressure faced by domestic firms. Poland's location between Western Europe and Russia makes it inevitable that the private sector will face intense competition from imports. In addition, it gives firms the opportunity to take advantage of large export markets. Tuhk J. I nnm ation Sinn: 1998 I", " I I lie' . r/wlJ Developed a major Upgraded an existing Introduced new technology that changed new product line product line the way the main product is produced. ·..... ~ .... --.... ~ .-........... -~-.---- ....... Poland 61 72 48 Czech Republic 43 67 42 Hungary 37 45 23 SJovak ~epublic 60 93 50 Source: World BanklEBRD BEEPS 2002 survey THE IJIJORLD BANK 47 Annex 2: Factors Behind Firm-level Productivity Growth R&D Expenditures. Although Polish firms have continued to invest in order to maintain their competitiveness, R&D expenditures are relatively low. In the 2002 BEEPS, average R&D expenditures in Poland were around 2 percent of sales, in line with levels in neighboring countries (Table 1). However, these figures are driven by a few firms with relatively large expenditures. The median value for all countries is zero. This means that most companies in Poland do not make R&D expenditures, but rely on older technologies and import proven production technology from other countries. Broadly defined, lower-technology exports account for a significant and growing proportion of Poland's exports. Pressure to Cut Costs Cost reduction. Domestic competition appears to put great pressure on Polish firms to reduce costs: 81 percent of sampled firms reported that pressure from domestic competitors is very important in their decision to reduce the cost of products and services (2002 BEEPS). This pressure appears to be significantly more important than in other countries in the region (Table 4). How have firms reduced their costs? The evidence shows that firms have resisted pressures from rising unit labor costs by shedding workers. Table 4. Importance Of Factors In Decision To Reduce Costs- Pressure From: Estonia 70.1% 35.8% 74.7% 22.1% Hungary 75.4% 32.1% 80.2% 17.0% Poland 80.9% 48.2% 87.0% 28.4% Russia 66.9% 23.3% 74.0% 26.1% Slovakia 62.9% 43.9% 70.1% 17.1% Slovenia 69.4% 33.9% 70.6% 16.8% Source: World Bank/EBRD BEEPS 2002 survey Summary In Poland, the increase in labor productivity has been accompanied by a dramatic reduction in employment. Real GDP growth averaged more than 4 percent between 1995 and 2002/ and industrial growth was even higher. But during the same period, industrial employment fell almost 10 percent, and the manufacturing work force shrank by almost a third ((50/ 2002). Poland/s labor productivity jump appears to be a story of industry shedding unneeded workers and becoming more competitive as firms improve their technology and the state reduces its role in the market. In the early and mid-1990s, many companies had large numbers of surplus workers remaining from the days when labor hoarding was common. But the evidence suggests that most of this "overhang" had already been eliminated by the end of the decade. In the 2002 BEEPS, managers were asked what employment level would they choose if they could change the number of full-time workers they employed without any restrictions. The majority of companies reported being at their desired size. Thus, the employment overhang appeared to have been dealt with, but firms continued to shed workers. Between 2001 and 2002 alone, industrial employment declined by almost 11 percent. This suggests that much of the recent downsizing may be due to improved technology and better management, not the correction of previous distortions. 48 THE WORLD BANK 43 ANNEX 3: DETERMINANTS OF TOTAL FACTOR PRODUCTIVITY: The BEEPS Extension 44 was conducted in 2003 in several countries (Moldova, Pakistan, India, China, Bangladesh, Uzbekistan, Tajikistan, and the Kyrgyz Republic) to allow for cross-country com- parisons of productivity performance. This survey instrument consists of a written questionnaire that is administered to business managers and accountants through face-to-face interviews by trained enumerators. The samples were drawn from the garment and food processing sectors (Table 1).45 Table 1. Poland-Share of garment/food processing output in manufacturing output 1998 2000 1999...._ - - _...._ - - _... _ 2001 2002...- - . ...- - -.. ~ Manufacturing output 334,887.1 365,518.9 426,517.3 426,830.2 436,674 Food processing 78,285.2 86,498.9 97,537.5 102,976.1 105,005 Garment 10,279.9 1 I output 100% Food processing 23.38% 23.66% 22.87% 24.13% 24.05% Garment 3.07% 2.66% 2.22% 2.24% 2.08% Total (%) 26.45% 26.32% 25.09% 26.37% 26.13% Source: CSO 1. Methodology Empirical evidence supporting the connection between total factor productivity (TFP) and the investment climate (Ie) is obtained by regressing productivity estimates against firm-specific charac- teristics and a set of variables assumed to be representative of the business environment Due to issues concerning the harmonization of investment climate variables across surveys, only the five countries targeted for the 2002 BEEPS extension were used. First Stage Productivity estimates are generated by doing a production function after pooling sectors and countries. Thus, the relationship between TFP and IC indicators is investigated at a higher level of aggregation when compared with the productivity gap calculations. The estimated production function includes measures of labor quality (schooling) and capacity utilization since homogeneous regressors are available across the five surveys used. We use nominal exchange rates to convert local currency units to US dollars, and the following specification is adopted: In (Output) cons + 13m In (Material j ) + 13, In (Labo1{) + Pc In (CapitalJ + 13" In (CapUtilJ + 4 I3s In (Schooling;) + I3tSectoralDummy + L I3n D n + Ei (1) n=l 43 This Annex was prepared by John Nasir and Fabiano Bastos (PSAIC). 