22173
THE NEWSLETTER ABOUT REFORMING ECONOMIES                                            March 2001
1~ RAN ITIN   Our ream isw
N E        W    SL E TTNE R1  I              THE WILLIAM DAVIDSON INSTITUTE
iN E     W     SL E T T EId R                  AT THE UNIVERSITY OF MICHIGAN BUSINES SCHOOL
Vol. 12, No. 1                                                                               February-March 2001
Managing World Bank Operations in the Balkan
Hot Spot-Interview with Country Director
Christiaan J. Poortman
Country Director Christiaan J. Poortman is responsible for World Bank operations in Albania, Bosnia-Herzegovina, Kosovo, FR
Yugoslavia, and Macedonia, a region that is considered one of the most dangerous hot spots in the world. What are the strategic
priorities of the Bank considering its limited resources? How can the Bank contribute to peace and stability in this area? These
were some of the issues discussed with Transition Editor Richard Hirschler in the following interview.
Q. Does the Bank have a regional  work. But we are trying to follow a more  and Transport Facilitation Project, we pro-
policy for this area, or do you deal with  coordinated, regional strategy, especially  vide similar loans or credits to Albania,
the individual countries separately?    since the crisis in Kosovo. We increasingly  Bosnia-Herzegovina, Bulgaria, Croatia,
collaborate with Andrew Vorkink, Country  FYR Macedonia, and Romania to update
A. As you know, we are providing loans  Director in charge of operations in Bul-  customs administrations and improve
on a country by country basis; individual  garia, Croatia, and Romania, on a regional
country programs are the focus of our  approach. So, for example, under a Trade           Continued on page 2
The Virtual Economy and Economic Recovery in
Russia
by Clifford G. Gaddy and Barry W. Ickes
Clifford Gaddy and Barry Ickes coined the term "virtual economy" to describe the complex relation between the barter and cash
sectors of the Russian economy This relation exists, they argue, because unprofitable enterprises seek to protect their value-
destroying activity. In an article published in Transition Newsletter (Vol. 9, No.4,August 1998) and in more detail in Foreign Affairs
(Vol. 77, No. 5, September/October 1998), they explain Russia's economic crisis in terms of the virtual economy. Now that
Russia is showing signs of recovery, is the virtual economy shrinking? Is this model still a useful one for analyzing the Russian
economic situation?
Russia is in the midst of an economic re-  asserts that the "current performance of  We argue that the answer is "yes." The vir-
covery. GDP is growing for the first time  Russia's macroeconomy could not be  tual economy hypothesis remains the best
since transition began. Signs of improve-  more impressive." Since the crisis, it is  way to understand current economic de-
ment appear widespread. Immediately  argued, there has been "a positive rever-  velopments. The recent performance of the
after the financial collapse of August 1998,  sal in all the indicators of the so-called 'vir-  Russian economy does not pose a puzzle
the future of the economy was spoken of  tual' economy." The question then arises  forthevirtualeconomyhypothesisbutisfully
in apocalyptic terms. More recently, opti-  whether the virtual economy model re-
mism has returned. One recent evaluation  mains applicable to Russia.                    Uontinued on page 15
Development Research Group    The World Bank M             The William Davidson Institute              SITE



border control, and thus promote trade flows  duced a regional strategy paper, "The Road  velopment, poverty alleviation, and
across the borders in Southeast Europe.   to Stability and Prosperity in South Eastem   across the board income generation will
Europe," which served as a background  certainly contribute to stability and peace
Our regional approach is coordinated with  documentatthefirst Regional Balkans Do-  among the various ethnic groups, but we
the Balkans Stability Pact, signed by coun-  nor Conference (see box). So we are in-  are also dealing here with political is-
tries of the region and the international com-  creasingly looking atthe regional dimensions  sues, vested interests, and criminality. In
munity after the Kosovo crisis. The Bank,  of ourcountry assistance programs.  Macedonia, for example, the Albanian
together with the European Commission, is                                     minority complains about being treated
charged with coordinating development as-  Q. If implemented, the strategy will radi-  as second-class citizens-in the politi-
sistance to the area. Last year the Bank pro-  cally change the political and economic  cal but also frequently in the economic
landscape of the Balkans. But recent  sense. The Macedonian government, in
eventsinMacedoniaremindusthatthe  which the Albanians are also repre-
Con j j j j j j j: '   t ents s  t>j3  ii;iiregion can easily become destabilized,  sented-has been trying to address that
th Balkan 1   that ethnic conflicts can erupt with  concern.
Wor itdfi 0; Bank g;0E Operatlofla 0  ai. i. frightening force. What are the chances
Rusiasnq-"  Virtua Z 9lEconom3ylJii0tiH I 0 i  that the Stabilization Pact holds?  Q. They are certainly racing against
tvia's Acceiisiiiiiiiiiggg$000oni.tiCstsiii i i0$ ji0 j QiiiiiXiiiiiii.iiiiii  time. Aided by the World Bank, the re-
A. This being the Balkans, we cannot plan  construction of Kosovo is making im-
ti Wjfnh iRe i' i  or j   i tov; Ciiritlc7 jiiiiwith certainty. After Milosevic was over-  pressive progress, but its economy is
iMoldov's ElectiXon-he Background ~   thrown and a democratic Yugoslavia  run by foreign experts. Locals are not
Chiriaa i   Globaization I. . emerged, it seemed finally that regional  involved in a substantive way in the
inc,,,e Ga-i 3?.0ini: } Chini 3 ji0gi00 l;0integration could become a reality. But this  work of the "fiscal authority" or the
MIGA'sj0nkR0ijMjj0giiji iLnf optimism is being overshadowed by the  "monetary authority," as the Ministry
crisis in Macedonia, which erupted so  of Finance and the National Bank are
jjjWj7RjWil ltjZi73 Dav,j'37idsonI nitutiW O:       ?quickly and unexpectedly. We are also fac-  called in this territory.
rtual Ecoomy (ntiued) 152;5ffi;5 jR u>2<> ing new problems in Bosnia-Herzegovina,
Ukri; lnieiisiiBankruptcy Lawio§iiiiiiiiii ~where Croats threaten to create their own  A. This is the result of the United Nations
ce  P        ilcations jjjjjj; 23 jj22 3I29 5'r;, iii jientity. A split between Montenegro and  Security Council resolution that created
Prescription forAsian Econoes 2X  iSerbia also is a distinct possibility.    UNMIK, the InterimAdministration Mission
iiiC.<ai a iiiii: ::ti. tt: Wiiiiikiio i. g 3 ijiti ijNfeiireiicei jii             in Kosovo. It is Special Representative of
We still hope that economic development  the U.N. Secretary General who has ulti-
5'p9iTE ? i iiii ii    j  ;jj ji?  ii? i?i??i 'and greater political stability will elevate  mate authority. But UMNIK's administra-
I  Accesslgo  ...     nAsruzj titir;;ac' tionii 28    these countries to a higher plateau, where  tive departments, which are analogous to
A forLborMoityR;ejs,earch j2i   conflict is increasingly seen as the wrong  ministries in a national administration, are
Work00Niiiing75i Paiers 29i iiiii0iiit'iii  way to resolve issues. Significantly, these  headed jointly by international civil ser-
iiiiiiLGi/OSiXiiiiftW  jjjjiiijjijjjj.jcountries aspire more than anything else  vants and local officials. A joint interim
to get closer to Europe. The European  council has been set up in which both Al-
Ftl iscal DcetitralizatiortB s 31 -   Commission has indicated a path toward  banians and Serbs are represented. This
Enilar9gingte at,a.ba;sDeii 3¢3iiiiiiii i i iieventual integration into the European  is an advisory council, it lacks executive
The Practice of 8eV Practics> 2       Union-the path of collaboration and coor-  power, but it reviews a wide range of is-
; ibnaytional Gjovernments j in Russ j ,iagi 34:  dination among the Balkan countres-and   sues.
Urban ManagementiwurselgAgMiii i Coursei 35 f the Bank is helping that process along.
UPSublitigongs i35 iiti00iii: iiiiiigSigg tgSiiiiii00i ii 00ii                At the beginning of this year Kosovo held
BF   0 nji nji ji;ii ij jig i jj , SS,<< t,-<8<.< Q. Certainly, but as you were pointing   municipal local elections, which went well.
out, ethnic hostilities can rise to the  Local people now represent the popula-
ittle: FJ in;:    R .a  Energy Sector j jtW. .R  0e surface quite unexpectedly, upsefting  tion at the local level. The next step may
Dariation in XoLg§iLIthuaenjia 3j5o ji  -i ambitious reconstruction and devel-  be elections for an assembly with del-
opment plans, as is happening right  egated responsibilities. The recent donor
Worl Ba FAenffj;<t; *< 0 ; aP {0 now in Macedonia.              conference underlined the need to train lo-
Cor.ifersnc Diary 000 cal Kosovars, give them more responsi-
ew.Boks andS Workng Papers 42   ,,A. These conflicts will continue to be a  bility, and make sure thatthey are readyto
.D uliotra of Sedl;<ete ticles    2 kproblem and a challenge. Economic de-  assume administrative duties. Part of our
*   TRANSITION, February-March 2001                                 The World Bank/The William Davidson Institute C) 2001



program is focused on building up lo-  Q. Yugoslavia's membership in the IMF,  gram. In addition, together with the Euro-
cal capacities, so that Kosovars can  and the European Bank for Recon-  peanUnion,theBankco-chairedthefirst
one day manage the                                 struction and Devel-  donor conference on supporting FR Yu-
economy themselves,                                opment (EBRD) has  goslavia. We are also working with the
whatever political settle-                         been established, but  authorities on a major medium-term
ment is reached.                                   its World Bank mem-  structural reform program, which will be
...........  i   bership is still not  submitted to the donor conference to be
Q. So, you have no clue                            settled.                held sometime in May or June.
about the political fu-
ture of Kosovo?                                    A. Although FRYugosla-  Membership is a complicated issue, be-
via is not yet a member  cause of Yugoslavia's arrears. Arrears to
A. No, and that is not my                          of the Bank that does not  the IMF were relatively small ($150 million)
business either. But it                            meanthatwearenotvery  and were financed with a bridge loan.
would be useful to get   ...                       active there. The Bank's  Yugoslavia's debt to the Bank is much
some clarity, because                              Board recently approved  larger ($1.7 billion). So we have to work
political developments                             a $30 million Trust Fund  out an arrears clearance plan, which is not
affect the environment for economic de-  to provide grants to Yugoslavia. We will  easy. All this takes considerable time. But
velopment, too. Uncertainty and insecurity  commit that Trust Fund very quickly to  we are making good progress and intend
do not create a good climate for private  bridge the period between now and the  to take the membership recommendation
investment. This is the greatest handicap  time membership be established and we  to the Board next month. It was easy for
the region faces.                    are up and running with the regular pro-  Yugoslavia to join the EBRD, as it had no
The Road to Stability and Prosperity in Southeastern Europe-A Regional Strategy Paper
The Southeast European region-Albania, Bosnia and  tures, particularlythose of the European Union. The international
Herzegovina, Bulgaria, Croatia, the Federal Republic of Yugo-  community must provide financial, technical, and political sup-
slavia, the former Yugoslav Republic of Macedonia, and Roma-  port. Four broad thrusts for action are designed to help achieve
nia-is a diverse region of 56 million people. Per capita income  peace, stability, and prosperity in the region:
in the region is about US$2,200-roughly half the income level
of five Central European countries. As a region, these econo-  * Move rapidly toward trade integration with the European
mies have recovered only 75 percent of their pretransition in-  Union and within the Southeast European region itself, creat-
come levels. In the past several years, growth has declined in  ing a stable, transparent, and nondiscriminatory environment
aggregate, increasing the gap between these economies and  for private sector development.
the rest of Europe. Living standards have deteriorated, as evi-  * Foster social inclusion and social change within the region to
denced by higher poverty, inequality, and unemployment.  reduce tensions and create the conditions for peace and sta-
bility (the region has about 1.7 million refugees or internally dis-
The poor economic performance can be attributed to four sets  placed people).
of factors:                                            * Improve institutional capacity and governance structures and
* Adverse initial conditions (unbalanced industrial structures,  strengthen anti-corruption efforts in the region, through greater
weak institutions, and fragmented civil societies) at the onset  transparency and accountability in the functioning of state insti-
of the transition.                                     tutions; better internal controls, including auditing and financial
| War, civil strife, and ethnic conflict.              management; a reduction in administrative discretion; and
* Inconsistent macroeconomic stabilization policies.   greater participation and oversight from civil society.
* Weak structural reform policies and lagging progress in trade  * Invest in regional infrastructure, including initiatives that safe-
liberalization, privatization, enterprise reform, competition poli-  guard the environment, to integrate the region physically with
cies and financial sector development, and institutional, social,  the rest of Europe,
and environmental policies.
Adapted from The Road to Stability and Prosperity in South
A credible and predictable path should be established to inte-  Eastern Europe: A Regional Strategy Paper. 2000. Washing-
grate all countries in the region with European and global struc-  ton, D.C.: World Bank.
( 2001 The World Bank/The William Davidson Institute                          TRANSITION, February-March 2001   U



arrears there. Arrears with the European  investment operations with social pro-  many of these countries are only gradually
Investment Bank have not been cleared  grams for the truly needy and vulnerable,  becoming creditworthy, so the amount of
yet.                                 while promoting newjob creation. It is also  IBRD loans we can offer them is relatively
important to help micro, small, and me-  small. They also have problems of howto
Q. You outlined three major areas  dium-size enterprises. We have intro-  absorb reasonably the borrowed money.
where the Bank is involved in Kosovo:  duced in the region some extremely  Macedonia, beginning this July, will "gradu-
building institutions, strengthening  successful small and microenterprise  ate" and receive only IBRD loans. As a re-
the private sector, and helping the  projects, but obviously it takes some  sult, none of them may be able to borrow
poor. Are these also the priorities of  time before they start to have major ef-  as much as they did earlier. Kosovo might
the Bank's strategy elsewhere in the  fects. Privatization often fails to bring  receive more, and new lending is ex-
region?                              about the desired employment creation  pected to FR Yugoslavia. To sum up, with
and economic growth. Many state enter-  the exception of FR Yugoslavia, there won't
A. Yes. We need in particular to support the  prises have been stripped of their assets  be dramatic changes in our level of total
private sector in the region, creating favor-  and are in need of radical restructuring, in-  lending.
able conditions for private investment,  cluding downsizing their labor force. They
bringing in foreign investors. The conflict in  require new investment. New private in-  Q. So, you have to manage operations
Macedonia could not have come at a worse  vestment is really the key to accelerated  with limited resources. What will be
time: it can destroy the investment climate  development, because that is eventually  your priorities be in the next couple of
thatwasbuiltupinthatcountryoverthepast  where the strong supply response is go-  months?
10 years. Macedonians were introducing  ing to come from, which will generate the
the right macroeconomic policies, but for  employment that is so badly needed to  A. First of all, in all these countries-Alba-
a long time investors were absent and the  deal with these social problems.  nia, Bosnia-Herzegovina, Macedonia, and
economy stagnated. Later things started                                   potentially Yugoslavia-we are going to
to look better. The countrywas settling its  Q. There are heated discussions  work more intensively with the govern-
differences with Greece, investors be-  within and outside the Bank about its  ments on poverty-reduction strategies. We
came interested in Macedonia, and the  future role, all underscored by budget  will continue with private sector develop-
economy started to expand. And then  cuts and staff downsizing. In South-  ment and public resource management.
came this crisis, which can harm not only  east Europe, however, the Bank has  We will assist capacity-building in Kosovo
the Macedonian economy but the region  responsibilities to maintain if not in-  and support private sector expansion in
as a whole. For example, the tourist in-  crease its activities. Will you be allo-  Macedonia and Bosnia-Herzegovnia. In
dustry in Croatia is hoping for another  cated more funds to use in Southeast  Albania we will finance relatively more in-
bumper year on the Adriatic, but if the  Europe?                          frastructure investment. We continue to
armed conflict drags on, there may be                                     provide budgetary support through adjust-
fewer visitors.                      A. The short answer is no. Of course, the  ment operations. In all of these countries
Bank will continue to be involved in these  operations reflect a change in the Bank's
Q. Even without conflicts, the govern-  countries, where per capita income is in  overall activity: we are gradually reducing
ments in the region are pressed hard  the lower range. Most of the countries are  our infrastructure investment and moving
by the transitionary recession: the  IDA recipients, but the pool of IDA money  increasingly toward a radical approach on
postsocialist economies must adjust  we can offer is limited. On the other hand,  poverty alleviation.
to a free-market economy, which
means, at least in the early phases,   Permissive Tax Measures
shrinking GNP, cutting back on living
standards, and accepting price hikes              p
and increased unemployment. This
can easily turn societies against their
governments. Is the Bank ready to
adapt its strategy to these realities?
How will it be able to help defuse the
escalating social conflict?
A. Very much in the same way it has in   "I can proudly announce the new tax relief, for example no flogging this year."
other countries. We are combining our  From the Hungarian magazine H6cipo
*  TRANSITION, February-March 2001                               The World Bank/The William Davidson Institute (D 2001



Latvia's Dilemma: Financing Accession Costs While
Maintaining Fiscal Constraint
by Inna Steinbuka
Latvia places high priority on joining the EU and participating in the Economic and Monetary Union soon after accession.
Through monitored programs, the Fund assists the Latvian authorities in meeting some of the most difficult targets in order to
comply with the Copenhagen and Maastricht economic criteria. Coordination and consistency between the Fund and the Euro-
pean Commission are lacking, however, because of the different and even conflicting mandates of the two institutions.
S   ince the start of transition in Latvia, external shocks is the key reason why the  scope for the active use of monetary in-
the IM F has been the main agency  Fund requires tight fiscal policies in all of  struments. In the past decade, the fiscal
supporting macroeconomic sta-  these countries. Although the outlook for  deficit was relatively low, exceeding the
bilization, while increasingly helping imple-  Latvia's external sector has improved  3 percent target only in 1994 (because
ment "transition packages" on the structural  since 1998 (table 1), the current account  of increases in net lending), in 1995 (be-
front. When Latvia applied for EU member-  deficit remains relatively large. Current  cause of the banking crisis), and in 1999
ship (in 1995), and particularly after the  improvement probably cannot be sus-  and 2000 (because of the Russian cri-
Helsinki Summit approved Latvia as a can-  tained in light of the expected accelera-  sis) (table 2). The Fund-which moni-
didate for EU membership (in December  tion in domestic demand. Latvia exports  tored the 16-month economic program
1999), the Fund's programs                                                         that started in late 1999-was
became an integral part of the  Table 1. CurrentAccount Balances in the Baltics, 1996-2001   not happywith the results, criti-
EU accession strategy.     (percent of GDP)                                        cizing the government for fail-
Country  1996   1997  1998  1999  2000 a 2001 a         ing to reduce the deficit. As a
By carrying outsuccessive eco- Estonia  -9.2  -12.1  -9.2  -6.2   -6.5   -6.5      result, the program was sus-
nomic programs endorsed by  Latvia   -4.2   -5.1  -9.8  -9.7   -7.2   -6.3         pended before its completion.
the Fund and supported by its  Lithuania -9.1  -10.2 -12.1  -11.2  -6.9   -6.7
stand-by arrangements, Latvia      .   .                                            Lithuania also failed to meet its
a. IMF projections.
was able to accelerate the ac- Source: International Monetary Fund.                fiscal targets in 2000, but its
cession process and the con-                                                       economic program was never-
vergence with EU member                                                            theless endorsed by the IMF.
states. (Stand-by arrangements are IMF  low value-added items, such as food prod-  There, however, modest overshooting of
credits that finance temporary balance of  ucts, textiles, and wood, while importing  the target reflected the ongoing recession
payments deficits of member countries and  high value-added products, such as trans-  and the impressive reduction of the cur-
must be repaid within 31/4-5 years.) The  port equipment and electronics. The need  rent account deficit. In contrast, in Latvia
new program, under a "precautionary"  for imported capital equipment to modern-  the economy is expanding rapidly, thus fu-
stand-by arrangement for 2000-01,  ize industrial production is likely to grow  elling imports, and the difference between
seemed to be consistent with the acces-  rather than diminish, as will demand for oil  the actual and the target fiscal deficit was
sion strategy. (The arrangement is consid-  and gas. As a result, the current account  larger than in Lithuania. In Estonia, where
ered "precautionary" because the money is  deficit is likely to increase.  economic prospects look good, the gov-
available, but the Latvian authorities are not                            ernment did not request a new arrange-
supposed to use it, only in case of a crisis.)  In the past decade, the current account  ment with the IMF after the successful
However, Latvian policymakers realize that  deficit was comfortably covered by foreign  completion of its last program, in 2000. By
they face a rather difficult tradeoff between  direct investment. This trend continued in  early 2001 Lithuania was the only Baltic
the extra budgetary spending implicitly re-  the first three quarters of 2000, despite de-  country that had an economic program
quired by the EC for EU membership and  lays in large-scale privatization. Ensuring  supported by an IMF precautionary stand-
the tight fiscal policies required by the Fund.  external sustainability remains one of the  by arrangement.
key challenges over the medium term.
The IMF Insists on Tight Fiscal Policies...                               The Latvian government is now ready for
Fiscal tightening is crucial in Latvia, largely  a new 20-month program, which it expects
Fear that high current account deficits  because the country has adopted a fixed  the IMF to support. The new program in-
leave the Baltic countries vulnerable to  exchange rate regime that leaves limited  cludes the typical medicines used to com-
© 2001 The World Bank/The William Davidson Institute                         TRANSITION, February-March 2001



Table 2. Consolidated Fiscal Balances in the Baltics, 1996-2001            could amount to 2-5 percent of GDP a
(percent of GDP)                                                          year. EU transfers to Latvia to finance at
least part of such spending could be
2000 (performance         2001      somewhat above 1 percent of GDP in
criteria under the 2000  (indicative   2001, at best these transfers would rise
Country  1996    1997   1998  1999        PSBA)a    (actual)  criteria)    only modest over thermedium rm.
only modestly over the medium term.
Estonia  -1.6    2.2   -0.3  -4.7           -1.2       -1.2      0.0
Latvia   -1.8    0.3   -0.8  -4.2           -1.9       -3.5     -1.5      Financing these costs under the tight fis-
Lithuania -4.5    -1.8   -5.9  -8.5         -2.8       -3.3      1.4      cal framework will be difficult for Latvia.
a. Precautionary Stand-byArrangement.                                     The only sensible way to do so is to im-
Source: International Monetary Fund.                                      prove prioritization and management of
public spending.
bat an increase in external imbalance and  the obligations of EU membership, pre-
potential pressure on local currencies:  sents an overall assessment of the chap-  The preparation of a Pre-Accession Eco-
tightening of fiscal policies and accelerat-  ters on the acquis communautaire. That  nomic Program has already helped
ing structural reforms.              implicitly imposes some potential pres-  policymakers focus on medium-term bud-
sure on Latvia's fiscal position, because  getary targets. In the years to come, how-
... While the European Commission  it requires that Latvia adopt EU environ-  ever, the Latvian government will have to
Requires New Spending                mental and other standards. Some ex-  handle the difficult tradeoff between fis-
perts estimate that the extra spending  cal discipline and extra spending.
The European Commission (EC) require-  requirements for EU accession may be
ments and guidelines for macroeconomic  as high as 5 percent of GDP for several  Inna Steinbuka is professor at the Univer-
and structural reforms are addressed in the  years in all candidate countries. The EC  sity of Latvia, at present, advisor to the
"JointAssessment of Economic Policy Pr-  Office estimates that the costs of meet-  Executive Director at the IMF. Author's
orities," prepared jointly by the EC and the  ing environmental requirements alone  Email: ISTEINBUKA@imf. org.
Latvian government. This document is gen-
erally consistent with the Fund-supported    Nightmare
programs. Three differences are notewor-
thy, however. First, the joint assessment is
aimed at medium-term priorities, while the
Fund programs focus on near-term objec-
tives. Second, the Fund-supported program
clearly lays out the govemment's responsi-
bilities and provides a timetable for full and
timely implementation. It is more specific
than the EC-Latvia Assessment , which al-
lows the authorities flexibility in selecting
and adjusting their policy mix in order to
achieve the medium-term priorities. This
document thus provides a framework for
dialogue between the Latvian authorities
and the EC rather than specifying a set of
policies. Third, implementation of Fund-
supported programs is well monitored
through a set of quantitative performance
criteria, indicative targets, and structural
benchmarks. In contrast, compliance with
the accession strategy is monitored by the
governmentand EC staff.                 ... And then, in my dream the world becomes one huge experimental lab
and I turned to a plain human resource...
The EC's "Progress Report on Latvia,"
which evaluates Latvia's ability to assume  From the Hungarian magazine HocipD0
*  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute C 2001



The World Bank Is Not Giving Up on Middle-
Income Countries
by James D. Wolfensohn
In a speech given in Berlin in April, World Bank President James D. Wolfensohn confirmed that 'the Bank is not tuming its back
on the middle-income countries." He responded to critics (see box) who would like to see the Bank play a smaller role in interna-
tional development.
H      ow can we further sharpen our development world]: civil society, includ-  Credit, by focusing on programmatic lend-
focus on poverty and maximize  ing NGOs, foundations, universities and  ing, will reduce conditionality.
the catalytic role we can play in  research institutions, and faith-based
the development community? In January  community groups; the private sector;  Remaining Engaged in Middle-income
this year, we discussed with our sharehold-  bilaterals; the other multilaterals; and gov-  Countries
ers a Strategic Framework for how we will ernments and their parliaments.
carryreformmforward overthe nextfewyears.                               We need to remain engaged in middle-
Underscoring that agenda are five funda-  Creating an Investment-Friendly Milieu  income countries. Eighty percent of the
mental ideas that we are operationalizing  in Low-income Countries      world's poor live in middle-income coun-
in all our work:                                                        tries. Let there be no mistake: we are not
[In low-income countries] the Bank has a  about to turn our back on them. Not only
- The Bank must retain a global compe-  crucial role to play in working with govern-  are these countries important for global fi-
tence and a global diagnostic capacity. But  ments to put in place good and strong gov-  nancial stability, but many of them have yet
we want to see more selectivity and a  emance, effective legal and judicial systems,  to put in place crucial structural and social
much better division of labor among all the  and a robust financial system and to assist  reforms that will move them to the next
players-international institutions, the  in the fight against corruption. Without these  stage of development.
United Nations, bilateral donors, NGOs,  initiatives it will be impossible for countries
and the private sector.            to attract foreign and domestic private in-  At the request of our Board, we are review-
o We must focus to help achieve the Inter-  vestment, which are so crucial as engines  ing our plans dealing with the scope and
national Development Goals [that envis-  of growth and poverty reduction.  nature of our support and the principles of
age] reducing by half the proportion of                                 costing of services. We do not intend to
people living in extreme poverty by 2015;  We need to continue our work in the rural  replace sources of funding available from
a two-thirds decline in infant and under-five  sector, home to 70 percent of the poorest.  private markets. The economic well-being
mortality and a three-fourths decline in  We need to help put in place safety nets  of the middle-income countries can trans-
matemal mortality; universal primary edu-  for the vulnerable and work with govern-  late into trade opportunities for low-income
cation for all by 2015; gender equality in  ments to focus on education, health, and  countries; on the other hand, financial in-
education by 2005; national strategies for  nutrition. We need to step up the fight stability, environmental degradation, and
sustainable development by 2005; and  againstAIDS, malaria, and TB and work  the proliferation of communicable dis-
ensuring that the current loss of environ-  with governments to meet their basic in-  eases can have deleterious effects far
mental resources is reversed globally and  frastructure needs: clean potable water,  outside [these countries'] own borders.
nationally by 2015.                 sanitation, power, communications, roads,
* We must focus on two areas in particu-  and telecommunications systems.  The Bank's engagement will be focused
lar: building the climate for investment,                               on providing secure long-term funding and
jobs, and sustainable growth; and empow-  We will push ahead with streamlining con-  advisory services, creating the right policy
ering poor people to participate in devel-  ditionality, focusing more on outcomes and  and institutional framework, addressing
opment. Development must be done by  lesson itemizing what stepsagovernment  weaknesses in social, structural, and
them and with them, not to them.    must take to reach them. We know that no  sectoral policies and institutions. With its
* Development must be country owned  amount of conditions can replace domes-  global reach, broad sectoral knowledge,
and country driven.                tic commitment to reform. A new instru-  and specific engagement with the private
* We must embrace all the players [in the  ment, the Poverty Reduction Support  sector through the International Finance
D 2001 The World Bank/The William Davidson Institute                       TRANSITION, February-March 2001   C



Corporation and the Multilateral Investment  countries may have a credit rating but do  that we will be selective, focusing on ar-
Guarantee Agency, the Bank Group has a  not have continuous access to intemational  eas where we have a comparative advan-
comparative advantage in advising on  capital in the size they need or on terms  tage and working closely with partners.
overall priorities and actions to improve the  that are manageable for them. Moreover,
investment climate.                  as our own research and experience  President Wolfensohn presented this
shows, World Bank lending has a catalytic  speech at the Public Discussion Forum
Will we be crowding out the private sec-  effect: it crowds in private capital, it doesn't  held by the Bundestag in Berlin April 2,
tor? I do not believe so. Many of these  crowd it out. But here again let me stress  2001.
Clipping the World Bank's Wings: A Critic Speaks Out
The World Bank has become in large part superfluous. That  To deflect public attention from these failures, the Bank resorted
may sound provocative, but it is accurate. Demand for World  to sponsored debt forgiveness for the most indebted poor coun-
Bank long-term investment loans and policy-based lending in  tries-often also the most profligate and incompetent of them.
middle-income countries is diminishing, as developing coun-  In doing so, it advocated a policy that has never been shown to
tries gain increasing direct access to capital markets and re-  exert positive growth effects.
ceive foreign direct investment.                       Financial intermediation is, in fact, being performed by private
In fact, only aid to poor countries, which the Bank administers  capital markets, and where they do not yet reach far enough, it
through its International Development Association (IDA), the  could be done by existing regional development banks. In this
body that provides long-term loans at below-market interest to  respect the World Bank could become expendable. But the
the poorest countries, remains in high demand. But aid by itself  Bank still has a useful and unique role to perform: encouraging
is failing to affect growth and poverty in recipient countries. The  the right development policies and transferring the right devel-
Bank needs to adapt to changing circumstances. Yet it seems  opment knowledge are functions that cannot easily be shifted
to be doing the opposite. Indeed, it is fighting to keep up both  to other existing public institutions or market mechanisms.
its lending and aid, while not doing enough to sponsor sound  The Bank's big shareholders, starting with the U.S., should keep
development policies.                                 this in mind when they re-examine the strategic functions of the
Private net flows to middle-income countries have increased  Bank, ataskthatcannotbedelayed. The World Bank'soverarching
enormously. In the past 10 years, about 40 out of the 60 middle-  aim is the pursuit of economic growth where conditions for it are
income World Bank borrowers received on average net private  not yet present and market reach is not wide enough. It should,
lending and investments equivalent to at least 3 per cent of their  therefore, focus its future lending activities in low-income and lower
gross national product per year. For 25 of the borrowers, annual  middle-income countries not yet capable of accessing capital
private capital inflows exceeded 5 per cent of GNP. Net private  markets and external technology on their own.
flows to all middle-income countries were on average equivalent  In countries without sound macroeconomic policies, establishing
to 4 per cent of GNP. World Bank netflows were 40 times smaller.  them should be the priority. Lending for balance of payments pur-
The Bank obtained these underwhelming results in spite of push-  poses should be left to the Intemational Monetary Fund. In addi-
ing loans in noncore areas and mixing loans at market terms  tion, IDA should make passable govemance and accountability in
with aid for some countries that already had ample access to
the use of resources and actual performance Indispensable con-
foreign capital. China, for example, became the largest World  ditions for the continued supply of aid to poor countries. The ob-
Bank borrower in the 1990s.                           jectives pursued should be strictly economic and developmental.
The Bank also continued to administer aid in the guise of invest-  Bank engagements in noneconomic areas should be stopped.
ments to countries unable to use it effectively. This is either the  A smaller and more effective organization would emerge from
result of the recipient countries' incompetence and corruption or  all this. The alternative is to let the World Bank gradually be-
because of their poor domestic policy environments.
come just another aid lobby, indistinguishable from any other
Much of this transfer of resources was done under the banner  international lobby or pressure group. This would hardly be a
of "fighting poverty" or pursuing other worthwhile social objec-  valid raison d'etre for a Bretton Woods institution.
tives. But the results have been disheartening. The knowledge  Enzzo Grilli is professorof international economics at the Paul
that providing aid is futile where good policies and good gov-  Nitze School of Advanced International Studies, Johns
ernment are not in place did not make much difference, even  Hopkins University. This article appeared in the Financial
though the Bank's own research had confirmed this.     Times in mid-April.
*  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute (C 2001



Understanding the Communist Election Victory in
Moldova
by Arcadie Barbarosie
After almost 10 years of reform, parliamentary elections in Moldova ended with a landslide victory by the Communist Party in
February The Communists now have a comfortable majority, permitting them to make any decision, including modifying the
Constitution. In April the chairman of the Communist Party, Vladimir Voronin, was elected Moldova's third president.
W        ith almost 51 percent of the  Poor Economic Performance          mum consumer basket. Increases in nomi-
popular vote, the Communist                                     nal wages have lagged behind the infla-
Party won 71 seats in the  Moldova's economy did not improve during  tion rate, causing living standards to drop
Parliament. The remaining 30 seats are  thetransition years (seetable), and the con-  significantly. During eight years of transi-
shared by the Popular Christian Demo-  ditions for economic growth were not cre-  tion, real income per capita also fell sharply.
cratic Party, a far-right party favoring inte-  ated. Instead, real GDP in 1999 shrank to  Salaries are not only low, they are also not
gration with Romania, which holds 11 seats,  33.7 percent of the 1990 level. As the Wall paid on time: arrears by enterprises and
and the Bragis Alliance, an ad hoc amal-  Street Joumal put it, "Moldova's improvised,  state organizations constituted more than
gamation of small and almost unknown  political and managerial classes failed to  381 million lei in February 2001.
parties and movements headed by former  pursue market reforms with any consistency.
Prime Minister Dumitru Bragis, which has  That failure led to economic collapse and  Income inequality has also grown. The in-
19 seats. (The high threshold of 6 percent  general pauperization, which the electorate  come of the top 20 percent of the population
needed to win a seat in Parliament pre-  perceived to be consequences of market  is more than 11 times that of the bottom 20
vented any of the other 14 parties and move-  economics, not of the absence thereof."    percent, and the Gini coefficient is 0.44, in-
ments from winning representation in the                                  dicating a high level of income inequality. (A
Parliament.) Election turnout was high (69  Widespread Poverty            country with a Gini coefficient of more than
percent), and international observers con-                                0.35 is generally considered to have a high
firmed that voting took place in a demo-  Ninety percent of the population in  level of income polarization.) Most of the
cratic, free way, with no fraud reported.  Moldova-some 4.5 million people-  country's 800,000 pensioners are socially
live on less than $1 a day. About 80  marginalized, and their average monthly
How could it happen? How could a country  percent of the population live on less  pension of 82 lei ($7!) puts them under the
described by the Economist as a "model of  than $20 (233 lei) a month-that is, be-  poverty level. No wonder a large majority of
correct reform and a perfect laboratory for  low the subsistence level-according to  pensioners voted for the Communist Party.
running reforms" become a model of stagna-  the Moldovan Department of Statistical
tion where the Communist party won by a  and Sociological Analysis. The average  The continuing deterioration of the qual-
landslide? Several factors have been atwork.  salary covers only 40 percent of the mini-  ity of life and the impoverishment of the
The World Bank Carries On in Moldova
"Regardless of the election results, the World Bank is ready to  ment climate and reduce corruption.
help Moldova's reform efforts while paying strong attention to in-  * Privatizing energy, telecommunications, and commercial ac-
stitutional factors. We will engage the new authorities in a policy  tivities, such as wineries, in a competitive manner.
dialogue," said Carlos Elbirt, the Bank's Resident Representa-  * Improving efficiency in education through training, curricu-
tive in Chisinau. In contributing to the government's Poverty Re-  lum development.
duction Strategy, the Bank will continue to emphasize:  * Providing basic health services.
* Modernizing the public sector through management reform.  Since Moldova joined the World Bank in 1992, the Bank has
* Promoting legal and judicial reform to improve the invest-  approved 14 projects totaling about $394 million.
© 2001 The World Bank/The William Davidson Institute                         TRANSITION, February-March 2001   U



population seriously diminish the social  bacco, and wine) led to the rapid deteriora-  throughoutthe 1990s.Asettlementis now
basis for further reforms. As recent pub-  tion of their balance sheets. Delaying  more likely as Moldova's new parliamen-
lic opinion polls show, 80 percent of the  privatization presumably gave state manag-  tary majority appears prepared to accept
public believe the country is heading in  ers enough time to strip these companies  federalization and grant Russia the status
the wrong direction. The majority of the  of their assets. The foreign loans and grants  of a state language in exchange for closer
population-some 70-90 percent-think  for supporting structural reforms were used  economic ties with the CIS.) The new gov-
that before 1991 (the year Moldova  mostly for consumption; total govemment  ernmentwillalsohavetodealwithfighting
gained independence) the quality of gov-  debt increased to 135 percent of GDP.  corruption, reducing tax evasion, shrinking
ernance, social protection, living stan-                                   the size of the shadow economy (equal to
dards, and even respect for human rights  InefficientAgriculture           some 60 percent of official GDP), creating
and liberties were better or much better                                   a stable legal environmentfor business, and
than they are today.                 Reforms in the agriculture sector were in-  consolidating the fiscal budget.
tended to change land ownership and im-
Missed Transition Targets            plicitly to increase the efficiency of land use.  These efforts are more or less consistent
The first step has almost been completed:  with the Communists' electoral program;
Transition proved to be a much more com-  75 percent of agricultural land concen-  other necessary reforms are not. Key to-
plexanddramatcprocessthanpolicymakers  trated in 989 large collective farms has  bacco, wine, energy, and telecommunica-
had expected. The government's "Program   been distributed to some 800,000 farm-  tion enterprises need to be privatized, for
of Transition to a Regulated Market Economy,"  ers. But the measure did not increase effi-  example. Agrarian reforms that will help
approved by Parliament in 1990, was sup-  ciency, as it is impossible to create an  create a market-oriented agricultural sec-
posed to create the framework for develop-  efficient agricultural sector based on farms  tor-such as developing the land market
ing a market economy and a democratic  of one or two hectares. Consolidating  and establishing independent commodity
society in a matter of a year and a half or two  small parcels into larger farms on a volun-  exchanges-must also be undertaken.
years. It is now clear that it was naive to as-  tary basis has only just begun.
sume that society could change that rapidly.                               Pragmatism Prevails?
Ethnic and linguistic differences in voting hab-
Despite creating the legal and institu-  itsareclearfromtheresultsofthelastelection,  Several commitments made during the
tional framework for a market economy,  inwhichtheCommunistPartygainedthesup-  Communists' electoral campaign could
reform in Moldova did not achieve the  portof80percentof Bulgarians, 63percentof  have severe negative consequences if ful-
government's declared goals. The popu-  Ukrainians, 58 percent of Russians, and only  filled. One example is the promise to re-
list voucher privatization process, which  27percentofMoldovans/Romanians.  draw the administrative districts by
sought to give all Moldovans a chance to                                   reintroducing the old rayons. Increasing
become "capitalists," did not improve cor-  Campaign Promises              pension payments and subsidies to en-
porate management or attract real invest-                                  ergy, public transportation, and other
ments in the privatized companies.   The economic and social situation in  goods and services would put tremendous
Moldova is so difficult that the new gov-  pressure on the budget. Joining the Rus-
Industry in the former Soviet Republic of  ernment will have little room for maneuver-  sia-Belarus Union could escalate social
Moldova was oriented toward Soviet mili-  ing. The new government's top priorities  and interethnic tensions.
tary needs; the dissolution of the Soviet  are to transform institutions that remain se-
Union was not followed by an efficient con-  rious impediments to economic growth  Will the Communist Party insist on imple-
version program of military-oriented en-  and to settle the Transnistria conflict. (This  menting its pre-electoral program, or is the
terprises. Prolonged state control of  breakaway territory with a large Russian  party pragmatic enough notto commit itself
enterprises in key industries (energy, to-  population enjoyed Moscow's backing  to a counterproductive antireform policy?
Only the future will tell.
Economic Indicators in Moldova, 1993-2000
Indicator                 1993      1994     1995   1996   1997  1998   1999  2000a    Arcadie Barbarosie is
Executive Director of
Real GDP growth rate(%)    -1.2    -30.9     -1.4   -5.9    1.6  -6.5    -4.4       0       the Institute forPublic
Annual inflation rate (%) 2,707.2    104.6   23.8    1.1   11.1  18.2   43.8    31.3        Policy, Chisina Mol-
Exchange rate (lei/$US)    3.64     4.27      4.50   4.65   4.66   8.32   11.59   12.3    dova. His email ad-
a. Estimate.                                                                                dress is arcadie_bar
Source: Moldovan Economic Trends, Department of Statistical and Sociological Analysis.      barosie@ipp.md.
a  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute © 2001



Meeting the Challenge of Globalization in China
by Chi Fulin
Globalization is exerting great pressure on Chinese policymakers to make fundamental changes to the administrative system,
accelerate enterprise reform, and open up the financial system to foreign competition. Accession to the World Trade Organiza-
tion (WVTO) has brought economic reform in China to a critical stage. Further progress will require deep structural changes and
an acceleration of the process toward a market-oriented economy
WTO membership will further integrate  The government will have to further relax  been lacking. Accelerating the reform of
China into the world economy, enabling it control of the economy, including restric-  government agencies and their operations
to participate in setting the rules of inter-  tions on foreign trade and investment. At will thus be very important.
national trade, not just standing on the side-  the same time, it will have to enact new
lines. It will also force China to gradually  laws and regulations and establish new  WTO membershipwill profoundly affectthe
reduce tariffs in the next five years and  rules. China's many years of central plan-  government's maneuvering space in regu-
open up its finance, insurance, telecom-  ning preserved too many direct and arbi-  lating the economy. As current accounts
munications, accounting, consulting, and  trary interventions, which still restrict many  become more open, capital oufflow may
tourism sectors to foreign competitors.  economic activities. The institutions  increase. Foreign banks will be allowed to
This schedule lends particular urgency to  needed to promote the enactment and  make renminbi loans, complicating control
reform efforts.                     implementation of new rules that have  over capital accounts. At the same time,
Recession Can Be Prevented in China
Some $4.6 billion in foreign direct investment has poured into  other $18 billion fiscal stimulus package and wants to hike
China in the [first three months of 2001], a 24 percent increase  wages and unemployment benefits for more than 100 million
over the same period a year ago. The doors to sectors once  unemployed workers to help reduce any friction exacerbated
closed to foreign investment have been thrown open. Contracted  by economic restructuring this year.
FDI skyrocketed a year-on-year 47.1 percent since January,
indicating that foreigners will probably increase their invest-  Such domestic dynamics point to continuing albeit constrained
ments in China.                                       growth. Retail sales have recovered on the back of a slowdown
in the growth of household saving deposits. This suggests im-
China's export industries have ceased to contribute to gross  proving consumer confidence, as households save less and
domestic product since late last year. Industrial output has  spend more. The dampening of China's high savings rate ap-
slowed along with exports, a trend that is likely to continue in  pears to have been affected by successive interest rate cuts
the coming months. A malfunctioning financial system is also  and a new tax on interest-bearing deposits levied in Novem-
constraining demand by distorting the allocation of capital for  ber. Consumer spending, which accounts for half of the economy,
investment and consumer spending. Moreover, narrow growth  is likely to remain strong.
of the money supply, a leading indicator of spending, has de-
celerated.                                            Deflation has ended; consumer prices are rising at an an-
nual rate of 1.2 percent. This is in sharp contrast to the fall-
China's policymakers, however, are aware of these drags on  ing price of exports, which is contracting at an annual rate of
the economy, and are thus unlikely to commit any major policy  more than 1 percent. This price divergence suggests that
errors, like Japan did in August 2000 by tightening up liquidity  the domestic sector remains relatively resilient. Consump-
prematurely. Their concerns about inflation will prove unneces-  tion is growing at more than 9 percent annually, stronger than
sary, since rising competition and structural changes will con-  the 3 percent growth in the U.S. Domestic sector growth and
tinue to curb any pressure on prices.                 supportive macroeconomic policy thus should prevent a re-
cession.
A significant loss of consumer confidence also seems unlikely,
since the government appears determined to prevent the  Excerpted from "China's Three Stresses,"Asian Wall Street
economy from faltering in the run-up to the change in leader-  Journal, by Chi Lo, regional head of NortheastAsia research
ship in the second half of 2002. Beijing has planned yet an-  for Standard Chartered Bank Global Markets, Hong Kong.
©D 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001   A