44 See Annex 1 for a description of the survey instrument. 45 In Poland, the food processing sector represented 24 percent of total manufacturing production in 2002; the garment sector, less than 2 percent of total manufacturing production. Between 1998 and 2002, production in the food processing sector increased by 34 percent, while production in the garment industry declined by 2 percent THE WORLD BANK 49 Annex 3: Determinants of Total Factor Productivity In this model, i indexes the firm, n the country where the firm is located, and j the number of countries used for each sector studied. Output denotes gross output produced; material is raw materials used in production; labor is total number of workers, including both permanent and temporary employees; and capital denotes the total replacement value of machinery, equipment, land, and buildings. CapUtil denotes capacity utilization, and schooling is a weighted average of years of education in the workforce. The table below summarizes the results: Table 2. Regression Results In (Output) Coefficient Std. Error Ln (Materialy------:7if'-"--- .0213 Ln (Labor) .27 I .0208 Ln (Capital) .05 I .0151 (CapUti!) .08 5 .0386 (Schooling) .42 1 .1260 Dummy Food .01 N .0307 Poland .34 I .0469 Tajikistan -.19 I .0518 Uzbekistan _.29 1 .0531 Kyrgyzstan -.31 I .0573 I Significant at 1percent; 5 Significant at 5percent; N Not significant These coefficients are used to back out TFP measures as follows: ~ TFP; = exp [In (Output;) - ~ In (Material ~ III ~ j ) ~ I In (Labolj ) ~ c In (Capital;) -J (2) f3u In (CapUtilJ - f3 s In (Schooling;) This formula implies that country dummies are relevant to the calculation of TFP only to the extent that they permit a cleaner estimation of input elasticities and coefficients on capital utilization and schooling. In fact the dummies are not explicitly subtracted in (2). Although it is true that linking TFP figures net of country-specific effects to Ie indicators would be a more powerful it is also reasonable to claim that the concept of investment climate contains a strong country-specific component, and as a result, dummies may wash away much more than intended. Indeed, this seems to be the case in the present analysis. Second Stage TFP estimates obtained as in (2) are regressed against firm characteristics and variables assumed to capture the business environment surrounding the firm. High-performing firms are likely to be able to reduce the investment climate problems they face. The process of choosing such variables is nontrivial and reflects a tension between the breadth of the Ie concept and necessary compromises associated with a quantitative approach. From a pragmatic perspective, multicollinearity among Ie indicators forces the election of a subset of variables. In this study, those variables were chosen on the basis of which institutional constraints were identified as the most relevant ones by regional teams, and on the basis of data quality. Another complication associated with the second-stage regression is the potential endogeneity of Ie indicators when taken at the firm level. Averaging Ie indicators within sample cuts is one way to lessen this problem, since the firm is less likely to affect the average than its individual observation. The question then is which cut to pick. Because country-level averaging would not fully exploit the 50 THE WORLD BANK Annex 3: Determinants of Total Factor Productivity richness of the firm-level dataset, there is a case for implementing compounding cuts, which exploits breakdowns inside the country and produces greater variability in the regressors. However, in doing so, the researcher must remember that the thinner the cut, the closer he gets to the endogeneity issue already mentioned. Bearing these points in mind, this study generates IC indicators by averaging firm's responses belonging to the same country, region, sector, and size class (small, medium, and large). In order to mitigate endogeneity problems, we drop firms for which the IC average is formed by less than 4 individual observations. Using TFP estimates from the first stage, the following specification is adopted: TFP; = cons + ~11n(AgeJ + ~2Exportsi + ~3ForeignOwnershipi + ~4DummyGarment + ~)C _BankCredit b + ~6IC _Inspectionb + ~7IC _TimeTax b + ~8IC _Powerb +e i (3) In this model, b indexes the breakdown at which IC averages are calculated, IC13ankCredit denotes the proportion of firms with bank loans or line of credit, ICJnspection captures the number of days spent in required meetings with officials in the previous year, IC_TimeTax captures the percentage of senior management's time spent on interpreting laws and regulations in the previous year, and ICYower measures the total number of hours (during the