the WTO requirement to gradually re-  Develop the Nonstate (Private) Economy  effective supervisory system to check
move nontariff barriers means that China                                   power, the way public sector employees
will become more dependent on indirect  Private investment in China failed to reach  are hired and awarded. The relation be-
regulatory means of controlling the bal-  the desired level in the past two years, de-  tween the government and the public
ance of payments (monetary, fiscal, and  spite the govemment's expansionary policy.  should correspond to the relation between
exchange rate policies). To respond to  Institutional barriers should be eliminated  China's socialist market economy and the
these challenges, Chinese policymakers  and legal protection extended to nonstate  people-its major beneficiaries. The wide
will need to take several steps immedi-  enterprises, including private property. Bar-  participation of the public in the reform pro-
ately.                               riers to market access must be eliminated,  cess could be the most important driving
financial support to private enterprises in-  force to stimulate vigor in Chinese soci-
Develop the Rural Economy and Im-  creased, and investment of private capital  ety. Such participation requires transpar-
prove Farmers' Living Standard       in the financial sector promoted.     ency, a continuous information flow, and
accountability of those in positions of lead-
The lack of a well-functioning social se-  Expand Social Policy Reform     ership. If civil society is well informed and
curity system and a rational income dis-                                   can participate in the decisionmaking pro-
tribution system  are lowering public  Policymakers need to address at least  cess, reform can be carried out even if
expectations as to the benefits of reform.  four issues:                   means temporary belt-tightening.
Increased unemployment has led to new
social problems. Corruption should be  * Policies need to be implemented to help  Reforms will deterrnine China's future. If suc-
eliminated at its roots, but administrative  narrow the huge income disparity among  cessful, they will lead to economic develop-
control over resource allocation and the  different professional and social groups.  ment and social stability and ensure that
lack of an effective supervision mecha-  * Individual social security accounts should  China enjoys the benefits of globalization.
nisms make doing so difficult.       be introduced, reducing state involvement.
Pension reforn should be financed through  Chi Fulin is Executive Director of the
Separate Government from Enterprises  floating special treasury bonds. The gov-  China Institute for Reform and Develop-
ernment should play a leading role in  ment (CIRD) and Vice-Chairman of the
Administrative interventions by party orga-  strengthening the social security system, at  Chinese Research Society for Economic
nizations and government agencies en-  the same encouraging private capital to in-  System Reform.
danger sound corporate governance.  vest in social security funds.
Reorganization of the state sector accord-  * Human capital development should be-    Crime in Russia
ing to market principles requires several  come a major focus of structural reform. In    .  : 
steps:                               a knowledge economy and infor-mation 
age, human capital development is deci-   .
- Large and medium-size manufacturing  sive for the competitiveness of a nation.
enterprises should be converted into joint  * Urban development and rural reform
stock companies.                     should be coordinated. Rural reform-
* The conversion of public service sector  which affects 800 million people in China-
companies in the telecommunications,  is at a critical stage. Farmers need
railway, civil aviation, and electricity sec-  long-term and secure land use rights. In the
tors into joint stock companies should be  next 10-20 years, rural reform is expected
accelerated. Reforms that promote invest-  to help 100-200 million farmers to leave
ment and financing on commercial terms,  the agricultural sector. To absorb this in-    X
eliminate excessive concentration, break  flux, the process of urbanization needs to   .,
up monopolies, absorb nonstate and so-  be accelerated.
cial capital, and encourage competition
should also be implemented.          Proceed with Political Reform
* State-owned commercial banks should
be restructured. This reform will have a  Economic reform calls for grassroots de-
major impact on the entire economy.  mocracy. Political reform could also help   z.
Opening up the financial sector and  eliminate corruption, which results from
adopting market-oriented interest rates is  rent-seeking, lack of an effective manage-  From the Moscow based magazine Busi-
also urgent.                         ment system for state assets, lack of an  ness in Russia
M   TRANSITION, February-March 2001                               The World Bank/The William Davidson Institute C) 2001



The Income Gap in China: Rural Areas Need a Lift
by Zhao Manhua
By the end of 1999, China's population exceeded 1.2 billion  rural incomes reached a record 2.9:1. In 1999 the gap narrowed
people, 69 percent of whom live in rural areas. The situation in  slightly to 2.7:1. In the first three quarters of 2000, per capita
China's countryside is thus a good indicator of economic devel-  cash income in rural areas increased 2.5 percent, while income
opment and reform progress in the country as a whole. One im-  in urban areas rose 8.4 percent, leaving the income gap a little
portant indicator is farmers' income level, which is closely related  wider than it was in 1978.
to their living conditions.
The change in income distribution is consistent with the inverted
Since 1998 the economic situation in China has changed dra-  U-shaped curve first put forward by U.S. economist Simon
matically. Shortages ended, and there is now an oversupply of most  Kuznets in 1955. According to Kuznets, rising inequality in in-
industrial goods. Weak demand has slowed China's economic  come distribution is inevitable as economic development takes
growth. Given these conditions, farmers' consumption is particu-  place. When economic development reaches a higher stage,
larly important for expanding domestic demand and propelling  income distribution becomes more equitable. Is Kuznets' hypoth-
economic growth. With a vast population and low living standards,  esis compatible with China's income distribution? What is the
China's rural areas represent a huge potential market. If farmers'  relation between income and development? When is the income
income can be increased, this potential market will play an impor-  gap still reasonable and acceptable?
tant role in promoting economic development in China.
In 1998 per capita consumption was 1,892 yuan in rural areas
Rural-Urban Income Gap Narrows in Early 1980s ...      and 6,201 yuan in urban areas-a ratio of 3.2:1. Refrigerators
and washing machines, which most urban households now own,
Since economic reform began in 1978, farmers' living conditions  are still uncommon in the countryside, where only 10 percent of
have improved and their income has gradually increased. In 1978  rural families own refrigerators and just 21 percent own washing
the annual per capita net income of rural households was a mere  machines.
134 yuan (1 US$=8.3 yuan). By 1999 it had increased more than
15 times, to 2210 yuan. Despite these improvements, the gap  Because the profit from agricultural investment is relatively low,
between urban and rural dwellers has grown.            many farmers decided to shift their investment out of agriculture,
into other more profitable sectors. If this trend continues, grain
In 1978 the annual per capita income of urban residents was 343  output in China could drop significantly, possibly forcing China to
yuan-two and half times the 134 yuan average income of rural  import grain, thereby weakening the foundation of the economy.
residents. This ratio reflects the fact that urban residents enjoyed
free medical care, free housing, good education, and convenient  Narrowing the Income Gap through Rural Urbanization
amenities-all of which were lacking in the countryside.
To narrow the income gap between urban and rural areas and
In early 1980s the income gap between urban and rural residents  improve rural living standards, China should take the follow-
narrowed. In 1984 the income ratio dropped to 1.6:1, a historic low  ing steps:
that was never repeated thereafter. The gap narrowed because
economic reform focused on rural areas and policies were favor-  * Speed up the development of agricultural production.
able to the agricultural sector. Before reform farmers were worried  Sixty-one percent of farmers' income comes from agriculture.
that they had too little grain to live on. In the mid-1980s, they pro-  The government should invest more in improving agricultural
duced so much grain they worried about the lack of storage capac-  infrastructure facilities and encourage individual investment in
ity. As a consequence, grain producers were able to achieve bumper  agriculture.
harvests in a row. By the mid 1980s, agriculture grew at an annual
rate of 7 percent. The successful rural reform resulted in a steady  * Develop nonagricultural sectors in rural areas. About
and quick increase in rural income, narrowing the income gap.  39 percent of farmers' income comes from nonagricultural sec-
tors, including agricultural produce processing, commerce,
... But Grows Again as Focus of Reform Shifts to the Cities  transportation, and services. To promote these sectors, China
should accelerate urbanization in rural areas. Rural urbaniza-
Beginning in 1985 the focus of China's economic reform shifted  tion can revitalize commerce and services and create a fa-
to cities, and the income gap grew. In 1994 the ratio of urban to  vorable environment for rural enterprises, which have become
© 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001  0



major sources of farmers' income in recent years. As rural areas  the same time, the government should set up a mechanism that
become more urbanized, many unemployed or underemployed  makes transfer of farmland possible, so that production can be
people will be able to find jobs, and rural incomes will rise.  adjusted to market demand.
* Deepen rural reforms across the board. In 1978 China be-  * Improve other policies that affect the rural economy. The
gan to put the household responsibility contract system into prac-  government should institute a legal system that protects farmers'
tice. This system has proved its viability. China is now introducing  rights and interest, establishes a rural credit and mortgage sys-
industrial management in agriculture in order to integrate agri-  tem, and takes more active measures to eradicate poverty.
cultural production, processing, and marketing. These reforms
will make agriculture more commercialized, specialized, and  Zhao Manhua is assistant professor at Taiyuan Teacher's Uni-
modern, increasing farmers' competitiveness and incomes. At  versity.
MIGA Launches Improved Privatization
Information Service: www.privatizationlink.com
by Birgit Braunwieser
TheMultilateral lnvestmentGuaranteeAgency  portunities, including tender announce-  than 70 transition economies and de-
(MIGA) of the World Bank Group recently  ments and procurement notices for advi-  veloping countries. It also provides links to
launched a new version of PrivatizationLink  sory services. A new option allows users  useful resources, such as sector and busi-
(www.privatizationlink.com), its free online  to customize by sector, region, and sub-  ness environment analyses from the Invest-
information service on privatization in  ject.                            ment Promotion Network (www.ipanet.net),
emerging markets. The service provides up-                                MIGA's portal site for international cor-
to-date, searchable details of upcoming  * The best practice section includes  porate investors, privatization-related
privatization transactions, including profiles of  case studies and resources with useful  news, and overviews of MIGA's guaran-
state-owned enterprises being divested and  information for privatization practitioners,  tee activity.
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country. In addition to an enhanced search  valuation, foreign participation, and labor,  mation on more than 8,000 privatization
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includes several newfeatures:       tization issues. To promote interaction  through a searchable online directory.
between privatization practitioners, us-
* The practitioners'corneridentifies the  ers can provide ratings and written feed-  Formed in 1988, MIGAisa member of the
staff of privatization agencies and their ad-  back.                      World Bank Group. Its mandate is to en-
visers-the people involved in marketing                                   courage foreign direct investment in transi-
and structuring transactions. It contains  * Country fact sheets provide back-  tion economies and developing countries
various hands-on learning and networking  ground, institutional framework, status,  by providing political risk insurance against
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* The investors' corner provides infor-  and foreign investors. Information is pro-  Birgit Braunwieser is Investment Analyst
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m  TPANSITION, February-March 2001                               The World Bank/The William Davidson Institute ©D 2001



THE WILLIAM DAVIDSON INSTITUTE
AT THE UNIVERSITY OF MICHIGAN BUSINESS SCHOOL
Continued from page 1                crease in real incomes depressed do-  improved, they now face an increased
mestic consumption. The increased com-  burden to import components and ser-
consistentwith it. The real puzzle is why the  petitiveness of domestic manufacturing  vice debt. Were it possible to switch to
recovery is so weak relative to the massive  has caused expenditure switching in favor  domestic producers, they would be in a
change in Russia's external competitive-  of domestically produced goods, but the  better position. The data on machinery
ness. As we show, the recovery occurred  extent of this import substitution has been  exports suggest differently.
because of the windfall brought about by  constrained by the decline in real incomes.
the exchange rate shock and the rise in                                    Level of Barter Declines
world market prices for oil and other re-  Perhaps the more important reason for the
sources that Russia exports, not because  limited response to the real depreciation  There has been a significant decline in
of any essential change in the behavior of  is that the incentives to undertake costly  barter as a share of industrial sales in Rus-
enterprises in Russia. This suggests that  restructuring activities remain weak.  sia since the August 1998 crisis. There has
although postcrisis developments have  Hence enterprises continue to operate as  also been an increase in tax payments
given Russia a window of opportunity, this  before. Poor quality means that produc-  paid in cash. These trends are widely in-
window is likely to close before any seri-  ers are unable to reap the benefits from  terpreted as a sign of a healthy behavioral
ous structural reforms take root.    the huge improvement in their external  change on the part of manufacturers, even
competitiveness: despite the improvement  as an indication of the demise of the vir-
Depreciation of the Ruble Improves  in the terms of trade, Russian producers  tual economy.
Exporters' Balance Sheets            are exporting less than they did before the
financial crisis.                    To understand why these signs may have
Understanding the current state of                                         been misinterpreted, it is important to dis-
Russia's economy has to begin with an  How can we account for the fact that while  pel a common misunderstanding. Barter is
examination of the real devaluation of the  Russian unit labor costs (measured in dol-  not the essence of the virtual economy. The
ruble that occurred in the wake of the cri-  lars) are still much lower than before the  essence of the virtual economy is the trans-
sis. Thanks to a nominal depreciation  crisis (figure 1), machinery exports (mea-  ferofvaluefrom value-producing sectors-
that exceeded the ensuing inflation rate,  sured in dollars) are below the levels  primarily, but notexclusively, energy and raw
the real value of the ruble at the end of  achieved in 1998? One reason is that the  materials-to value-destroying sectors.
1998 was only about 36 percent of its  real depreciation increased the cost of  BeforetheAugustmeltdown, barterwasa
immediate precrisis value.           imported inputs, and the possibilities for  means of implementing this transfer.
import substitution in components for ma-
In view of this dramatic real depreciation,  chinery manufactures may be slim-much  One needs only to think about the effect of
it should hardly be surprising that Russia  smaller than in, say, food processing. Ma-  the real ruble depreciation on barter to
has shown signs of recovery. This ex-  chinery producers may thus see their cost  understand what has been happening. The
change rate shock has hugely increased  advantage dissipate.               extent to which enterprises use money or
the ruble value of exports. Hence even with-                               barter is an economic decision. Because
out any behavioral changes, the balance  There is an ironic paradox here. Con-  barter is costly, enterprises used cash for
sheets of exporters improve significantly.  sider the plight of enterprises that had  some transactions even when use of bar-
invested to improve their competitive-  ter was at its peak. Enterprises traded off
One important mitigating factor slowing  ness before the crisis. They may have  the transactions cost of barter against the
recovery is that the increase in competi-  purchased foreign-made machinery or  cost of using money. (In the current Rus-
tiveness has coincided with a dramatic fall  retooled to be able to use high-quality  sian environment, that cost is primarily in-
in household incomes. This was especially  imported components and materials, in-  creased visibility, which implies greater tax
true in 1999, when incomes were roughly  curring dollar-denominated debt to pur-  liability.) When cash is more plentiful, the
75 percent of the 1995 level. This de-  chase them. Although their efficiency  margin between using barter and using
(D 2001 The World Bank/The William Davidson Institute                         TRANSIIION, February-March 2001   D



money shifts. Real depreciation thus shifts  posed of two equal parts: one part sells to  real value of exports due to the devalua-
behavior toward greater use of money.  export markets (fordollars), the othersells  tion: neither growth nor "remonetization"
This is a behavioral change, but it does  domestically (for rubles). The barter sec-  involved a change in enterprise behavior.
not represent restructuring.        tor is exclusively domestic. Say that total  All the enterprises in all of the sectors con-
output in the economy is 100 rubles at of-  tinue to produce exactly what they did be-
A second effect of the depreciation on  ficial prices. This means that the break-  fore, in the same amounts (absolutely and
barter-one that involves no behavioral  down between the sectors is as shown in  relatively), selling to the same customers
change at all-is probably much more im-  table 1.                        as before. They use (and perhaps waste)
portant. The depreciation of the ruble in-                               the same physical amounts of inputs (gas,
creases the size of the export-oriented  Let us now subject this economy to an "Au-  electricity, steel, labor, and so on) as be-
part of Russia's economy (which is pre-  gust 17-like" event. That is, we devalue the  fore. In fact, it is easy to see that the posi-
dominantly value adding and cash based)  ruble against the dollar by a factor of four  tive effect of the increased value of exports
in ruble terms relative to the dinosaur part  and let domestic prices double. This  could even offset (and conceal) negative
of the economy (which is largely value  means that the cash export sector's out-  developments elsewhere. For instance,
subtracting and noncash based). Hence  put is now worth 100 rubles instead of 25,  the barter sector could grow in size (in
the nonmonetary transactions that are  the domestic cash sector's sales are  terms of physical volume of goods pro-
needed to subsidize production at value-  priced at 50 rubles instead of 25, and the  duced and traded) or the domestic cash
destroying enterprises shrink in ruble  barter sector's recorded sales are 100  sector could actually shrink. But if the
terms. This does not reduce the cost to  rubles instead of 50. Table 2 shows the  growth of the export sector-thanks exclu-
the economy of this value transfer, how-  new ruble values and the percentage of the  sively to the devaluation-were large
ever: the opportunity cost of the transfer  total economy that each sector now rep-  enough, the overall figures could still show
rises with the increased profitability of  resents.                      net growth and net remonetization.
exports.
Finally, let us deflate these values to account  The point of this exercise is to underscore
Real depreciation will necessarily reduce  for inflation, using a deflator of 2.0. That is,  that barter is not the essence of the virtual
the dollar value of the value-destroying  the barter sector's inflation-adjusted output  economy. Barter is not the main problem
sector. Think of it this way: a large enough  is 50 rubles, the do-
ruble depreciation would shrink the dollar  mestic cash sector's Table 1. The Pre-August Economy
value of the virtual economy to zero. But  is 25, and the export                Cash sector
that would still not end value-destruction as  cash sector's is 50  Barter Domestic Export  Total  Total
long as the industries responsible continue  (table 3).  Item     sector cash     cash   cash  economy
to operate. If there is no behavioral
change, resources are still being de-  Table 3 presents the  Rubles  50    25     25      50    100
stroyed.                            postdevaluation out- Percentage 50    25      25      50    100
come in predeval-
Understanding the Relationship be-  uation(table1)rubles. Table 2. The Post-August Economy (Nominal Values)
tween Growth and Remonetization: A  Comparing table 3                          Cash sector
Simple Accounting Example           with table 1, we see                       Cash expor
two positive effects.        Baffer Domestic Export  Total  Total
The fact that a large real depreciation can  First, total output in Item  sector cash  cash   cash  economy
makeeconomicperformancelookstrong  the economy grew  Rubles       100   50        140    150   250
without any change in behavior is a rather  from 100 to 125-a  Percentage  40   20  50     60   100
simple point, yet it seems to be lost amid  real (inflation-ad-
the glowing statistics. A simple account-  justed) increase in
ing example can illustrate just howthis phe-  output of 25 percent. Table 3. The Post-August Economy
nomenon works.                      Second, the share of
barter in the economy                      Cash sector
Imagineaneconomy(whichwecalla"pre-  dropped from  50              Barter Domestic Export Total  Total
August" economy) that appears in terms  percent to 40 per- Item   sector cash     cash   cash  economy
of the recorded value of output or sales to  cent. Both of these  Rubles  50    25  50    75    125
be half barterand half monetized.Assume,  effects come solely  Percentage 40    20  40    60    100
too, that the monetized sector is itself com-  from the increased
*  TRANSITION, February-March 2001                              The World Bank/The William Davidson Institute (C 2001



in the Russian economy; it is a symptom   These statistics would suggestthat Sakha's  The recovery in consumption is an impor-
of the problem. The essence of the vir-  economy is growing, monetizing, and mod-  tant positive sign. During 1999 recovery
tual economy is enterprise behavior that  ernizing. Yet other indicators raise some  was fueled almost exclusively by the de-
exploits what we have called relational  questions. The percentage of loss-making  preciation of the ruble. The high cost of
capital to protect and maintain value-de-  companies rose from 57 percent to 63 per-  imports led to increased consumption of
stroying activity-soft goods production.  cent, and only 14 percent of enterprises  domestic goods, but this effect was seri-
Barter is important because it facilitates  were technically solvent. Nonpayment prob-  ously limited by the decline in household
that behavior. The real question for the  lems were also getting worse.  income in the wake of the August crisis.
Russian economy is what happened to                                      The fact that consumption is increasing
enterprise behavior as a result of the posi-  How can these conflicting trends be recon-  means that there are some domestic
tive cash shock and the shift in relative  ciled? The answer is one word: dia-  sourcesofdemand.Thoughstillnotatthe
prices between hard and soft goods pro-  monds. The region's largest enterprise is  1995 level, consumption does appear to
duction? This stylized example tells us that ALROSA, which accounts for 69 percent  be on a steady increase.
simply looking at figures on the percent-  of all industrial output. Although the
age of barter in the economy tells us noth-  region's industrial output, measured in  The recovery in consumption is a welcome
ing about behavior.                 rubles, rose 80 percent, the physical vol-  sign for Russia. But it is important to rec-
ume of output barely increased at all. The  ognize that consumption has yet to achieve
Impressive Figures May Conceal  reason is that ALROSA, which exports  the levels reached in 1997 and early 1998.
Harsh Truths: The Case of Sakha     nearly all of its diamonds for dollars,  At this point there is no evidence to sug-
earned four times as many rubles on the  gest that this is more than a cyclical recov-
There is another important lesson here. It same volume of exports as before. Ag-  ery from the depths of the crisis-a
is that aggregate statistics can often dis-  gregate net profits in the republic in the  "catching up"from the earlierdecline. There
tort reality. While the virtual economy per-  first half of 1999 were Rub 5.4 billion, and  is no evidence that Russian consumers are
meates the Russian economy, it does not ALROSA's net profits were Rub 5.6 bil-  more optimistic about the future and have
do so in a uniform way. Often we can gain  lion. This means that taken together, the  altered their consumption behavior, gener-
real insight into its operation only by look-  region's other 19,300 corporate entities  ating a new source of aggregate demand.
ing at specific regions or industries.  had a net loss of Rub 0.2 billion. Thus the  Whether or not consumption growth is sus-
increased ruble value of ALROSA's dia-  tainable will depend on what happens to
A case study of one (admittedly extreme  mond exports alone-its positive cash  income, which in turn depends on whether
but not unique) case, the Republic of  shock-explains the region's higher prof-  the recovery itself is more sustainable. The
Sakha (Yakutiya), shows just how mislead-  its, increased industrial output, and im-  recovery in consumption isnotan indepen-
ing statistics can be. During the first half  proved fiscal performance. There is little  dent variable in this recovery.
of 1999, the economy in Sakha appeared  to indicate that anything else changed in
to be performing impressively:      the region.                          The steady growth in investment ap-
* Industrial output was up 80 percent in                                 pears to be an even more positive sign.
constant prices (160 percent in current  Consumption and Investment Re-  Investmentgrewrobustlyinthepastyear,
prices).                            cover                                rising 17 percent over the same period
* Gross regional product was up 1 per-                                   the previous year between January and
cent.                               The most important positive sign during  August 2000. But the increase is from
* Fixed capital investment was up 30 per-  2000 has been the recovery in consump-  an extremely low level. Real expendi-
cent in constant prices.            tion and investment. We have seen that tures on new construction and equipment
* Corporate profits were up 1,400 per-  increased monetization is not necessar-  are about 12 percent higher than in the
cent.                               ily indicative of real change, but a re-  summer of 1999, but they are still below
* Budget revenues were 21 percent over  bound in consumption and investment  the level of 1995 and 1996, and the av-
target and spending was 38 percent un-  may signal that recovery is sustainable.  erage age of the capital stock rose from
der target.                         Of course, as we have shown with our  8.4 years in 1970 to 16 years in 1998. It
* Tax revenues were up 120 percent.    simple accounting example, real depre-  is hard to believe that the recent upsurge
* Cash revenues were up 300 percent,  ciation causes an increase in real in-  in investment can make a serious dent
and cash in the first half of 1999 made up  come. This increase ought to manifest  in this trend. Moreover, direct foreign in-
85 percent of budget revenues (up from  itself in higher consumption and invest-  vestment was actually 22 percent lower
48 percent in the first half of the previous  ment. The real question is whether this  in the first half of 2000 than in the same
year).                              recovery is more than just that.     period in 1999.
© 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001   *



The real question, however, is not the vol-  firm's social assets, which included hospi-  structuring that seems to have taken
ume of investment butwhat this investment  tals and kindergartens.         place during this window of opportunity.
is used for. It could be that enterprises are                              Some evidence can be inferred from re-
using their export windfall to make neces-  The General Director of Uralsyazinform   cent profit data. In the first four months of
sary changes that will increase competi-  is investing-but not necessarily in reduc-  2000, real profits in large and medium-
tiveness. But it is also possible that  ing the competitive disadvantages of his  size enterprises in Russia were up about
enterprises are using this windfall as  enterprise. Investing in relationships may  50 percent over January-April 1999. How-
breathing room to avoid having to make  be advantageous to the director-and   ever, most of this growth came from the
such changes. Enterprises may be con-  even to the enterprise in its negotiations  resource industries. Excluding oil and oil
tinuing to invest in good relations with offi-  with officials-but it does nothing to im-  products, real profit growth was only
cials and workers rather than in better  prove the economy as a whole. Invest-  about 10 percent. Excluding metals (fer-
productive processes. The critical ques-  ment may thus rise in response to the  rous and nonferrous), profitswere 13 per-
tion is whether this investment is an indi-  improvement in the financial condition of  cent lower in January-April 2000 than in
cator of restructuring. An illuminating  enterprises; whether that investment will  the same period in 1999.
discussion of how the export windfall has  be directed toward restructuring will de-
translated into investment comes from a  pend on how durable agents expect the  Infrastructure Remains Weak and
recent discussion of reform in the region.  recovery to be.                Capital Flight Continues
Some view [the devaluation] as the latest
removal of a hard budget constraint and  Is the Windfall Disappearing?     One barrier to a robust recovery in Russia
an opportunity to recreate the firm [sic]                                  is the still frail nature of its infrastructure.
which existed before the collapse in pro-  The real depreciation of the ruble ended  The sorry state of Russian infrastructure
duction. They are reinvesting in social as-  in January 1999. Since then the ruble has  was highlighted, to some extent, by the
setstocreateabetterenvironmentfortheir  appreciated gradually in real terms, as a  events of last summer: the Kursktragedy
workforce, and see their major task as in-  result of inflation, which averaged more  and the fire at the Ostankino TV tower.
creasing production to pretransition levels  than 19 percent during 2000 while the  Generally, though, Moscow is somewhat
with little thought to efficiency or profitabil-  ruble held fairly steady. The rise in infla-  of an outlier with regard to infrastructure.
ity. The General Director of Uralsyazinform,  tion has been due to rapid money growth,  The situation elsewhere is much worse.
one of Russia's most successful and po-  a consequence of unsterilized capital in-
tentially promising regional telecoms, in the  flows, the counterpart to Russia's large  Perhaps the most important sign of the
same breath mentioned that he was plan-  current account balance.          state of the Russian economy is capital
ning to sell 8 percent of his company in the                              flight, an important indicator of how agents
form of ADRs to increase liquidity (perfectly  This raises the question of whether the  view the stability of the economy. Capital
laudable) and that his number one aim for  windfall is disappearing-an especially  flight from Russia remains high. The net
investment was to improve the quality of his  troublesome question given the lack of re-  oufflow as of mid-2000 was about $18.4
Former U.S. Secretary of State Madeleine K. Albright Joins the William Davidson Institute
Former U.S. Secretary of State Madeleine K. Albright will join  Albright, the highest-ranking woman in the history of the U.S.
the William Davidson Institute as its first Distinguished Scholar,  government, served as U.S. Secretary of State from 1997 to
effective September 1, 2001, B. Joseph White, dean of the Uni-  2001. From 1993 to 1997 she was the United States' Perma-
versity of Michigan Business School and President of the Insti-  nent Representative to the United Nations and a member of
tute announced. "Economic development in emerging markets  President Clinton's cabinet and National Security Council. Be-
is heavily dependent on those countries' success in democrati-  fore that she was president of the Center for National Policy,
zation and human rights. No issue could be more significant to  a fellow at the Woodrow Wilson International Center for Schol-
their long-term developmentand to ourown future,"Albrightsaid.  ars, and a senior fellow in Soviet and Eastern European Af-
"My association with the William Davidson Institute represents a  fairs at the Center for Strategic and International Studies. From
remarkable convergence of my own interests in developing eco-  1982 to 1992 Albright was a Research Professor of Interna-
nomically viable democracies based on the rule of law and hu-  tional Affairs at Georgetown University's School of Foreign
man rights with the Institute's extensive knowledge and expertise  Service. She earned her bachelor's degree from Wellesley
assisting governments, policymakers, and firms in developing  College and her master's degree and doctorate from Colum-
economies as they transition to market-driven economies."  bia University.
0   TRANSITION, February-March 2001                               The World Bank/The William Davidson Institute © 2001



billion-double the 1999 rate and about  Figure 1: Hourly Wage Costs in the Russian Federation, January 1998-July
18 percent of GDP. This increase coin-  2000
cides with a massive improvement in the  $
current account balance. To some extent
this is a blessing for Russia. If capital flight  $ 0
were not so high, inflation would be worse,  $0.90
because the Central Bank of Russia can-  $0-80
not effectively sterilize inflows. Given the  $0.70
lack of behavioral change, it is likely that a  $0.60
substantial share of domestic investment  $0.50
is going into production capacity typical of  $0.40
the virtual economy (that is, soft goods pro-  $0.30
duction). Given that likely alternative, capi-  $0.20
tal flight at least preserves some of  sojio
Russia'swealth until it can be used more  so.oo
productively.
One thing that is clear is that banks do not
seem to have identified profitable invest-
ment opportunities. They are still flush with  been not on enterprises but on households.  generate the incentives facing enterprise
cash: bank credit (loans and interbank  The rise in profits has come largely at the  directors have not appreciably changed.
credit) accounted for less than 38 percent  expense of a decrease in real wages. The  The underlying structure of the virtual
of total banking assets during the first half  consequent pressure on households has  economy remains intact-value producers
of 2000 (in the West the figure is 80-90  not led to a push toward the market. The  are still subsidizing value destroyers.
percent). The banks hold about 45 percent  virtual economy is a protective mecha-  Costly restructuring that could make an
of theirassets in foreign exchange and an-  nism. When it prevails, further pressure  enterprise more competitive is still inhib-
other 14-15 percent in noninterest-bear-  merely tightens the cocoon of protection  ited by fear of tax consequences and an
ing accounts at the Central Bank of  against the market. The greater the hard-  end to subsidies. The economy is still stuck
Russia.                              ship, the less likely people are to leave the  in the virtual economy trap.
cocoon.
Conclusion                                                                 The power of that trap is clearly huge. One
The real depreciation of the ruble, fol-  would think that a 70 percent real depre-
TheAugust 1998 devaluation represented  lowed by the rise in commodity prices  ciation would be a large enough shock to
a pure windfall for Russia's raw materials  on the world market, gave Russia a win-  change the expectations of all players in the
exporters, whose earnings rose by a fac-  dow of opportunity to alter the course of  virtual economy. And yet if such a shock is
tor of four as a result. The devaluation rep-  its transition. The depreciation could  viewed as temporary and if departing from
resented a massive, positive cash shock  have provided the cushion needed to  the behavioral strategies of the virtual
for these enterprises and for local econo-  begin extricating Russia from the grips  economy has long-term consequences, it
mies based on them. As a result of the de-  of the virtual economy. To date, however,  should not be a surprise that agents are
valuation, tax revenue also increased, and  there are few signs that such an effort is  wary. To induce behavioral change it is nec-
wage, pension, and tax arrears fell. The  underway. This window opened at great  essary to convince them that the policy re-
devaluation also had modest benefits for  cost to the Russian population, and it is  gime has changed.
a small sector of the economy that gained  now starting to close.
a price advantage relative to foreign im-                                  What, then, can we say about policy, both
ports. But these benefits carried a heavy  Even if this opportunity is not seized, there  in the postcrisis period and in the future?
cost. Incomes fell drastically, and they re-  will no doubt be another in the future. But  Since the financial crisis, the primary im-
main down. The poverty rate rose by  lessonsfromthiscurrentexperiencemust  perative of Russian leaders, including
nearly 50 percent.                   be drawn. The key question is why behav-  Yegeniy Primakov and Vladimir Putin, has
ior has not responded to the real depre-  been national security and domestic sta-
The squeeze on households has been  ciation,whytheopportunityprovidedbythe  bility, not radical economic reform. This is
important. If there has been pressure to  devaluation is being dissipated. The most  not surprising. Radical reform would re-
change anywhere in the economy, it has  basic answer is that structural factors that  quire wrenching economic change at a
© 2001 The World Bank/The William Davidson Institute                          TRANSITION, February-March 2001



time when real income is already declin-  government leadership, enterprise direc-  Clifford Gaddy is an economist at the
ing due to the real depreciation. As a re-  tors most likely concluded that the window   Brookings Institution. Barry Ickes is a re-
sult, the windfall in tax revenue that these  of opportunity was not likely to remain  search fellow of the William Davidson In-
governments enjoyed was used to pay ar-  open. For the overwhelming majority, the  stitute and professor of economics at
rears rather than to close plants that need  response has been to pocket the windfall  Pennsylvania State University.
to be shut down. Given the absence of  rather than make painful adjustments.
Ukrainian Bankruptcy Law Offers Alternative to
Liquidation
by Richard Wolfe and Gleb Glinka
January 1, 2001, marked the first anniversary of an important and progressive new law in Ukraine: the Law on Restoring the
Solvency of the Debtor or Declaring It Bankrupt. Enacted in June 1999 and signed into law six weeks later by President Kuchma,
this powerful and flexible legal instrument became effective January 1, 2000. Before the new law was enacted, it was virtually
impossible for a Ukrainian enterprise to reach a global debt settlement with its creditors. As a result, heavily indebted but poten-
tially viable enterprises continued to deteriorate with little or no hope of recovery.
The new law provides thousands of heavily indebted industrial  mills; manufacturers of heavy producer goods, such as agricul-
enterprises with an alternative to liquidation. Since the law be-  tural and construction machinery; and producers of electronic com-
came effective, with the consent of their creditors, more than 20  ponents. Some factories have shut down, others are operating at
industrial firms oegan restructuring cases in commercial court,  5 or 10 percent of capacity. Most transactions are typically in bar-
converted liquidation cases filed by their creditors under  ter, as bank accounts of heavily indebted enterprises are frozen
Ukraine's old (1992) bankruptcy law to restructuring cases, or  bythe statefor arrears in taxand pension system payments, leav-
reached amicable settlements with their creditors establishing a  ing no cash available to pay wages, debt service, or trade payables.
workable schedule of debt forgiveness and repayment. As infor-  Some manufacturers of consumer goods are equally distressed,
mation about the opportunities available under the new law  although certain manufacturers of fast-moving consumer goods,
spreads around the industrial, financial, and legal community,  such as processed foods, have been able to find cash customers
hundreds of new cases are likely to be filed.           and operate more or less normally.
So far the law has proved far more effective than similar laws in  The current situation began to unfold in the early 1990s, when
other former Soviet Republics, with the possible exception of the  the breakup of the Soviet Union severed trade relations, causing
Russian law, underwhich a number of amicable settlements have  industrial enterprises to lose both customers and suppliers. Con-
been reached since its enactment in 1998.               ditions worsened in the mid-1 990s, when the government, under
budget pressure, eliminated direct subsidies to the enterprises
Crisis in Ukraine's Industrial Sectors                  as well as subsidies for their major inputs, such as energy. By
this time, most industrial enterprises were accruing economic
You pass through the iron gate and drive through a tree-lined  losses, although under Soviet tax accounting rules, many were
prospect into an industrial park with factories, machinery, rows  still "profitable" and incurring profits tax liability. Eleven consecu-
of workshops, a garage, an imposing administrative building,  tive years of economic decline in Ukraine, through mid-1999,
medical facilities, kindergartens, a recreation center, dining halls,  combined with poor enforcement of the rights of shareholders
residential housing, and all the components and amenities of a  and creditors shut off the flow of new investment to the industrial
complete factory town-except that the buildings are dilapidated,  sector. Faced with massive loan defaults, banks stopped mak-
freezing cold, and eerily empty, as in a second-rate science fiction  ing industrial loans.
movie. All of the physical infrastructure for production is in place-
but nothing is being produced. There are almost no people.  This story is no doubt familiar to the reader. With some varia-
tions, the same scenario has occurred throughout the former
Such an enterprise represents an extreme example of the paraly-  Soviet Union. In very depressed economic environments, it is
sis that has overtaken entire industries in Ukraine, including textile  still possible to revive individual enterprises and begin generat-
*  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute C) 2001



ing operating profits using a combination of restructuring mea-  and culture. UnderArticle 53 of the Ukrainian law, as in Chapter
sures (cost reduction, product portfolio adjustment, strengthen-  11 of the U.S. law, debtor enterprise management can petition to
ing of marketing and sales functions, and so forth.) The necessary  reorganize and retain control of the enterprise.
preconditions include a good product, a good market for that
product, and progressive enterprise management. Even in the  The bankruptcy law defines a set of "sanation" procedures that
presence of these conditions, however, an enterprise's solvency  govern the financial restructuring of a debtor enterprise as a go-
and financial health will not be restored if debt service require-  ing concern. UnderArticle 53, with the consent of a majority of its
ments exceed operating profits, causing continuing negative cash  creditors, the debtor enterprise takes the initial step by submit-
flow. Tax penalties for late payment will generate new losses,  ting a restructuring petition. After claims are filed and the court
exacerbating the cash flow problem. Enterprise management,  approves the claims register, creditors with approved claims meet
constantly short of cash, will be forced to make second-best de-  and elect a committee on the basis of debt-weighted voting. The
cisions. Heavy debt burdens will discourage potential investors  debtor enterprise nominates a "sanation manager," who must
and lenders. Without new investment, aging production equip-  be approved by the creditors' committee and the court. The
ment will fail or become obsolete, and the enterprise will eventu-  sanation manager assumes responsibility for the day-to-day
ally lose its entire market share to domestic-or more  operation of the enterprise, under the supervision of a trustee,
often-foreign competitors.                              who is nominated by the creditors' committee and approved by
the court. The sanation manager is required to prepare and sub-
As part of the initial privatization process, Ukraine, like most of the  mit a sanation plan, which must be approved by the creditors'
other former Soviet republics, enacted a basic bankruptcy law fa-  committee and the court. At any time during the proceedings, an
cilitating the liquidation of insolvent enterprises. In healthy econo-  amicable settlement agreement can be negotiated with the credi-
mies, liquidation of insolvent enterprises serves to redeploy idle  tors' committee. Once approved by a majority of creditors, the
and underused assets into more productive uses, as well as pro-  agreement, which includes a debt repayment schedule, is bind-
vide at least partial compensation to creditors while there is still  ing on all creditors, whether or not they voted for the sanation
some residual value left. In a moribund economy like Ukraine's  plan or the agreement.
during the 1990s, liquidation must contend with the failure of mar-
kets for used assets (plants and machinery), which exist in abun-  The presence of a trustee representing the interests of the credi-
dance. The 1992 law was used primarily by the tax authority for  tors in a debtor-managed restructuring provides a mechanism
"housekeeping," to rid the tax rolls of completely defunct enter-  of control to the creditors' committee that is usually lacking (no
prises, most of which had already been stripped of all assets. The  such provision exists in Chapter 11 of the U.S. Bankruptcy Code,
law did not provide any useful mechanism to revive the industrial  for example). The Ukrainian law is thus more balanced between
sectorand put people back towork. Instead, the government ad-  creditors and debtors than Chapter 11, which is generally con-
dressed the problem by creating a government agency charged  sidered by insolvency experts to be rather lenient on debtors.
with restructuring enterprises. That agencyfailed in its mission, as
did its counterparts elsewhere in the region.           The most important features of the new law that provide financial
benefit to the debtor enterprise are discussed below. In the suc-
In 1997 an initial attempt failed to enact a new law that would  cessful restructuring cases we have seen to date under this law,
facilitate restructuring enterprises by commercial entities. The  all except the last two provisions have constituted significant
law was opposed by the Communist Party, then dominant in the  sources of internal capital generation. Together with various
legislature, largely because it was viewed primarily as a law that  operational restructuring measures, these provisions have al-
would merely make liquidation procedures more efficient. In 1998  lowed firms to move from negative to positive cash flow in a rela-
proponents of the law worked with the Communist Party to cre-  tively short period of time.
ate a new law that would allow enterprises to be restructured as
going concerns. Although liquidation procedures were also im-  1.  Moratorium (Articles 12.2-12.5). Introduced upon ac-
proved and the rights of creditors strengthened, the Communist  ceptance by the court of the debtor's petition, the moratorium
faction in the legislature sponsored the law because of its poten-  prohibits the debtor enterprise from paying any pre-petition credi-
tial to restore employment in the industrial sectors.   tors, including the tax and pension authorities and secured claims
(except wages, alimony and child support, claims for injury to life
Major Features of the Ukraine Law on Restoring Solvency  or health, and royalties). It prohibits creditors from taking any mea-
sures to secure payment. The moratorium remains in force for 12
The Ukrainian bankruptcy law draws heavily on U.S. bankruptcy  months, plus an additional 6 months at the discretion of the court.
law but also contains special provisions that adapt it to the reali-  Imposition of new fines and penalties (such as fines for late tax
ties of the Ukrainian legal system as well as the country's politics  and pension payments) is also suspended during the moratorium.
© 2001 The World Bank/The William Davidson Institute                          TRANSITION, February-March 2001  m