year) that the establishment experienced interruptions in the power service. These four IC indicators cover the areas of finance, regulatory burden, and infrastructure. The table below reports the results. Table 3. Regrt'ssion Results Ln (Age) .03 .0151 Export .0008 10 .0004 Foreign Ownership .08 10 .0431 Dummy Garment .026 N .0204 IC BankCredit .20 1 .0457 IC_Inspection -.003 1 .0009 IC TimeTax .001 N .0027 IC Power -.0001 5 .00006 1 Significant at 1%; 5 Significant at 5%; N Not significant 2. Regression Results for Poland The results of the Investment Climate Assessment (ICA) make it clear that Poland's high producti- vity is due in large part to its superior business environment. A multivariate regression analysis of TFP for the five ECA countries (Poland, Moldova, the Kyrgyz Republic, Tajikistan, and Uzbekistan) iden- tifies a number of key investment climate indicators as significant factors affecting TFP. While these measures have a large degree of explanatory power, they are only indicators of the overall investment climate. There are many additional factors that affect TFP, but not all could be put into one regression since they tend to be correlated. This analysis identifies some of the most important indicators of investment climate in such areas as infrastructure, finance, and regulation and demonstrates the importance of the investment climate in determining productivity. THE WORLD BANK 51 Annex 3: Determinants of Total Factor Productivity Training and Worker Skills The TFP calculations held labor quality constant by taking into account the education level of workers. In this respect, Polish workers appear less educated than their foreign counterparts. 46 The median proportion of workers having completed secondary school or higher in Poland is only 60 percent, compared with 100 percent in the Central Asian countries. However, research has proven that in addition to education, firm-level training is important and firms that invest in worker tra- ining have much higher levels of productivity than those that do not Here, Poland ranks far above the other countries, with over 60 percent of the sample reporting that they conduct some formal training, compared with only 34 percent in Moldova and 18 percent in Uzbekistan. The need to be internationally competitive clearly forces Polish firms to train and constantly upgrade their workers' skills. This firm-specific training more than makes up for the lower level of formal education Table 4. Percentage of Firms Conducting Some Formal Training Food Kyrgyz Republic .48 Moldova .34 Poland .60 Tajikistan .20 Uzbekistan .18 Exports Empirical studies across a large number of countries have shown exporting to be a major learning mechanism that enables enterprises to improve productivity. Enterprises learn from their customers and must continuously improve productivity to remain competitive in the world market. In our sample, the percentage of a company's total exports appears to be highly significant for explaining productivity. Poland has a large domestic economy, and many companies are focused on serving it. Thus, only a fraction of the food processing firms and about 30 percent of the garment firms in our Polish sample exported a significant amount of their products. However, Poland is a relatively open economy, and many firms in the general economy do export. In light of the importance of exports revealed in the leA's empirical analysis, it is clear that this openness is a major factor in Poland's high level of productivity. Table 5. Percentage of Exporters Defined as Firm Exporting :\lore Than 10 percent of Their Sales Food Processing Garment Kyrgyz Republic 12 Moldova 34 45 Poland 7 30 Tajikistan 3 o Uzbekistan 2 4 46 There are indications that workforce skills are a non-negligible problem in Poland. A 1996 GEeD study of functional literacy found that a substantial fraction of the Polish workforce (larger than in other countries in the sample) is functionally illiterate, i.e., is unable to understand and process simple information. This may be a particular constraint in a globalizing world and increasingly knowledge-based economy. Also in Poland, the variation in levels of literacy and test achievement is substantial, suggesting large inequalities in skills and thus worker productivity. 52 THE WORLD BANK Annex 3: Determinants of Total Factor Productivity Foreign Ownership Foreign direct investment (FDI) is another important learning mechanism. Foreign investors bring new technologies and links to foreign markets, enabling enterprises to improve their productivity. The ICA analysis confirms this and shows that significant foreign ownership leads to higher productivity. Research has also shown significant spillovers from FDI. High levels of FDI often improve countrywide productivity, even among locally owned firms. Analysis of the ICA sample bears this out, and foreign ownership has a large and significant impact on productivity. While the level of foreign ownership appears low in this small sample, overall Poland has encouraged FDI and has seen some of the highest levels of FDI among the transition countries. Foreign investment, attracted by the improving investment climate, was clearly a major factor in the performance and rapid growth of the Polish industrial sector during the mid-1990s. Tahir 6.. \\(T