The amount of the debt is fixed as of the moment of filing, and  forestalling the dismemberment of the debtor as it slides into
penalties are suspended for the duration of the sanation.  bankruptcy, ensuring equality of distribution, and combating cor-
ruption, these provisions, modeled on U.S. law, can provide
2.     Elimination of Claims Not Filed before the Deadline  sources of funding for the debtor.
(Articles 14.5 and 31.5). After acceptance of the petition, notice
of insolvency proceedings must be published; claims must be  We are not aware of any other law in the region that contains this
filed by creditors within a specified time period after the publica-  potent combination of tools for sanation. Most of the laws we have
tion of the notice. Claims that are not filed on time or that are  reviewed contain provisions for a moratorium and a claims regis-
successfully contested by the debtor are eliminated.    ter similar to the Ukrainian law. We are not familiar, however, with
any other law in the region containing automatic tax forgiveness or
3.     Automatic Tax Forgiveness (Article 36.2). Under the  voidable preferences. Some laws (such as the Croatian law) do
amicable settlement provisions of the law, debtor enterprises  not bind dissenting creditors to the plan or agreement.
concluding such an agreement, by majority vote of the creditors'
committee, receive automatic forgiveness of all tax and pension  Successful Restructuring of Enterprises During the First
debts (including interest and penalties) that are more than two  Year of the New Law
years old and the opportunity to pay the remaining tax and pen-
sion debt over a six-year period, providing that the enterprise  Effective bankruptcy laws are characterized by a high degree of
remains current on new tax obligations. This provision is loosely  flexibility. No two insolvency cases are exactly like, and different
based on U.S. bankruptcy law.                           circumstances require different solutions. The diverse paths that
the enterprise restructuring cases have followed under the new
4.     Debt Forgiveness by Commercial Creditors (Article  law in Ukraine demonstrate its flexibility. To date, we have seen
18.2.4). Commercial creditors may forgive debt or agree to a  five major variants, each of which we illustrate below with a case
deferred repayment schedule. Under Ukrainian tax law, the amount  example. We also discuss a sixth variation, which is allowed un-
of forgiven debt can be deducted by the creditor and is taxable  der the law but as yet untested. We expect that as use of the law
to the debtor. (Under the U.S. law, the forgiven debt is deductible  develops and the various provisions of the law are tested, addi-
by the creditor but is not taxable to the debtor.)      tional variations will arise.
5.     Transfer of Social Assets (Article 18.2.12). Worker hous-  1.  Article 53 plans. The standard route under the new law
ing, kindergartens, and other facilities inherited by enterprises during  begins with submission of a petition with the support of a major-
Soviet times, all of which represent sources of financial loss to enter-  ity of creditors, proceeds through submission and approval of a
prises, may be transferred to local govemments quickly and without  sanation plan by the creditors and the arbitration court, and con-
cost to the enterprise as part of a court-approved sanation plan.  cludes with a negotiated amicable settlement. The first case suc-
cessfully completed under the new law involved a furniture factory
6.     Debt to Equity Swaps (Articles 18.2.12; 37.4). Under a  in western Ukraine. The process took less than six months from
consensual, court-approved plan, the enterprise may issue ad-  the filing of the petition to conclusion of the amicable settlement.
ditional stock to convey to creditors in satisfaction of debts.  An export customer agreed to provide needed investment for
retooling upon approval of a plan that included some debt reduc-
7.     Rejection of Contracts (Article 17.10). Although not  tion and the rescheduling of the remaining debt. Creditors agreed
much used yet, the new law includes a provision allowing a  to a two-year grace period without any debt repayment. The por-
sanation managerto rejectwithin 3 months of sanation economi-  tion of the debt that was not forgiven isto be paid in equal quar-
cally burdensome contracts that have not been fully performed.  terly installments over the next four years.
As under the comparable provision of the U.S. Bankruptcy Code,
the other party to the rejected contract may file an unsecured  2.  "Prepackaged"Article 53 plans. A significant variation
claim for damages.                                      on the Article 53 plan involves not only an agreement to the
sanation plan but also an agreement in principle to an amicable
8.     Preferences and Fraudulent Transfers. As yet untested  settlement even before the petition is filed with the court. The
under the law, voidable preferences and fraudulent transfers rep-  amicable settlement, however, cannot actually be approved until
resent an additional potential source of internal capital genera-  the claims register is established, a prerequisite to constituting
tion. The sanation manager may pursue payments made to  the creditors' committee. A meat factory in eastern Ukraine fol-
unsecured creditors at the expense of the remaining pool of credi-  lowed this path, taking about eight months from commencement
tors within six months of filing or conveyances to "insiders" (de-  to the conclusion of an amicable settlement. The cornerstone of
fined by Article 1) for less than equivalent value. In addition to  the settlement was the conversion of all the factory's commercial
*   TRANSITION, February-March 2001                               The World Bank/The William Davidson Institute C) 2001



debt to equity, with no future cash payments. Commercial credi-  committee. To our knowledge, no such cases have occurred.
tors accounted for 93 percent of the debt. The official debt-for-
equity swap was unprecedented in bankruptcy in Ukraine.  A set of amendments that should improve the efficiency of the
law is awaiting debate in Parliament. The bankruptcy law has
3.     Sanation. The new law also contemplates cases in  now become a cornerstone of the commercial law system in
which a sanation plan is negotiated with the committee and ap-  Ukraine and will undoubtedly assist in Ukraine's transition to a
proved by the court but no amicable settlement is reached. In  vibrant and successful free market economy.
cases in which an enterprise can be operationally restructured
by taking advantage of the moratorium and the reduction of the  Richard Wolfe is an economist and Gleb Glinka a bankruptcy
creditor pool confirmed in the claims register only, such sanation  attorney with the international accounting and consulting firm
without an amicable settlement may be enough to turn the debtor  Deloitte Touche Tohmatsu. The firm has been assisting the
around.Abakery in southeastern Ukrainewhose cash flowwould  Ukrainian govemment with its bankruptcy program since 1995,
support its existing debt service requirements under these cir-  through donorfunding provided by the U. S Agency for Intema-
cumstances used this type of arrangement.             tional Development.
4.     Creditor-filed case concluded with amicable settle-
ment. A case originally initiated to liquidate the debtor can,
with the consent of the creditors' committee, change course  Recent Working Papers of the
and conclude in an amicable settlement. One such a case- William Davidson Institute
involving a sugar mill in western Ukraine, initially brought by a
minor creditor under the old bankruptcy law- was converted  www.wdi.bus.umich.edu
in March 2000. After conversion the case proceeded along
customary lines, with the moratorium, a redetermination of the  LUzal, Lubomir, and Jan Svejnar. Investment, Credit Rationing,
creditors' claims register, and the formation of a creditors' and the Soft Budget Constraint: Evidence from Czech
committee. The ability under the new law to make important  Panel Data. (Revised Davidson Institute Working Paper No.
decisions and bind dissenting creditors with a simple major-  60a.) No. 363, February 2001.
ity of creditors-a substantial difference from the old law-
enabled the case to reach a successful conclusion 10 months  Zhao, Zheng, Anand Jaideep, and Will Mitchell. A Network Per-
later in an amicable settlement. In this case, the creditors for-  spective on Inter-Organizational Transfer of R&D Capabili-
gave 90 percent of the debt.                          ties: A Study of International Joint Ventures in Chinese
Automobile Industry. No. 362, February 2001.
5.     Case filed by a friendly creditor. In some situations, it is
virtually impossible to useArticle 53, even though the manage-  McDermott, Gerald A. Network Restructuring and Firm Cre-
ment of the enterprise would like to conduct a restructuring. It ation in East-Central Europe: A Public-Private Venture. No.
may not, for example, be able to mobilize the shareholders to file  361, December 2000.
a petition-as is sometimes the case when the state owns a
majority of the enterprises' shares. Similarly, if a majority of the  Filer, Randall K., and Daniel Munich. Responses of Private and
debt is held by the state, it can be difficult to obtain consent of a  Public Schools to Voucher Funding: The Czech and Hun-
majority of the creditors to file a petition (especially if it is nontax  garian Experience. No. 360, October 2000.
debt, such as a loan). Article 53 can be circumvented by per-
suading a friendly creditor to file a petition against the enterprise.  Stillman, Steven. Labor Market Uncertainty and Private Sec-
The creditors' committee can then vote for sanation (rather than  tor Labor Supply in Russia. No. 359, September 2000.
liquidation) and approve the debtor enterprise's current manager
as sanation manager. Because the procedure ostensibly contin-  Jovanovic, Brando. Russian Roulette: Expenditure Inequal-
ues to be filed by the creditor, it is not necessary to appoint a  ity and Instability in Russia, 1994-1998. No. 358, Septem-
trustee. A textile mill in southeastern Ukraine, owned mostly by  ber 2000.
the state, followed this path. The friendly creditor that filed at the
request of the enterprise management was the pension fund.    Bonin, John P., and Yiping Huang. Dealing with the Bad Loans
of the Chinese Banks. No. 357, January 2001.
Conversion of creditor-filed to debtor-led case. Article 53.8 al-
lows for cases that were initially brought by creditors to be con-
verted to debtor-led cases with the approval of the creditors'                      Continued on page 33
©) 2001 The World Bank/The William Davidson Institute                      TRANSITION, February-March 2001



Economist Prescribes Slow, Steady Reform for
"Sick" Asian Economies
According to Bernard Yeung, a leading emerging markets ex-  which could be fatal to nations like the Democratic People's
pert on Asian economies at the William Davidson Institute, the  Republic of Korea as winter approaches. In the long run, indus-
entire Asian region is on the verge of its second economic crisis  trial pollution of the environment is a serious concern as well.
since 1998. Little leadership is coming from the United States,
and the ongoing political crises in both Japan and the Philip-  "Japan, Taiwan (China), the Philippines, and other East Asian
pines underline the lack of leadership in the region. Taiwan (China)  Tigers need to sweat out this economic slowdown if they are not
is already on the verge of a crisis because of its property and  to repeat the broad collapse of 1998," says Yeung, "They must
stock market slump. What the economies of Asia need most is  not rush to make rapid changes in the expansion of their fiscal
patience and determination to stay the course they have plotted. supply, boosting their government spending, or in their economic
diversification. A sick body needs rest, and Asia should simply
There is no source for optimism in the economic outlook for  trytogatheritsstrengthforaslow-butcertain-recovery. If you
any SoutheastAsian country, Yeung believes, largely because  try to boost the economy, you get inflation, currency devaluation,
of their overreliance on the financially troubled high-technology  and a repeat of the old problems."
sector. By tying their manufacturing hopes to high-tech indus-
tries in the United States and Europe, the Republic of Korea,  According to Yeung, Asian governments should implement the
Singapore, Thailand, and other East Asian nations have left  following measures to ensure their recovery:
themselves highly vulnerable to instability in the global technol-  * Create transparent capital markets that provide entrepreneurs
ogy market.                                            with healthy incentives and market investments at a reasonable cost.
* Improve the transparency of corporate governance to allow
At the same time, none of the recovery measures prescribed by  more efficient allocation of resources, better corporate decisions,
the IMF or the World Bank since the 1998 economic crisis have  and broader scope for professional managers to apply and le-
been taken. After the 1998 economic crisis, Asian countries  verage their capabilities.
needed to install more checks and balances in their governments  * Create healthy public governance that upholds the rule of law
and better corporate governance to assure local and international  and makes prudent investments in infrastructure.
investors of their stability. Only the Republic of Korea took steps
in this direction. To make matters worse, there is no end in sight  Bernard Yeung is Area Director for Research on Foreign In-
to Japan's economic illness, to the continued political turmoil  vestment at the Davidson Institute and the Abraham Krasnoff
between China and Taiwan (China), to the imminent economic  Professor of Global Business at the Stern School of Business,
slow down in the United States, and to rapidly rising energy prices,  New York University.
Davidson Institute Conference Announcements
Value Creation Tools for Financial Services: A Workshop  daily operations of organizational units and whose decisions guide
for Financial Service Managers                        the future of theircompanies orwhose success depends on working
May 22-26, 2001, Prague, Czech Republic                with other managers ora professional staff. Program fee: $4,800.
Information: Katerina Mitasova, CMC Graduate School of
The Davidson Institute and the CMC Graduate School of Business  Business, tel.: 420 202/899, fax: 420 202/892 150, email:
are sponsorng an interactive five-day workshop for financial service  mitasova@cmc. cz.
managers who want to develop new skills. The workshop will intro-
duce participants to experts' insights into local, regional, and global  Marketing Challenges for Post-WTO China
economic development; value-creation strategies to enhance share-  June 8-9, 2001, Shanghai, China
holder value; cutting-edge approaches to leadership and teamwork;
and best-practice tools forstrategy definition and implementation. The  This two-day intensive executive workshop is targeted at senior
program is designed for financial sector managers who direct the  managers responsible for theirfirms' marketing strategies in China.
C  TRANSITION, February-March 2001                              The World Bank/The William Davidson Institute (C 2001



Through seminars and open exchanges by marketing experts and  The Third European Conference of the Fondazione Rodolfo
world-class scholars, participants will be exposed to recent devel-  Debenedetti will take place in Trieste, Italy, June 23, 2001, at the
opments in China's post-WTO market environment and will learn  Sala Oceania of the Centro Congressi of the Stazione Marittima.
how firms build sustainable competitive advantage in their opera-  The one-day conference is being organized by Tito Boeri of the
tions in China through their marketing strategies. Participants will  Universita Bocconi. The William Davidson Institute is cooperat-
interact with professionals and experts on how best to manage  ing in organizing the conference.
their marketing strategies in China. They will also be exposed to
the latest developments in support systems that can help them   The conference will be based on two reports, prepared by two
understand, plan, make decisions, and implement their marketing  teams of experts, under the supervision of the Fondazione. The
strategies. The workshop is being jointly sponsored by the  focus of the first team is on the pressures on European welfare
Davidson Institute, the China European International Business  states exerted by immigration and the enlargement of the EU.
School, and the Chinese Management Centre, University of Hong  More than 100 experts, including academics, economists in in-
Kong. Program fee: $800.                               ternational organizations, policy advisors, representatives of
Informnation: Nell Gao, Senior Program Coordinator, China Euro-  unions and employers associations, and civil servants, will at-
pean Intemational Business School, email: gnell@mail.ceibs.edu.  tend the conference.
Information: Roberta Marcaletti, Fondazione Rodolfo
The Third European Conference of the Fondazione Rodolfo  Debenedetti, Universitb Bocconi, Via Salasco, 5, 20136 Milan,
Debenedetti-Immigration Policy and the Welfare State   Italy, tel.: 39-02-583-63342, email: roberta.marcaletti@uni-
June 23, 2001, Trieste, Italy                          bocconi.it.
Continued from page 31                                 Guriev, Sergei and Barry W. Ickes. Microeconomic Aspects
of Economic Growth in Eastern Europe and the Former
Bonin, John P., and Abel, Istvan. Retail Banking in Hungary: A  Soviet Union, 1950-2000. No. 348, November 2000.
Foreign Affair? No. 356, December 2000.
Jurajda, Stepan, and Katherine Terrell. Optimal Speed of Tran-
sition: Micro Evidence from the Czech Republic. No. 355,
December 2000.
Overland, Jody, Kenneth L. Simons, and Michael Spagat. Politi-
cal Instability and Growth in Dictatorships. No. 354, Novem-
ber 2000.
Fidrmuc, Jarko, and Jan Fidrmuc. Disintegration and Trade.
No. 353, November 2000.
Batiargal, Bat. Social Capital and Entrepreneurial Perfor-                           .0.001
mance in Russia: A Panel Study. No. 352, December 2000.
Batiargal, Bat. Entrepreneurial Versatility, Resources, and
Firm Performance in Russia: A Panel Study. No. 351, De- 
cember 2000.
7  70       L
Batiargal, Bat. The Dynamics of Entrepreneurial Networks
in a Transitional Economy: The Case of Russia. No. 350,
December 2000.                                                 'Ifeel like I'rn constantly searching for
something.'
Kinoshita, Yuko. R&D and Technology Spillovers via FDI:
Innovation and Absorptive Capacity. No. 349, November
2000.                                                   From the UK magazine The Spectator
( 2001 The World Bank/The William Davidson Institute                         TRANSITION, February-March 2001   D



* hSITE
Stockholm Institute of Transition Economics
STOCKHOLM SCHOOL OF ECONOMICS
From Regatta to Big Bang?
The Impact of the EU Accession Strategy on Reforms in Central and
Eastern Europe
by Erik Berglof and Gerard Roland
Eastern enlargement of the EU became a realistic possibility only once the Central and Eastem European countries had em-
barked on their transition from socialism toward modern democracies with market economies. Since then the desire to "return to
Europe" has played an important role in breaking political constraints and sustaining the momentum of reform in many coun-
tries. Perhaps never before in history has the attraction of joining an association of countries had such profound impact on the
political and economic development of an entire region. In the countries in which membership has been a realistic option, the
past decade has witnessed perhaps the most radical reorientation of trade and structural adjustment in modem history. The
impressive record of the accession countries stands out even more clearly when contrasted with the disappointing record of the
transition economies left out of the accession process.
W         A  Ihether by design or through its slow decisionmaking, tain the momentum of reform as the costs of transition have be-
the EU anchor has had a strong impact on the pace  come more visible, as initial enthusiasm for reforms has faded,
of reforms in Central and Eastern Europe. This ef-  and as idealism has given way to cynicism and self-interest. As
fect is increasing over time, as the nature of transition changes  willingness to make personal sacrifices declines, pressure from
and the date for the accession decision approaches. Given the  the EU becomes a more important tool to maintain reform ef-
leverage of a threat to exclude, it makes sense for the EU to  forts. There is one important sense in which leverage may be
postpone membership and use it to apply pressure on would-be  decreasing over time, however. An important reason for the
members to reform. The EU has converged on a strategy that  strength of the EU as an outside anchor is the broad popular
makes sensible use of this leverage. However, the policy has  support for accession in candidate countries. As the EU's lever-
changed significantly over time, creating uncertainty about the  age grows the closer accession comes, it also becomes more
EU's intentions. Recently, new elements were introduced, under-  intrusive. The attitude of the population is likely to grow more
mining the incentive effects of the EU anchor.        negative as bargaining gets tougher and shifts toward issues of
EU self-interest.
What do we know about the effects of prospective EU member-
ship on reform in the transition economies of Central and East-  * The EU's enlargement policy has evolved over time, with
ern Europe?                                           increasing emphasis on the incentives of individual candi-
dates to reform. The EU has gone from dividing candidates into
* The EU has played an important role as an "outside  two distinct groups to allowing mobility and eventually replacing
anchor" to the reform process. Causality runs both ways,  the groups with a queue. By opening the door to substantial ex-
but the likelihood of becoming an EU member has been one of  ceptions, the EU has allowed for considerable variation and cre-
the most important predictors of reform. The importance of the  ated uncertainty over the meaning of membership. The prospects
leverage exercised by the EU is particularly apparent when we  for early accession have increased for some countries, while the
compare the reform records of Central and Eastern Europe with  date has been postponed for the frontrunners. The net effect of
those of the former Soviet republics. Prospective membership  these changes is uncertain, but they have probably strengthened
in the EU has helped focus expectations and create initial mo-  the incentives of the countries originally at the top of the second
mentum.                                               echelon and weakened those of the countries in the top group.
* EU leverage grows as transition proceeds but may de-  * A shift to a "big bang" strategy, in which all or most of the
cline once accession grows near. It has been difficult to sus-  candidate countries would be allowed to enter simulta-
*  TRANSITION, February-March 2001                             The World Bank/The William Davidson Institute (3 2001



neously, would seriously weaken the leverage of the out-  ship. A more important, but indirect, effect stems from the wide-
side anchor. Such a strategy would seriously undermine the in-  spread perception inside the EU and among the candidate coun-
centives for countries to differentiate themselves by accelerating  tries that the pace of enlargement is linked to EU reforms. Since
reforms. It would also postpone entry for the frontrunners. More-  the speed of these reforms is beyond the control of the individual
over, a big bang strategy would be possible only if many individual  candidate countries, such a link increases uncertainty and thus
exceptions to the entitlements of membership were made.  weakens leverage.
* Sequencing entry to the EU has important costs. New   The European Monetary Union (EMU) provides an "inter-
temporary barriers will have to be erected between early and  nal"anchorto continued reforms once countries are mem-
late entrants. Some countries may lose existing preferential  bers. The lure of joining the EMU thus serves as an important
access, and the tariffs they are charged on particular goods  incentive once countries join the EU.
will increase. Excluded countries will also be excluded from the
broader access accorded to members. The effects of exclu-  Erik Bergl6f is Director of the Stockholm School of Economics
sion are enhanced through agglomeration effects and loss in  (SITE) and a member of CEPR.
competitiveness.
G6rard Roland is professor of economics at ECARES, Free
* The failure of the EU to implement internal reforms weak-  University of Brussels and a member of CEPR. An article
ens the leverage of the outside anchor. By postponing its own  based on the ideas presented here will appear in the World
reforms, the EU creates uncertainty about the value of member-  Economic Outlook.
Research on Labor Mobility in Russia Receives
Global Development Network Award
An Interview with Winners Guido Friebel and Sergei Guriev
'Should I Stay or Can I Go? WorkerAttachment in Russia," a paper by Guido Friebel and Sergei Guriev, has won the first annual
research award in the category of institutional dimensions of a market economy. The award was presented at the Global Devel-
opment Network conference held in Tokyo in December 2000. The network (www. gdnet. org) supports linkages between research
institutes and policy institutes involved in development related issues. We asked the winners about their research.
Q. How did the idea for this paper come up and how did it  cumulated huge wage arrears; they pay wages in kind and
develop into a paper?                                  through fringe benefits, ranging from kindergartens to hous-
ing, although the government promised to transfer social as-
Guriev: The paper stems from our work at the Russian Euro-  sets to municipalities.
pean Center for Economic Policy (RECEP) in 1998-2000. To-
gether with a team of young economists and experienced  Guriev: At some point, we saw a link between these two features
researchers from the EU, we did research and provided policy  of the Russian labor market. Our main point is that low mobility
advice on labor and social issues for the Russian government.  may actually be a result of firms' strategies to "attach" workers to
We were stunned by the low interregional mobility of Russian  regions. Workers who are paid in nonmonetary ways find it harder
workers. Indeed, it is a mystery that given the huge differentials  to move. We also show that these strategies can prevail only if
in wages and unemployment rates, mobility is so low. Partially,  the local labor market is not too competitive. In other words, la-
this may be due to administrative barriers to mobility, like the  bor market competition can protect workers against the risk of
infamous propiska (city passport) system, but it does not explain  being "attached."
the magnitude of the problem.
Friebel: It should be noted that firms may have an interest in at-
Friebel: The problem of low interregional mobility is impor-  taching workers for a very simple reason: workers who cannot
tant, since structural changes require substantial worker mo-  move have less bargaining power and can thus be hired at lower
bility. We found it interesting that low mobility coincides with  costs. So, in general, we should expect that less mobile workers
the massive demonetization of wages. Enterprises have ac-  are worse off.
C) 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001  *



The Art of "Attachment"
Our paper investigates the strategies  makes itdifficultforworkers to raise the cash  theory-that controlling for regional and
firms in an economically declining local  needed for migration. We showthat monop-  personal characteristics, out-migration
labor market may use to restrict migra-  sony is not a necessary condition for attach-  should be higher in more competitive lo-
tion of their workers. "Attaching" work-  ment. Oligopsonies can sustain the strategy   cal labor markets-with data from the
ers to a local market has rather obvious  as well, provided that there are not "too   Russian Longitudinal Monitoring Survey
advantages for firms, since less mobile  many" firms in the local labor market. Our  and find some supporting evidence. Our
workers have less bargaining power.  model also highlights that attachment in-  theory has novel implications for the un-
But how can firms implement attach-  volves the risk of workerexploitation.  derstanding of firms' market power on
ment, and should one not expect that at-                                 labor markets and for the emergence of
tachment can be sustained only in  Modern Russia is an interesting testing   endogenous labormarket imperfections.
monopsonistic local labor markets?  ground for this theory. Here, wealth con-
straints are important, many regions are  Abstract of the award-winning paper. The
We argue that in the presence of wealth  subject to structural change, and local la-  paper can be downloaded at http://
constraints, firms can attach workers by  bor markets are highly concentrated. We   www.gdnet.orglfiles.fcgi/783_guriev.
paying wages in nonmonetaryforms. This  investigate the main prediction of our  PDF
Q. What was the context for the collaboration between you?  Friebel: Even in OECD countries, relatively little is known about
And what was the role of your home institutions and the  geographical labor mobility in general and worker attachment in
links between them?                                     particular. The data are scarce. This makes the work both diffi-
cult and exciting. It would be wonderful to have better data on
Gudiev. The collaboration worked verywell. We worked together both  mobility and firms' policies. We have just started taking steps to
via email and by visiting each other for a few days. Actually, our joint generate such data.
work has grown into a personal friendship. Our home institutons were
very helpful in this work. We were both part-time faculty at RECEP   Guido Friebel is assistant professor of economics at SITE,
Now the Center for Economic and Financial Research (CEFIR) pro-  Stockholm School of Economics, affiliate of the Center for Eco-
vides an excellent plafform for such policy-relevant research in eco-  nomic and Policy Research (CEPR), and affiliate of the Center
nomics. Ourfull-time employers [the New Economic School in Moscow  for Economic and Financial Research (CEFIR). Sergei Guriev
for Guirev and the Stockholm School of Economics for Friebel] en-  is assistantprofessorat the New Economic School and CEFIR,
couraged us to work together and provided all the support needed.   and affiliate of CEPR.
Q. Are you conducting any further research in the area?    Borrowing "Doesn't Pay"
How is this area of research evolving?
Friebel: We are going to do more work in this field. We now
believe we have an analytical framework that can be used to better
understand unregulated labor markets in other countries and
comparable situations in history.
Guriev: Russia is a great testing ground for a theory that argues
that firms may use strategies to make their workers immobile                  E
and dependent. One of the largest structural changes in history               il
is taking place there, and understanding geographical labor
mobility is both interesting and important. But even in Western
countries, firms have used attachment strategies, such as com-
pany housing and company stores.
Q.: What have been the most problematic aspects of this                                                __
investigation?                                          From the Moscow based magazine Business in Russia
M   TRANSITION, February-March 2001                               The World Bank/The William Davidson Institute ©D 2001



SITE Working Papers
We review recent SITE working papers. The papers can be downloaded from our Web site, www.hhs.se/site.
Privatization, Competition, and Transition Policy Strategies: Theory and Evidence from Russian
Enterprise Panel Data
J. David Brown and John S. Earle, SITE, Stockholm School of Economics
The interaction between the effects of private ownership and mar-  minant of the choice of transition policy strategy. While stabiliza-
ket competition on enterprise behavior has been a crucial unknown  tion and liberalization policies were generally introduced rapidly
for policy design in transition economies. While most economists  and with relatively little controversy (at least among most West-
have been ready to believe that the efficiency of state-owned en-  ern economists), the proper pace of privatization has become
terprises might be increased through both privatization to improve  the most contested policy design issue in the transition econo-
corporate governance and price and entry liberalization to open  mies. A closely related controversy has concerned the choice of
up competition, the implementation of privatization has faced many  privatization method. Skepticism is frequently voiced about the
practical and political problems in the transition economies. As a  quality of corporate governance likely to result from employee
result, privatization has proven slow and difficult, and a central  buyouts and voucher programs, but the justification for these
debate among policymakers and analysts of transition has arisen  methods is usually couched in terms of their speed, with atten-
concerning the urgency of privatization.                tion paid to design details that mitigate governance problems.
Given the difficulty of carrying out trade sales to large investors,
An important, but largely implicit, assumption in this debate con-  the debate is over whether such methods of privatization, even if
cems how the forces of competition and privatization interact. On  second best, should nevertheless be a priority for policy.
one side of the debate are advocates of "big-bang" transition strat-
egies, who see competition as ineffective in the absence of private  In this paper, we argue that the debate suffers from two prob-
ownership and effective corporate governance, which is generally  lems. First, it has been conducted on the basis of very little em-
supposed to be achieved through concentrated ownership by out-  pirical evidence, particularly firm-level information on the
side blockholders. During the ealy transition period, several econo- interaction between privatization competition. Second, it has
mists emphasized the desirability of rapid privatization, seeing  overlooked an important interaction at the level of the firm's prod-
liberalization as necessary but not sufficient to inducing restructur- uct market. We argue that the degree of competition in a market
ing. Atthe same time, they did notfavor privatization without market is a function not only of market structure, concentration, or the
liberalization. According to this view, competition and privatization extent of price and entry liberalization but depends as well on
are complements in their effects on enterprise performance:  who the participants in the market are. We hypothesize that pri-
privatization may be enhanced by more competitive markets, but  vate firms may be more aggressive competitors than state firms
competition cannot substitute for privatization.        and thus that a firm operating in a given market may face tougher
competition if most competitors are private. Thus even if the ef-
On the other side are critics of privatization, who believe that  fect of privatizing a firm is independent of or substitutable for
competition can improve performance in the absence of private  exposing it to competitive markets, privatization of competitors
ownership. Given the difficulties of designing and carrying out  may be complementary, raising the effective competition asso-
effective privatization policies, a more cautious, "gradualist" ap-  ciated with a particular market structure. The indirect effects of
proach is implied. According to this view, privatization and com-  privatization, working through market competition, may be as
petition are substitutes, or at least independent, in their effects  strong as or stronger than the direct effects, which work through
on firm behavior, in the sense that the marginal gain from market  the corporate governance of a particular firm.
liberalization is not increasing with the extent of privatization.
Market liberalization need not be followed up by immediate  WeanalyzeasimpleCournotcompetition modelthatdistinguishes
privatization, as state-owned enterprises are disciplined by the  two aspects of the interaction between competition and
market even as they await privatization. Some advocates of the  privatization: privatization of a firm and privatization of the firm's
delayed privatization approach stress the need to demonopolize  competitors. Under plausible conditions, the model implies that
industry in advance of privatization, suggesting that privatized  privatizing a firm is a substitute for exposing it to competitive mar-
monopolists would simply raise prices in lieu of restructuring.    kets but privatizing its competitors is complementary.
The substitutability or complementarity of the forces of market  We then test the model empirically. Our empirical work has sev-
competition and private ownership is therefore a critical deter-  eral distinct advantages over earlier studies of competition and
© 2001 The World Bank/The William Davidson Institute                          TRANSITION, February-March 2001  0



firm performance in transition economies in terms of the size  market concentration, but the privatization of its competitors in-
and coverage of the data set, the time span of observations on  creases this marginal effect. The marginal effect becomes posi-
each firm, and the availability of a variety of measures of market  tive when most of the firm's competitors are privatized. It is largest
structure and competition. The panel data setwe use forestima-  when the firm's competitors are foreign owned, although the
tion purposes is quite comprehensive, including 13,288 Russian  marginal effect is still strong when the firm's competitors are
manufacturing enterprises covering 83.3 percent of total employ-  domestic firms with either private or mixed private and state own-
ment in Russian industry in 1992, the year of the liberalization  ership. The results imply that an important indirect impact of pri-
shock, and spanning eight years (1992-99). Since our data com-  vate ownership is the intensification of market competition and
prise nearly the entire population of medium-size and large in-  thus that competition only among state-owned enterprises may
dustrial enterprises, including information on their exact locations  be ineffectual in stimulating them to increase efficiency.
and disaggregated five-digit industries, we can use much more  Privatization improves firm efficiency whether or not the firm faces
precise measures of market structure than those available to  competition, while reducing market concentration improves
other researchers.                                      firm efficiency only if the other firms in the market are private.
This evidence suggests that liberalizing the economy without
We find that on average privatization improves efficiency while  also privatizing it is likely to be ineffective, that it would be
reduced market concentration does not. The privatization of a  beKter not to wait until after demonopolizing an industry to priva-
firm reduces the marginal impact on firm efficiency from reduced  tize its firms.
Worker Training in a Restructuring Economy: Evidence from the Russian Transition
Mark C. Berger, Department of Economics and Center for Business and Economic Research, University of Kentucky; John S.
Earle, SITE and Central European University; and Klara Z. Sabirianova, William Davidson Institute, University of Michigan and Urals
State University
Using 1994-98 data from the Russian Longitudinal Monitoring  field than for retraining for new fields. This result is consistent
Survey, we measure the incidence and determinants of several  with the hypothesis that schooling and training are complemen-
types of worker training and estimate the effects of training on  tary but become more substitutable in a restructuring environ-
workers' interindustry, interfirm, and occupational mobility; their  ment. Foreign ownership of the firm also positively affects the
labor force transitions; and wage growth in the Russian Federa-  probability of undertaking training, providing evidence of active
tion relative to the United States. We hypothesize that the shock  restructuring by foreign investors. Additional training in workers'
of economic liberalization in Russia may raise the benefits of  current fields is estimated to reduce mobility and earnings, sug-
training, particularly retraining for new jobs, but uncertainty con-  gesting inertial programs from the pretransition era. Retraining
cerning the revaluation of skills may raise the costs, with an over-  in new fields increases all types of worker mobility and is associ-
all ambiguous effect on the amount of training undertaken. The  ated with higher retums than those typically observed for training
Russian Longitudinal Monitoring Survey indicates a lower rate  in the United States, but it also raises the variance of earnings
of formal training than studies of the United States have found,  and the probability of unemployment, consistent with a search
suggesting that the second effect dominates. Previous school-  view of such retraining. Given the large returns to retraining, the
ing is estimated to affect the probability of training positively, but  efforts of Russian workers to learn new skills may increase as
the relation is much stronger for additional training in the same  uncertainty diminishes and restructuring proceeds.
Risk Factors and Predictability of Stock Returns in Central and Eastern Europe
Anete Pajuste, Stockholm School of Economics; Gatis Kepitis, Price Waterhouse; and Peter Hogfeldt, Stockholm School of Eco-
nomics
Using broad market indices instead of subindices of high-per-  plaining variance in returns, followed by information about emerg-
forming stocks selected ex post, this paper avoids the common  ing markets. European risk factors have not been very important
survivorship bias problem that afflicts most other studies of risk  so far, but their importance is growing. There is increasing cor-
and return in emerging markets. It analyzes risk factors influenc-  relation between the Central and Eastern European markets and
ing equity market returns in five Central and Eastern European  Western European markets, especially since mid-1997. The
emerging markets and the changing importance of European  potential for stock return predictability based on past informa-
risk factors. Local risk factors-the exchange rate, foreign re-  tion is found in Slovenia and to some extent in Poland; it is not
serves, and trade-are shown to be the most important at ex-  evident in the Czech Republic or Hungary.
*  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute © 2001



O*s   Local Government
It -1   and Public Service   Open So                                                 Institute
Reform  Initiative
Fiscal Decentralization: Basic Policy Guidelines for
Practitioners
by Kenneth Davey
Fiscal decentralization is the currently fashionable term used to  decentralization. Without devolution of such responsibility, local
describe the financial aspects of devolution of power to regional  government expenditure is unlikely to exceed 5-6 percent of GDP.
and local government. The term covers two interrelated issues:  Responsibilities for education, health care, or social assistance
the division of spending responsibilities and revenue sources  are likely to increase local expenditures by a factor of two or three,
across levels of government (national, regional, local, and so forth)  with a major impact on financial self-sufficiency. Major social
and the amount of discretion given to regional and local govern-  sector responsibilities are usually combined with substantial
ments to determine their own expenditures and revenues (both  dependence on state grants or tax shares, both because of the
in aggregate and in detail). These combined dimensions have a  limited capacity of revenues that can be assigned to local levies
significant impact on the reality of decentralization in its broad  and because of the need to equalize financial resources in order
political and administrative sense. How much power and respon-  to meet expectations of geographical equality in access to these
sibility regional and local governments actually exercise depends  social services.
crucially on what range of public services they finance, whether
their revenues are commensurate with their responsibilities, how  It is customary to distinguish between current and capital expen-
much real choice they have in allocating their budget to individual  diture. Current expenditure covers such operating costs as sala-
services, and whether they can determine the rates of their taxes  ries, repairs, energy and other utilities, travel, materials, and debt
and charges (both allowing them to vary their level of spending  service. Capital expenditure covers investment in new construc-
and making them answerable to the payers).             tion, major renovations, and purchase of land and durable equip-
ment. It is also customary to distinguish between the financial
Spending Responsibilities                              sources for these two types of expenditure. Operating costs are
normally covered by a combination of local taxes, user fees, in-
There is wide diversity across states in terms of the scale of tasks
devolved to local government. In most countries, local govemment is
responsible forwhat are often called communal services: local roads  tral Eu.ocex 1990 t  1998
and lighting, water supply and sanitation, waste management, parks   a
and sports facilities, cemeteries, low-income housing. What varies     Early
greatly is the extent of local responsibility for the social sector, chiefly  Country  1990s 1994  1995 1996 1997 1998
comprisingeducation, health, andsocialassistance. Insomecases,  Czech Republic  9.3   8.0   7.9   7.1  6.8  -
these services arefunded bythe state budget; insome,costsare  Estonia   7.1  11.9  11.7  11.3 10.5  11.9
split between levels of govemment, and, in others, local budgets meet  Hungary  17.4  16.8  14.1  13.3  12.0  13.0
all costs exceptcentral supervision. Cost splitting maybe byfunction  Latvia  12.5  10.3  10.8  11.7  9.4  9.4
(the state pays for secondary education, hospitals, and social ben-  Lithuania  13.1  11.2  11.1   9.0  7.6  -
efits, and local government pays for basic education, primary health  Poland  5.9  7.1   6.5   8.2  8.6  8.6
care, and social services)orbycostfactor(thestate providesprofes-  Slovakia  4.8   4.3   3.7   4.0  4.1  3.8
sional salaries, while local govemment pays all otheroperating costs).  Slovenia  4.4   5.4   4.6   4.9  4.8  4.9
- Not available.
The degree to which local budget responsibility for the social  Source: World Bank, Ministry of Finance, Budapest, Tamas M.
sector varies has an important effect on the nature and scale of  Horvath, and Janis Bunkss.
© 2001 The World Bank/The William Davidson Institute                         TRANSITION, February-March 2001  U



tergovernmental transfers (either grants or subsidies), or shares  particularly on business, to stimulate investment and growth. The
of state taxes.                                         extent of local discretion is, therefore, a matter of balance be-
tween national and local interests: neither central control nor lo-
Local Discretion                                        cal autonomy has priority.
Clearly, the structure of local government responsibilities and  Dynamic Process
resources affects the local government's discretionary power-
its ability to make decisions about the nature and levels of local  Fiscal decentralization determines the framework of expenditures,
revenues, and legal discretion within which regional and local
Table 2. Local Government Expenditure as Percentage of Gen-  governments operate. It does not deal with issues of financial
eral Govemment Expenditure in Central Europe, 1994-98   management, budgeting, accounting, delegation, procurement,
Country       1994   1995   1996   1997        1998     auditing, or other similar processes through which local govern-
ments manage their financial affairs. These are equally impor-
Czech Republic 20.6   20.8   18.8   16.6   -            tant, butthe subject ofa separate body of law and practice.
Estonia       33.1   31.4   29.8   28.1   30.6
Hungary       26.7   26.6   27.2   25.5   24.7          Fiscal decentralization is inevitably a dynamic process. Although
Latvia        26.0   26.2   26.2   24.2   25.2          local governments' responsibilities and resources may be fixed
Lithuania     32.7   31.8   28.7   22.9   -             in law, demands on their services and the value of their revenues
Poland         19.0   19.1   24.6   26.8   34.0         respond to social and economic changes over which lower lev-
Slovakia       11.8   11.0   12.0   12.2   13.9         els of government have little control. It is essential to maintain
Slovenia       11.5   10.1   10.8   10.5   9.2          channels of consultation between national governmentand local
-Not available.                                         government associations so that adjustments can be made in a
Note: Figures exclude social insurance fund expenditures.  timely and equitableway usuallythrough theequalization formula.
Source: Tamas M. Horvath, ed. 2000. Decentralization: Experiments
and Reforms. Budapest: LGI.
This article is based on "Fiscal Decentralization," published in
services. If local government obtains a significant proportion of  the LGI quarterly, Local Government Brief in September 2000.
local taxes and charges, it is in a much better position to deter-  It is available online, at Igi.osi.hu/newsletter/index.html.
mine how it spends the money. Revenue shares and block grants
should provide more freedom of allocation than targeted grants.
In practice, local discretion depends on a more complex set of      [1        l 1
factors. Sharing a well-established national tax may support more
budgetary choice than dependence on a politically sensitive and
administratively burdensome local tax. Targeted grants may sim-
ply release local government funds for other expenditures. Ex-
penditure decisions may be largely determined by national
regulations over service requirements.
The classic argument for maximizing local discretion is most
associated with U.S. economist Wallace Oates. He argues that
the greatest efficiency is achieved when budgetary choices are
made by local officials elected by local people who have to meet
the full cost of their decisions through local taxes. This view has
been challenged by European writers, who consider the link be-
tween local government budget choices and popular preference
somewhat tenuous. They argue that the efficiencies of local ex-
penditure choice outweigh those of local taxation; many impor-
tant fields of local expenditure, such as education or environmental
services, combine legitimate national and local interests. More-
over, in recent years national macroeconomic policy has sought  'I have here the results of your brain scan. '
to restrict fiscal burdens; it has been common for governments
in both Eastern and Western Europe to restrict local taxation,  From the UK magazine The Spectator
*  TRANSITION, February-March 2001                                The World BankWTlie William Davidson Institute (C 2001



Enlarging the Database for Local Initiatives for
Resolving Ethnic Conflict: Call for New Best-
Practice Studies
Innovative local policymaking practices for preventing and solv-  and Southeast Europe-are available in Russian and English.
ing ethnic conflicts as well as pursuing multicultural politics in Cen-  They are searchable by country, minority group, and topic, in-
tral and Eastern Europe and the former Soviet republics are in  cluding conflict resolution, participation and representation of
high demand. In early 1997 the Local Government and Public  minorities, the socioeconomic empowerment of minorities, mi-
Service Reform Initiative (LGI) decided to initiate an in-house  nority education, and use of the mother tongue.
research project, "Managing Multiethnic Communities," in order
to identify best practices and disseminate them to community  The Center for European Migration and Ethnic Studies (CEMES)
leaders, local and regional govemments, NGOs, and educational  recently decided to join LGI in updating and maintaining the da-
institutions.                                         tabase. Both CEMES and LGI invite public administration offi-
cials, civil society activists, and researchers, scholars, and other
A large database was built, containing more than 100 case stud-  experts to share information on innovative practices in commu-
ies describing methods for improving community relations in  nity relations in multiethnic environments and local initiatives for
multiethnic environment and settling ethnic conflicts. The data-  resolving ethnic conflict. Contact Andrea Krizsan, Email:
base allows researchers, activists, and public officials to share  andrea@cemes.org, or Petra Kovacs, Email: kovacsp@osi.hu.
their experiences. The case studies-collected from 20 coun-  To view the online database or download a submission form,
tries in Central and Eastern Europe, the former Soviet republics,  please visit the Web site, at: http://lgi.osi.hu/ethnic/csdb.
The Practice of Best Practices
by Mityas Gaspar
The term "best practice"-long used in private sector feasibility  others, they can reduce the risk associated with research and
studies and performance evaluation in Western countries-has  pilot schemes, thereby speeding up the development process.
recently become a buzzword in public administration reform in
Central and Eastern Europe. The term is increasingly used to  The range of stakeholders is broad. Primary user groups include
refer to successful, innovative solutions to public sector prob-  citizens (the end-users of all services and benefits), voluntary
lems. Best practices are defined in many ways:         organizations, politicians and community leaders, experts in pub-
lic administration and public service, the business sector, re-
* Methods of achieving maximum impact performance.     search and development organizations, and central, regional, and
* The optimal means, techniques, and procedures for solving  local govemments.
problems, achieving goals, and fulfilling needs.
* Paths leading to organizational excellence.          The collection and dissemination of already proven practices is
* Solutions that have already been applied elsewhere.  less expensive and involves much less risk than experimenting
* Solutions that can be sustained legally, politically, socially, fi-  with new practices. Best-practice information systems can be
nancially, institutionally, and strategically.         powerful tools for building capacity, analyzing current trends, net-
* Solutions that can be shared with and used by others  working and exchanging information, engaging in technical co-
operation and forming partnerships, involving citizens, and
Systematically collecting and disseminating new solutions-  making organizations more competitive and effective.
products of individual and communal creativity that have proved
effective in practice-is the basic innovation technique in social,  Monitoring press reports is an ffective method of collecting infor-
community, and public service. Major international, national, and  mation on best practices. It is generally applied as a preparatory
regional development programs are based on them. Policymakers  technique, as the level of detail and accuracy of press reports
have begun to recognize that by incorporating best practices of  varies. Supplementary research methods include organizing tar-
©) 2001 The World Bank/The William Davidson Institute                       TRANSITION, February-March 2001   C



get-oriented research projects; issuing "calls for tenders" on  This article is based on "The Practice of Best Practices," LGI
creating good solutions, documenting existing innovations, and  Discussion Paper Series No. 14, published in 2000. The pa-
writing case studies; purchasing descriptions; studying the lit-  per is the outcome of an LGI research program on best-prac-
erature on benchmark analysis; and collecting information  tice information systems in Central and Eastern Europe
through innovation networks of associations, unions, and other  launched in February 1998. It is available online, at lgi.osi.hu/
organizations.                                          publications.
Types of Subnational Governments in the Russian
Federation
A wide variety of subfederal government structures exists in the  (small towns, rural districts, districts within cities), which also re-
Russian Federation. Indeed, "local government" can have a signifi-  port back to the regional government. Financial relations between
cantly different meaning from one oblast (region) to another. Mod-  this second level of local government and the regional govern-
els of local government vary, often according to local traditions and  ment work through the intermediate level created in this system.
the priorities of regional leaders. Four (by no means comprehen-
sive) basic models of subnational govemments can be distinguished,  Under the second approach, regional governments refuse to rec-
each offering different degrees of budgetary autonomy.  ognize all branches of local self-government as full-fledged par-
ticipants in intergovernmental fiscal regulations. Instead, they
Model 1: Local Governments in Cities and Rayons (Districts)  delegate their intergovernmental fiscal powers to "traditionally"
formed bodies of local self-government, disregarding any sub-
Under this scheme, municipalities in larger cities and rayons  rayon level municipal entities that may have spun off.
report to the regional government (smaller cities could also be
included in the rayon category). Financial dealings with federal  Model IV: Local Governments with No Budgetary Rights
government agencies (transferring funds, sharing taxes) are
specified by branches of the regional governments. This pattern  Two common approaches actually eliminate the budgetary power
is typical of most Russian regions.                     of local government, even within elected representative and ex-
ecutive bodies.
Model II: Local Governments at the Sub-Rayon Level      * In the first approach, regional authorities unilaterally resume,
or retain, their functions of levying local taxes and forming local
Many municipal governments in large and small cities and rural  budgets within territories under their jurisdiction. The municipal
villages operate at levels below the rayon. Regional governments  government bodies then execute budgetary functions assigned
have been reluctant to recognize these governments as partici-  to them without assuming responsibility for the sources of the
pants in intergovernmental fiscal relations (despite Article 1 of  revenues or how they are spent.
Russia's Federal Law on General Principles of Organization of  * Under the second approach, regional authorities officially vol-
Local Self-Govemment, which asserts that the major criteria clas-  unteer to perform functions delegated to them by local self-gov-
sifying a self-government are appointment of bodies of power by  ernment bodies, including establishing local taxes and forming
election, availability of municipal property, and an independent  local budgets in territories within their jurisdictions.
budget). At this level, local governments usually set up divisions
of sublocal executive bodies that "interpret" the decisions made  Subfederal governments in the Russian Federation are highly
by the higher elected government authority.             diverse, with regions having two, three, and even four levels of
government. Policy recommendations for regional and subre-
Model Ill: "Double-Layer Cake" of Local Government      gional government and budgetary reform must take into account
this structural diversity if they are to be effective.
Different regions have interpreted this model in different ways,
but most have taken one of two approaches. In the first approach,  For more information on intergovernmental fiscal relations in
regional bodies create an intermediate level of local rayon-level  the Russian Federation, see "Budgetary Pluralism of Russian
government in the rayons and cities-local self-government bod-  Authorities," by Galina Kurlysandskaya, LGI Discussion Paper
ies that report back directly to the regional government. Local  No. 17 2001). The paper will soon be available online, at http:/
self-government bodies are also formed in all populated areas  /www.lgi.osi.hu/publications/index.html.
m  TRANSITION, February-March 2001                                The World Bank/The William Davidson Institute D 2001



World Bank Institute and LGI Offer Urban and
City Management Course
The World Bank Institute and the Local Government and Public  tion of privatized services have been initiated. These best prac-
Service Reform Initiative (LGI) of the Open Society Institute are  tices are introduced in the course, together with other tools city
currently cooperating to run an urban and city management course,  managers and policymakers need to plan, manage, and govern
in Budapest, Hungary. The aim of the two-week course is to im-  cities.
prove urban governance in the Central and Eastern European re-
gion.                                                  The course is appropriate for executives and mid-career
decisionmakers and officials from Central and Eastern Europe
Most of the population of Central and Eastern Europe lives in  holding either elected or appointed positions in local govern-
cities, and the lion's share of the region's economic activities  ments. Future trainers of similar courses, urban practitioners, and
take place there. The newly established democracies and local  private consultants working for local governments are also wel-
governments in the region face multifaceted and complex urban  come. The teaching staff of the course includes practitioners and
challenges, including the ever-growing demand for better infra-  academics from the World Bank and other international institu-
structure; the need for fast, flexible, and efficient public and pri-  tions and leading experts on Central and Eastern Europe. In ad-
vate services; and increasing expectations for better urban  dition to lectures, case study presentations, and discussions, the
environments. At the same time, local governments must oper-  course allows participants to operationalize what they learn by
ate within the framework of a shrinking public sector.  applying it to a concrete situation involving Budapest.
These conditions call for new methods of urban governance. Cit-  LGI will publish the best case studies collected from the course
ies throughout the region have adapted and implemented inno-  as part of its working paper series. Together with the World Bank
vative solutions, with varying degrees of success. In several urban  Institute, it will also publish a textbook on Central European
centers, participatory decisionmaking, new methods of munici-  Urban Policy and Management. For more information, see the
pal financing, privatization of public service delivery, and regula-  course Web site, at www.aemnet.hu/urbancourse.
LGI/OSI Publications
To order: Local Government and Public Service Reform Initiative (LGI), P.O. Box 519, H-1357, Budapest, Hungary, email:
Igprog@osi.hu or.
Gabor Locsmandi, Gabor Peteri, and Bela Varga-Otv6s, Urban  be based on the harmonized use of these types of assets.
Planning and Capital Investment Financing in Hungary,  Local governments with well-integrated assets management
2000, 109 pp.                                          will be able to improve their services and their financial posi-
tion.
This study examines urban development in six Hungarian mu-
nicipalities of different sizes, positions, and locations. It focuses  Urban development is a complex activity that requires coop-
on four types of local government activities: urban planning and  eration among various types of professionals (property and
regulations, local government property management, utilization  real estate managers, urban planners and regulators, local
of municipal service delivery rights and competencies, and local  government and company finance experts). These experts do
government capital investment.                         not communicate easily, and local government administrators
often fail to support cooperation among them.
Urban planning, regulations, and administrative powers may
have an impact on local revenue-raising and should thus be  Local Government Brief, (A Quarterly Newsletter of the Local
regarded as assets. Similarly, municipal service delivery rights  Government and Public Service Reform Initiative/Open Society
can be utilized in such a way that private partnership leads to  Institute).
improved infrastructure and better services. Local revenue  Information: Budapest 1051, Nador.u. 11, email:.lgprog@osi.hu,
policy measures are also assets. Urban development should  Web site: www osi.hu/lgi.
© 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001   U



WBank of Finland
Institute for Economies in Transition
BOFIT Publications
Meager Foreign Investment Delays Improvement in Russia's Energy Sector
by Juhani Laurila
Foreign direct investment (FDI) inflows to the Russian Federa-  essary to modernize the energy sector and calculates that friend-
tion have been modest by any standard: according to the State  lier treatment of foreign investors could bring in $60-$70 billion
Statistics Committee, the gross flow of financial capital to  in foreign investments during the next 10-15 years.
Russia's corporate sector was $11 billion in 2000, about 40 per-
cent of which (or $4.4 billion) was FDI. The accumulated stock of  Russia will need substantial amounts of financing to explore, ex-
all financial capital in Russia between 1993 and 2000 amounted  tract, and transport oil, natural gas, and electricity to be able to
to $32 billion, about half of which was FDI. In per capita terms,  meet expected Western European demand. IEA and Russian
the FDI stock in Russia is among the smallest in European tran-  estimates indicate that investments of $5-$7 billion a year will
sition economies. A hostile business climate and prohibitive con-  be needed in the next 20 years simply to sustain the current level
trols efficiently bar access to Russia in general and to the energy  of oil production. About $2 billion a year is needed just to main-
sector in particular. In fact, only about 10 percent of last year's  tain production in depleting gas fields. Estimates of investments
FDI went to the energy sector.                        needed in the power sector are in the range of $5-$9 billion a
year. Thus during the coming 20 years about $15 billion a year
Production-sharing agreements (PSAs) were designed to attract  will be needed to keep the Russian energy sector in business.
foreign investment in the energy and raw material sectors. These
agreements also seek to ensure Russian control and at least 70  The scant FDI is bound to slow development of Russia's energy
percent involvement in the exploitation of natural resources, with  sector. Low, regulated domestic energy prices and nonpayment
corresponding benefits. These rules and the prevailing business  of energy bills increase strain on the sector. Russian energy pro-
climate explain why only three, or possibly four, of the 28 PSA  duction and investments, burdened by high capital costs, must
contracts approved since the introduction of the PSA regime in  also compete with lower-cost energy from elsewhere.
1996 are operational.
Time is running out. Exploration and construction of production
Although the Ministries of Economy and Energy recently agreed  facilities, pipelines, and related infrastructures takes years. It
on modification of the tedious authorization procedures, doubts  takes even longer to create market institutions and behavior con-
have already arisen about the tax rules introduced in the draft of  ducive to a healthy business climate. Perhaps a more liberal and
the new PSA law (that is, concerns over the possibility of double  permissive PSA regime would serve Russian interests better by
taxation). The PSA regime reflects the psychological or political  attracting FDI to Russia's energy and raw materials sectors.
ambivalence that Russian officials, policymakers (particularly at
the regional and local level), and citizens feel toward FDI, which  Juhani Launla is an economist at BOFIT This is an abridged
helps finance exploration but may exploit national assets and  version of his article "FDI and the Russian Energy Sector An
wealth to Russia's disadvantage. The Russian government, how-  Ill-Managed Partnership," published in BOFIT's Russian
ever, acknowledges that foreign capital and technology are nec-  Economy: The Month in Review, April 6, 2001.
Continued Dollarization of the Lithuanian Economy
by Igor Vetlov
In an environment of high inflation and excessive exchange rate  evolution of dollarization can serve as a direct indicator of the
volatility, the ability of a domestic currency to provide the basic  credibility of the domestic currency and the overall success of
functions of money can be significantly distorted. Such condi-  stabilization efforts.
tions can motivate a country to substitute a more stable foreign
currency for its domestic currency. This shift to a foreign currency  In the earlier stages of transition, Lithuania, like other transition
as a store of value and unit of account is often referred to as  economies, experienced a flight from its domestic currency, trig-
dollarization. In the context of macroeconomic stabilization, the  gered by near hyperinflationary levels of inflation and a substan
*  Tsx\SITION, February-March 2001                             The World Bank/The William Davidson Institute ©D 2001



tial devaluation of the domestic currency. The U.S. dollar increas-  The Russian crisis in the second half of 1998 again increased
ingly became the store of value, unit of account, and medium of  dollarization in Lithuania-although, given the circumstances,
exchange. The currency reforms of 1992-93 and the subsequent  the increase was surprisingly small. The big surge in the ratio
tightening of monetary policy and stabilization of the exchange  came in the second half of 1999, when dollarization reached its
rate helped restore public trust in the domestic currency and sig-  highest level since 1995, probably in response to the rise in in-
nificantly reduced dollarization. The introduction of a national  terest rates paid on dollar-denominated assets abroad. The con-
currency, the litas, in June 1993 led to a dramatic decline in the  tinuing rise in the dollarization ratio may be related to the
dollarization ratio in the second half of 1993.         approaching repegging of the litas to the Euro, due to take place
in early 2002, according to the Bank of Lithuania.
Additional stabilization measures-including adoption of a cur-
rency board arrangement and the pegging of the litas to the U.S.  Igor Vetlov is a senior economist at the Bank of Lithuania Eco-
dollar in April 1994-did little to reduce the dollarization of the  nomic Research Center. This is an abbreviated version of his
economy, however, perhaps because of the low initial level of  article "Dollarization in Lithuania," published in BOFIT's Baltic
confidence in the currency board arrangement. Rumors of an  Economies: The Quarter in Review, in January 2001. See also
impending devaluation of the litas persisted throughout the first  BOFITDiscussion Papers, 2001, o. 1. BOFlTaddress: PO. Box
half of 1995. As a result, the dollarization ratio hit a peak in the  160 FIN-00101 Helsinki, Finland, tel.: 3589- 183-2268, email:
summer of 1995, rising to 50 percent over its 1994 level.  bofit@bof.fi, Web site: wwwbof.fi/bofit.
World Bank/IMF Agenda
Global Development Finance 2001: Tem-  countries benefited from increased ex-  dent for Europe and Central Asia, after con-
porary Slump after Strong Recovery    ports to the EU, which contributed to a 4.6  cluding a three-day visit to Moscow in early
percent rate of growth-a marked im-  April. The largest of the three credits likely to
Growth in the transition economies of Eu-  provement over 1999, when growth de-  be put before the Bank's board by June is a
rope and Central Asia [plus Turkey, which  clined 0.3 percent. The CIS countries  $150 million loan to kick-starttreatment and
is part of the Bank's Europe and Central  posted growth of 6.8 percent, up from 2.6  prevention programs for HIV/AIDS and tu-
Asia Vice Presidency] is expected to slow   percent in 1999. In the Russian Federa-  berculosis. Eighty million dollars will be lent
to 2.3 percent in 2001, according to Glo-  tion and Central Asia, higher oil prices al-  in a pilot program to relocate people from
bal Development Finance 2001, a new  lowed for increased fiscal outlays and  high-maintenance cities above the Arctic
World Bank report. The trend reflectsade-  investment, especially the pay-down of  Circletowarmerclimeswithin Russia.A$50
cline in external demand, the effects of sta-  arrears and a shift to cash payments.  million programwillfinance education reform
bilization and structural reform programs,                                in three regions of Russia. Off the agenda
the impact of policy tightening to avoid over-  Long-term external debt in the region de-  is the fourth structural adjustment loan, aimed
heating (in Poland, for example), and the  clined slightlyto $387 billion in 2000, down  atfinancingfundamental economicreforms.
crisis in Turkey. Pressures on fiscal bal-  from $391 billion in 1999. The debt-to-ex-  "At this point, when the federal budget and
ances include large public sectors, overex-  port ratio improved markedly, falling from  the balance of payments are looking good,
tended social security systems, significant  144 percent in 1999to 114 percent in 2000.  Russia doesn't need such loans," Linn ex-
off-budget expenditures, forthcoming gen-  The debt-service ratio also improved, fall-  plained. However, the Russian government
eral elections, and ongoing adjustment  ing from 18 percent in 1999 to 14.6 per-  has requested the World Bank develop a
costs related to the EU accession process.  cent in 2000. Net long-term capital flows to  monitoring system which can track the re-
(Bulgaria, the Czech Republic, Estonia,  the region increased slightly, from $52.5  form efforts. Russia is one of the World
Hungary, Latvia, Lithuania, Poland, Roma-  billion in 1999 to $54.8 billion in 2000.  Bank's largest borrowers, with $9.5 billion
nia, Slovakia, Slovenia, and Turkey are                                   in loan commitments, $7 billion of which has
seeking EU membership.) Annual growth  World Bank Plans New Loans to Russia  already been disbursed.
in the region is expected to stabilize around
4 percent in 2002 and 2003.          A total of six to seven projects for Russia  Russia Turns Down IMF Stand-By
amounting to $600 million in new loans are
Average GDP in the region posted a  expected infiscalyear2001,ofwhich three  In March the Russian Federation turned
strong recovery in 2000, growing 5.6 per-  totaling $280 million are still to be com-  down a one-year stand-by arrangement
cent. The Central and Eastern European  pleted, said Johannes Linn, Vice Presi-  proposed by the IMF. While the deal would
© 2001 The World Bank/The William Davidson Institute                          TRANSITION, February-March 2001   U



not have provided Moscow with fresh infu-  bank, funneled some $700 million in cen-  accelerate liberalization of its relatively re-
sions of cash, it might have helped the  tral bank reserves on loan from the IMF  strictivetrade regime. Private sectordevel-
government reschedule about $40 billion  through the Cyprus affiliate of Credit  opment and foreign direct investment will
(45 billion Euros) in debt with the Paris  Suisse First Boston, the Swiss-U.S. in-  be promoted byeasingbarrierstoentryand
Club group of creditor nations. Russian  vestment bank. Bondar was arrested in  liberalizing the business environment for
Finance MinisterAlexei Kudrin said Rus-  March. The investigation into his activities  both domestic and foreign investors. Policy
sia decided against signing the agree-  has wide political implications. Those op-  transparency will also be improved.
ment"afterassessingitscapabilities."The  posing the reform policy of Ukraine's
IMF's offer involved no money, unless the  popular prime ministerViktorYushchenko  IMF Conditonality: Reduced but Not
Russian economy took a sharp turn for the  hope to use the case to weaken his posi-  Dispensable
worse, but the accord would have required  tion as he headed the central bank from
the Russian government to charge market  1993 to 1999.                     Discussions on how the IMF uses condition-
rates on central bank loans to the govern-                                 ality have moved forward, and the Fund is
ment and release more information about  Bos n ia-Herzeg ovi na Has Lowest  seeking external comments before a Board
the operations of the Russian central bank  Level of Foreign Investment in East-  meeting in June. On March 7 the IMF Board
and the state-run savings bank, Sberbank.  ern Europe                      agreed to reduce the use of structural con-
IMF and World Bank economists have                                         ditionality, applying it only when critical to
noted that Russia has done little to reform   Between 1996 and 1999 foreign direct  achieve macroeconomic stability. The need
its banking sector since the country's 1998  investment (FDI) in Bosnia-Herzegovina  for conditionality will be assessed on a case-
financial blowout and warned that another  was just $4.7 million a year. During the  by-case basis and applied narrowly. Struc-
crisis is looming if nothing is done.  same period, annual FDI was $56 million  tural benchmarks, which have tended to be
in Albania, $54 million in Moldavia, and  applied much like conditions, will be used
The IMF last lent money to Russia in the  $43 million in Macedonia.        more sparingly and only to monitor policy
summer of 1999, when it disbursed $640                                     outcomes. Letters of Intent should make a
million as the first part of a $4.5 billion pack-  The World Bank is ready to help the authori-  clearer distinction between a govemment's
age. That aid program was put on hold  ties create a better business climate, accord-  overall policy program and that part that is
amid complaints that Russia failed to meet  ing to World Bank Executive Director Pieter  subject to Fund conditionality. Stressing that
various reform promises and stashed  Stek. Toward that end, the Bank has pre-  conditionalitycannot compensate for lack of
some central bank funds to offshore banks.  pared a report recommending how to re-  country ownership of the reform process, the
(Based on report of Alan Cullison of the  move obstacles to private investment and  Board advised staff to reduce financing
Wall Street Journal)                 improve the business environment. The  where support is lacking. More will be done
Bank has also compiled a report on corrup-  to test prior commitment and intent through
No Misappropriation of Ukraine Funds  tion, seen as a major obstacle to economic  "prior actions." The streamlined approach
development in Bosnia-Herzegovina.   will be applied immediately.
"No instances of misappropriation of
funds were uncovered," wrote Thomas C.  IMF Approves $368 Million Loan for  Since Horst Koehler's "Streamlining Struc-
Dawson, Director of IMF External Rela-  Vietnam                            tural Conditionality" guidance note was is-
tions Department in his letterto the editor of                             sued last September, the average number
the Financial Times (April 12, 2001).  In earlyApril the IMF Executive Board ap-  of structural conditions in Poverty Reduc-
Dawson was responding to an article in the  proved in principle a three-year $368 mil-  tion Growth Facility (PRGF) programs has
Financial Times that stated that foreign re-  lion "arrangement" to Vietnam under the  been reduced by about a third. In some
serves of the National Bank of Ukraine were  Poverty Reduction and Growth Facility  cases they have increased, however, with
misused during 1997-98. "it is not unclear  (PRGF). The loan is intended to boost  the addition of new governance condition-
where most of the $700 million in central  growth and reduce poverty. The Board also  ality. The IMF has not yet published its pa-
bank reserves went. In fact, as detailed in  approved the release of a $53 million loan  per on governance conditionality-a new
the audits the National Bank of Ukraine re-  underthe arrangement. Underthe program,  priority in its PRGF programs.
ceived all the income streams it was due,"  Vietnam's GDP growth is projected to rise
wrote Dawson.                        to 7 percent in 2003 (up from a projected  IFC Plans Governance Clauses
rate of growth of 5 percent this year), with
According to the article in question, in  inflation held to less than 5 percent. Per  The International Finance Corporation
1997-98 Volodymyr Bondar, the former  capita income should rise by an average  (IFC), a private sector arm of the World
first deputy chairman of Ukraine's central  annual rate of 4.5 percent. Vietnam is to  Bank Group, plans to include corporate
N    TRANSITION, February-March 2001                              The World Bank/The William Davidson Institute C) 2001



governance clauses in loan agreements.  help integrate the three countries with the  management, before eventually selling its
IFC Executive Vice President Peter  European Union. The Bank will continue  stake. In 12 years of operation it has
Woicke told the Financial Times that  to maintain its country offices in Bucharest,  helped create 7,000 jobs and boosted the
projects supported by the IFC already must  Sofia, and Zagreb.           competitiveness of more than 160 small
meet strict environmental and social re-                                 and medium-size enterprises.
quirements. "We want to push for corpo-  World Bank Consults on Belarus'
rate governance, transparency, and  Country Assistance Strategy          Joint IMF-World Bank Study to Re-
minority shareholder protection in our loan                              build North Korea's Economy?
agreements," he said.               The World Bank Group has begun a se-
ries of consultations with various social  IMF Managing Director Horst Kohler has
New Initiative Launched in Bratislava  groups in Belarus to gather ideas and  proposed a joint survey by South Korea
to Clean Urban Air                  feedback that will help design its strategy  and the World Bank to help rebuild North
of assistance to the country (CAS) for the  Korea's devastated economy. Following
The ways and means to clean the polluted  next three years. The CAS, which is ex-  a survey of the economic situation, work-
air in the cities of Central and Eastern  pected to be finalized by the end of the  shops would be organized with the partici-
EuropeandCentralAsiawerediscussed  year, will contain all the Bank's planned  pation of the two Koreas and the two
during a three-day workshop, "Clean Air  operations, including lending, analytical  international agencies. President Kim
Initiative," held in Bratislava, Slovakia, in  work, and technical assistance programs.  Dae-Jung has responded favorably to the
mid-April. The workshop was organized by  It will be designed with the government of suggestion, agreeing that a special ana-
the World Bank Institute and the Europe  Belarus, in consultation with a range of  lytical model is needed to rebuild the
and Central Asia Region and supported  representatives from civil society, includ-  North's economy.
by the Dutch and Japanese governments  ing NGOs, community groups, the media,
and the host city. The workshop provided  professional associations, and religious  North Korea's economy is in a shambles
a forum for discussion of various air qual-  groups. So far the strategy of assistance  after it collapsed because of mismanage-
ity themes, including health, environment,  covers targeted social protection activi-  ment and the halt of major subsidies fol-
governance, transport, energy, public  ties, the impact of the Chernobyl disaster,  lowing the break-up of the former Soviet
awareness, capacity building, and project  the HIV/AIDS epidemic, and protection of  Union. As result, factories are at a stand-
financing.                          the environment.                     still, hunger is widespread, and people are
freezing in their unheated homes. Kim
World Bank Opens Regional Office in  Global Partnership for Investment in  Jong-l1, has made a call for "new thinking,"
Croatia                             Small and Medium-Size Enterprises  which officials in the South Korea say could
Launched                            lead to the opening up of the socialist
The World Bank will open a regional of-                                  economy to outside investment and tech-
fice in Zagreb in the fall, in a bid to in-  To help small and medium-size enter-  nology.
crease the impact of its assistance in  prises gain greater access to financing
Bulgaria, Croatia, and Romania. "This  and consulting services, the International  IMF, World Bank: How Poor Countries
decentralized structure allows us to be  Finance Corporation and the Small Enter-  Should Manage Debt
closer to our client countries, other devel-  prise Assistance Funds (SEAF) have
opment partners, and stakeholders; to be  launched a $2.5 million global partnership  A decade after the break-up of the Soviet
more effective in our support for economic  initiative. SEAF, an NGO based in the  Union, some of its former republics are still
reforms and development; and to be more  Netherlands and the United States, oper-  desperate for investment. Armenia, Geor-
cost effective in our operations," said the  ates a network of 14 commercially driven  gia, the Kyrgyz Republic, Moldova, and
head of the new office, Andrew Vorkink,  investment funds around the world. With  Tajikistan, which are among the poorest
Directorofthe South Central Europe Coun-  $140 million under its management, it in-  countries in the world, need foreign assis-
tryUnit,whichisresponsiblefortheBank's  vests in small and medium-size enter-  tance and reform, according toa jointre-
assistanceprogramsinthethreecountries.  prises(firms with 10-100 employees and  port by the IMF and the World Bank
According to Vorkink, the move is expected  annual revenues of $200,000-$2 million)  released in March. (The report, "Armenia,
to help the Bank respond better to the  with high growth potential. After taking a  Georgia, the Kyrgyz Republic, Moldova,
needs and challenges of the Stability  minority equity position, SEAF provides a  and Tajikistan: External Debt and Fiscal
Pact-launched in 1999 by major Western  combination of fee-based and donor-  Sustainability," is available on the Web, at
powers to help overhaul security, infrastruc-  funded customized consulting services in  http://www.imf.org/external/np/eu2/2001/
ture, and economy in the Balkans-and  key areas, such as marketing, finance, and  edebt/eng/mai.i.pdf.)
(© 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001



Having suffered severe financial strains  sprojects/Project.asp?pid=P055173.  and small and medium-size businesses.
after the break-up of the Soviet Union in  For more information, contact Bart Web site: http://www4.worldbank.org/
1991, the combined external debts of  Stevens (tel.: 202-458-2563, Email  sprojects/Project.asp?pid=P056891.
these countries-debt-free a decade  Bstevens@worldbank.org).
ago-have ballooned to more than $5.7                                      Russia: $85 million project loan (5-year
billion. That sum represents a staggering  Mongolia: $34 million IDA credit (10-year  grace period, 17-year maturity) to im-
debt load, averaging 422 percent of their  grace period, 40-year maturity) to recon-  prove efficiency of district (municipal)
annual government revenues and 122 per-  struct and upgrade roads in Mongolia's  heating systems and promote sound
cent of their annual exports, according to  central and western regions, implement a  cost-recovery policies and commercial
the report.                         financial accounting system for the rail-  practices. Project funds will initially go to
ways, and initiate a system of annual ve-  9-10 Russian cities, including Syzran,
The two principal authors of the study,  hicle inspections.               Nerungri, Mytishi, and Dubna. Kostroma,
Mohammad Shadman-Valavi, MMFAssis-  Web site: http://www4.worldbank.org/  Krasnoyarsk, Volgograd, Kazan, and
tant Director, and Samuel Otoo, World  sprojects/Project.asp?pid=P056200.  Tambov could join the project later.
Bank Sector Manager, confirmed that this  For more information, contact Kimberly
debt burden creates serious fiscal difficul-  Versak (tel.: 202-473-4919, fax: 202-522-  Ukraine: $28.2 million project loan (5-year
ties and will adversely affect poverty reduc-  3405, Email: kversak@worldbank.org).   grace period, 20-year maturity) to improve
tion efforts in the coming years. The report                              Sevastopol's heating supply by introduc-
finds that the key to improving matters is  Romania: $80 million adaptable program  ing decentralized gas-fired mini-boilers.
gaining the confidence of foreign inves-  loan (5-year grace period, 17-year matu-  Sevteploservis, a new enterprise, will im-
tors, which requires significant progress  rity) for the development of rural finance  prove heating services in this major city
toward curbing corruption, increasing  services, providing access to investment  on the Black Sea on a commercial basis.
transparency, and improving the judicial  capital and safe banking services to indi-  Web site: http://www4.worldbank.org/
process so that investors have some pro-  vidual farmers, rural microentrepreneurs,  sprojects/Project.asp?pid=P055738.
tection under the law.
Newly Approved World Bank Loans in                             D
Brief                                Conference Diary
China: $105.5 million project loan (5-year
grace period, 20-year maturity) for envi-  For the Record                 EBRD Annual Meeting and Business
ronmental recovery of the Huai River and                                  Forum 2001
its tributaries. The loan will provide facili-  "Two New Leaders: Will It Make a Dif-  April 22-24,2001, Hilton London Metropole
tiesforcollectingandtreatingwastewater  ference?" Harvard-Columbia Arden  Hotel and Conference Centre, London,
and establishing municipal wastewater  House Conference on American-Rus-  United Kingdom
utilities.                           sian Relations
Web site: http://www4.worldbank.org/  March 16-18 2001, Arden House Confer-  The European Bank for Reconstruction
sprojects/Project.asp?pid=P047345. For  ence Center, Harriman, NewYork, United  and Development (EBRD) held its 10th
more information, contact Kimberly  States                                annual meeting in London April 22-24,
Versak (tel.: 202-473-4919, fax: 202-522-                                 2001. The occasion marked the 10th an-
3405, Email: kversak@worldbank.org).   Participants included Timothy Colton,  niversary of the start of the bank's opera-
Andrei Illarionov, Marshall Shulman,  tions. The theme of this year's conference
Georgia: $25.9 million, three-phase  Grigory Yavlinsky, Padma Desai, and  was "Ten Years of Investing for Economic
adaptable program credit (10-year grace  Marshall I. Goldman.             Growth and Transition." The EBRD Busi-
period, 40-year maturity) to support the  Information: Harvard-Columbia Arden  ness Forum, held alongside the annual
development of primary and general sec-  House Conference Center, Davis Center  meeting, comprises a series of seminars,
ondary education over the next 12 years.  for Russian Studies, Harvard University,  roundtables, and debates on the coun-
Phase 1 will develop a national curriculum   1737 Cambridge Street, Cambridge,  tries in which the EBRD invests.
for primary and general secondary educa-  Massachusetts, United States, 02138,  Information: http://www.ebrd.com/annual
tion, train teachers and principals, and pro-  tel.: 914-351-2171 or 617-495-8900, fax:  meeting, Office of the Secretary General,
vide basic learning materials.       617-495-8319, Email: dgurvich@fas.  Annual Meetings Unit, European Bank
Web site: http://www4.worldbank.org/  harvard.edu.                       for Reconstruction and Development,
9 TRA\srrioN, February-March 2001                                The World Bank/The William Davidson Institute (C 2001



One Exchange Square, London EC2A   growth and prosperity levels eventually  tral and Eastern Europe. Young academ-
2JN, United Kingdom, tel.: 44 0 20 7338  be reached in Eastern and Southern Eu-  ics will receive feedback on their work in
6625, fax: 44 0 20 7338 7320, Email:  rope, or are old divisions simply being  progress from established academics in
aminvitations@ebrd.com.              replaced by new ones with respect to  the field and from one another. The work-
levels of development and economic  shop is organized by Mark Schaffer,
Forthcoming                          structure? Why has performance in the  Centre for Economic Reform and Trans-
Balkan countries been so different from  formation, Heriot-Watt University; Janez
World Bank's Thirteenth Annual  performance in Central Europe? Why did  Prasnikar, Research Center of the Fac-
Bank Conference on Development  the Balkans fail in many respects in their  ulty of Economics, University of Ljubljana;
Economics                           transition from plan to market?Are domes-  and G6rard Roland, ECARES.
May 1-2, 2001, Washington, D.C., United  tic policy failures or unfavorable initial con-  Information: wwwcepr.org.
States                               ditions and geography responsible for
their poor performance? What has been  Sustainable Agriculture in Central and
Opening address by World Bank Presi-  the policy response of the European Union  Eastern European Countries: The En-
dent James D. Wolfensohn, keynote ad-  and other international organizations? Is  vironmental Effects of Transition and
dress by World Bank Senior Vice  this policyresponseadequatelydesigned  Need for Change
President and Chief Economist Nicho-  and implemented? What are the goals,  September 10-16, 2001, Nitra, Slovakia
las H. Stern.                        composition, impact, and future of the Sta-
Session One: Globalization and Inequal-  bility Pact? The conference will attract de-  Organizers: Consortium of Chair of Re-
ity (Kevin O'Rourke, Trinity College, Dublin;  velopment experts, policymakers, and  source Economics, Germany; Agricultural
Daniel Cohen, Ecole Normale Superieure,  leading academics.               University of Nitra, Slovakia; and the Food
Paris; Richard N. Cooper, Harvard Univer-  Information: Pedion Areos, 38334 GR-  and Agriculture Organization Subregional
sity; and Anthony Venables, London  Volos, tel.: 30 421 74467-8, fax: 30 421  Office for Central and Eastern Europe in
School of Economics).                74385, Email: petrakos@uth.gr or mt  Budapest, Hungary.
Session Two: Health and Development  siapa@uth.gr, http://wwwuth.gr/main/rese  Call for papers: Papers should address the
(Morten Rostrup, Medecins sans Frontieres;  archlsynedria/anakoinvseis/se_de v  following questions:
Jean 0. Lanjouw,Yale University;Anne Case,  _conf.htm                     * What are the causes and effects of in-
Princeton University; and TomasJ. Philipson,                              stitutional changes on water, soil, and
University of Chicago).              The Sixth Annual International Confer-  biodiversity/landscape?
Four parallel workshop sessions will be  ence on Transition Economics,    * What are the determinants of current
held each afternoon. Participation by non-  June 23-26, 2001, Portoroz, Slovenia    agri-environmental policies and their ef-
Bank and non-IMF staff by invitation only.                                fects on water, soil, and biodiversity/land-
Information: Boris Pleskovic, Research  Sponsored by the Centre for Economic  scape, and what are the opportunities for
Administrator, Development Economics  Policy Research (CEPR) and the William   policy changes?
Vice Presidency, Room MC 4-402, World  Davidson Institute, this conference will cre-  * What are the natural, economic, and
Bank, 1818 H Street, N.W, Washington,  ate a forum in which leading transition  political determinants of farming systems
D.C. 20433, tel.: 202-473-1062, fax: 202-  economists from different universities and  in Central and Eastern European coun-
522-0304, Email: bpleskovic@world  countries can present new research, meet  tries during transition, and what impact do
bank.org, Web site: http://www.worldbank.  and develop long-term collaborative rela-  they have on the environment? Which in-
org/research/abcde/.                tionships, and complete ongoing research.  dicators are useful for capturing the envi-
Information: www. wdi.bus. umich. edu.  ronmental effects of farming systems?
Restructuring Stability and Develop-
ment in Southeastern Europe          Transition Economics Workshop for  Deadline: May 15, 2001.Abstract must be
June 1-3, 2001, Volos, Greece        Young Academics                      written in English and sent electronically in
June 27-July 5, 2001, Portoroz, Slovenia  Microsoft Word format to the Seminar Sec-
Organizer: South and East European De-                                    retariat in Berlin. Abstract should include the
velopment Center of the University of  Sponsored by the Centre for Economic  names of all authors, with the surname of
Thessaly, Greece (SEED).             Policy Research (CEPR), this workshop,  the paper presenter typed in capitals; the
Participants in this international confer-  a follow-up to the international confer-  Email addresses of all authors; and the in-
ence will discuss the situation in the  ence, will promote the research activities  stitutional affiliations and mailing addresses
Balkan region and try to answer several  of Ph.D. students and recent Ph.D.s from   of all authors. Abstracts should contain no
open questions: Will Western-type  both the EU and Phare countries of Cen-  symbols, references, orequations.
(D 2001 The World Bank/The William Davidson Institute                        TRANS11ION, February-March 2001   *



Information: Dr. Pavol Stehlo, Research        D
Institute of Agricultural and Food Eco- New  Books and Working Papers
nomics, Cesto pod zlatym brehom,  The Macroeconomics and Growth Group regrets that it is unable to provide the pub-
94901 Nitra, Slovakia, tel.: 421-87-6512-  lications listed.
180, fax: 421-87-6512-180, Email: vuep
p1@nr.sanet.sk,orFranz Gatzweilerand
Renate Judis, Chair of Resource Eco-  World Bank Publications            as well as, share of exports, agriculture,
nomics, Department of Agricultural Eco-                                  and investment in GDP.
nomics and Social Sciences, Humboldt  To receive ordering and price informa-
University of Berlin, D-10099, Berlin,  tion for World Bank publications, contact  Investment Promotion Toolkit:A Com-
Luisenstr. 56, tel.: 49030-2093-6145, fax:  the World Bank, PO. Box 960, Herndon,  prehensive Guide to FDI Promotion,
49030-2093-6339, Email: renate.judis  Virginia 20172, United States, tel.: 703-  Multilateral Investment GuaranteeAgency
@agrar.hu-berlin.de, Web site: http://  661-1580, fax: 703-661-1501, Email:  (MIGA), February 2001.
wwwceesa.de.                        books@worldbankorg, Web site: http://
www.worldbank.org/publications, or visit This toolkit describes international best
Marketing and Business Strategies for  the World Bank InfoShop in the United  practices in investment promotion, gained
Central and Eastern Europe          States, at 701 18th Street, N.W, Wash-  during MIGA's 12 years of investment ex-
December 5-7, 2001, Arcotel Hotel  ington, D.C. 20433 (teL 202-458-5454).  perience in more than 150 emerging
Wimberger, Vienna, Austria                                               economies and developing countries. It is
Recent Titles                       a useful guide to national and local invest-
The ninth annual conference of the Kellstadt                             ment intermediaries for attracting and re-
CenterforMarketingAnalysis and Planning,  World Development Indicators 2001,  taining foreign direct investment. Its nine
DePaul University, Chicago and the Depart-  April 2001, 400 pp.          modules cover all basic functions of invest-
ment of International Business, University                               ment promotion: understanding foreign
of Economics and Business Administra-  In its fifth edition, this World Bank statisti-  direct investment, developing an invest-
tion, Vienna. Empirical research, and case  cal reference provides a comprehensive  ment promotion agency, creating an in-
studies are sought that address such top-  view of the world economy. The print edi-  vestment promotion strategy, building
ics as comparative analysis of conditions  tion contains more than 80 tables and 600  effective partnerships, strengthening the
of market entry in Central and Eastern Eu-  indicators for 148 economies and 14 coun-  location's image, targeting and gener-
rope, market entry through exports versus  try groups, with basic indicators for another  ating investment opportunities, servicing
marketentrythrough capital investment, ac-  59 economies. The six sections cover  investors, monitoring and evaluating ac-
quisitions versus joint ventures, marketing  world view, people, environment, economy,  tivities and results, and utilizing informa-
strategies to reach consumers in the region,  states and markets, and global links. The  tion technology.
marketing-mix decisions for markets in the  volume includes the most recent data on
region, financial strategies for opening  poverty, education, health, and the environ-  Technical Papers
markets in the region, and case studies of  mentfrom around theworld, aswell as new
experiences by Western firms in Central  data on the digital divide and how infor-  Karen M. Brooks and Zvi Lerman,
and Eastern Europe. Abstracts of the pa-  mation communication technology is  Turkmenistan: An Assessment of
pers, in English, should be received by  changing the process of development.    Leasehold-Based Farm Restructuring,
September 10, 2001. Final papers must be                                 TP 500, 2001, 88 pp.
ready by November 1, 2001.          World BankAtlas 2001, April 2001, 64 pp.
Information: Prof. Dr. Reiner Springer,                                  Pietro Garibaldi, Mattia Makovec, and
Wirtschaftsuniversitat Wien, Althanstr. 51,  This volume provides easy-to-read col-  Gabriella Stoyanova, From Transition to EU
1090 Wien, Austria, tel.: 43-1-313 36/ orful world maps, tables, and graphs  Accession: The Bulgarian Labor Market
4371, fax: 43-1-313 36/751, Email:  highlighting key social, economic, and  Duringthe199os,TP494,2001,8Opp.
Reiner.Springer@wu-wien.ac.at, or Prof  environmental data for 206 countries. The
Petr Chadraba, Kellstadt Center for Mar-  atlas parallels the six thematic sections of  Working Papers
keting Analysis and Planning DePaul the World Development Indicators (world  www.worldbank.org/research/workingpa
University, 1 East Jackson Boulevard,  view, people, economy, environment,  pers
Chicago, Illinois 60604, tel.: 312-362-  states and markets, and global links). It
6200, fax: 312-362-5647, Email: pcha  contains new estimates of purchasing  Michael Lokshin and Martin Ravallion,
drab@wopost.depaul.edu.             power parities and gross national income,  Short-Lived Shocks with Long-Lived
M   TRANSITlON, February-March 2001                             The World BankWThe William Davidson Institute (D 2001



Impacts? Household Income Dynam-  Stephen Knack and Omar Azfar, Are  reducingadministrativebarriersinthebusi-
ics in a Transition Economy, WPS 2459,  Larger Countries Really More Corrupt?  ness environment encourage investment
October 2000, 26 pp.                 WPS 2470, November 2000, 28 pp.      and improve the efficiency of resource allo-
cation. Policymakers in transition economies
In theory it is possible that a vulnerable  The claim has been made that government  should complement privatization with insti-
household will never recover from a suffi-  corruption is less severe in small countries  tution building and promote foreign direct
ciently large but short-lived shock to its in-  than in large countries. The authors show  investment and public and private investment
come. Such shocks could explain the  that this relation is a result of sample se-  in education and research and development.
persistent poverty that has emerged in  lection. Most corruption indicators provide  To order: Anne Nelson, Room H6-393,
many transition economies. In general,  ratings only for countries in which multina-  tel.: 202-473-7117, fax: 202-522-0073,
however, households bounce back from  tional investors have the greatest interest.  Email: anelson@worldbankorg.
transient shocks, albeit not rapidly, as this  These tend to include almost all large na-
study, based on statistics from Hungary,  tions but only those small nations that are  Cevdet A. Denizer, Mustafa Ding, and
shows.                               well governed.                       Murat Tarimcilar, Measuring Banking
To order: Patricia Sader, Room MC3-556,  To order: Paulina Sintim-Aboagye,  Efficiency in the Pre- and Post-Liber-
tel.: 202-473-3902, fax: 202-522-1153,  Room MC3-422, tel.: 202-473-8526, fax:  alization Environment: Evidence from
Email: psader@worldbank.org.         202-522-1155, Email: psintimaboagye  the Turkish Banking System, WPS
@worldbank.org.                      2476, November 2000, 58 pp.
Max Alier and Dimitri Vittas, Personal
Pension Plans and Stock Market  Asad Alam and Arup Banerji, Uzbekistan  Banking efficiency in Turkey was expected
Volatility, WPS 2463, October 2000,  and Kazakhstan: A Tale of Two Tran-  to improve after liberalization. Instead, it
51 pp.                               sition Paths, WPS 2472, November  declined, because oftheworsening mac-
To order: Agnes Yaptenco, Room MC3-  2000, 25 pp.                        roeconomic situation.
444, tel. 202-473-1823, fax: 202-522-                                     To order: Mustafa Ding, Room MC2-814,
1155, Email: ayaptenco@worldbank.org.  Despite a common parentage for most of the  tel.: 202-473-6233, fax: 202-522-3669,
tentieth century, Uzbekistan and Kazakhstan  Email: mdinc@worldbank.org.
Carlos B. Cavalcanti and Zhicheng Li,  followedseeminglydifferentpathsinthetran-
Reforming Tax Expenditure Pro-  sition to a market economy. Uzbekistan  William Easterly, Can Institutions Re-
grams in Poland, WPS 2465, October  adopted a cautious, gradual approach to  solve Ethnic Conflict? WPS 2482, No-
2000, 23 pp.                         market reform, while Kazakhstan followed a  vember 2000, 32 pp.
more aggressive strategy. Kazakhstan may
Various "tax expenditure programs"-tax  have achieved a better policy environment,  High-quality institutions-reflected in the
deductions, exemptions, credits, defer-  but its economic performance has not been  rule of law, bureaucratic quality, freedom
rals, preferential tax rates, and exclusions  better than Uzbekistan's. Missing pieces of  from government expropriation, and free-
from taxation-that Poland introduced in  reform-especially deficiencies in the com-  dom from government repudiation of con-
1992 to compensate lower-income tax-  petitive environment-combined with a rap-  tracts-mitigate the adverse economic
payers for the withdrawal of subsidies  idly diminishing role for the state may have  effects of ethnic fractionalization. Ethnic
have proliferated, making the normative  limited the gains from policy reforms in  diversity has a more adverse effect on
tax system difficult for the average tax-  Kazakhstan.                    economic policy and growth when a
payer to understand, reducing the tax  To order: Lorie Henson, Room H4-347,  government's institutions are poor. But
base, and benefiting higher-income tax-  tel.: 202-458-4026, fax: 202-522-2751,  poor institutions have an even more ad-
payers more than the taxpayerstheywere  Email: lhenson@worldbank.org.     verse effect on growth and policy when
originally designed to help. The authors                                  ethnic diversity is high. In countries in which
suggest that strengthening the adminis-  David A. Grigorian and Albert Martinez,  institutions are good enough, however, eth-
tration of Poland's tax expenditure pro-  Industrial Growth and the Quality of  nic diversity does not weaken growth or
grams is the first step toward making  Institutions: What Do (Transition)  worsen economic policies. Good institu-
these programs effective and equitable,  Economies Have to Gain from the  tions also reduce the risk of wars and
limiting their costs, and preventing the tax  Rule of Law? WPS 2475, November  genocidethatmightotherwiseresultfrom
base from shrinking.                 2000, 20 pp.                         ethnic fractionalization.
To order: Anita Correa, Room H4-318,                                      To order: Kari Labrie, Room MC3-456,
tel.: 202-473-8949, fax: 202-522-2755,  Developing the legal and regulatoryframe-  tel.: 202-473-1001, fax: 202-522-3518,
Email: acorrea@worldbankorg.         work, improving contract enforcement, and  Email: klabrie@worldbank.org.
(D 2001 The World Bank/The William Davidson Institute                        TRANSITION, February-March 2001   *



Helena Tang, Edda Zoli, and Irina  ments dealt only with bad debt inherited  Capita Wealth, WPS 2498, November
Klytchnikova, Banking Crises in Tran-  fromthesocialistperiod;whensmallbanks  2000, pp. 28
sition Econonries: Fiscal Costs and  that held few deposits were allowed to fail,
Related Issues, WPS 2484, Novem-  where the social costs of such failure were  With the notable exception of China, in
ber 2000, 78 pp.                    low; and when only banks that got into  most countries with below-median per
trouble because of external shocks were  capita income the population has grown
The authors examine strategies fordealing  rescued while those suffering from poor  faster than total wealth. This trend is ulti-
with banking crises in 12 transition econo-  management were liquidated.  mately unsustainable. For many of these
mies-fivefrom Central and Eastem Europe  * The government, not the central bank,  countries, policies for sustainability will
(Bulgaria, the Czech Republic, Hungary,  should undertake bank restructuring. Cen-  require both boosting savings and slow-
Macedonia, and Poland); the three Baltic  tral bank refinancing is not transparent and  ing population growth.
states (Estonia, Latvia, and Lithuania); and  can lead to hyperinflation.  To order: Luz Rivera, Room MC5-206,
fourCIS countries (Georgia, Kazakhstan, the  To order: Armanda Carcani, Room H4-  tel.: 202-458-2819, fax: 202-522-1735,
Kyrgyz Republic, and Ukraine). The Central  326, tel.: 202-473-0241, fax: 202-522-  Email: lrivera@worldbank.org.
and Eastem European countries extensively  2751, Email: acarcani@worldbank.org.
restructured and recapitalized their banks,                              Bartlomiej Kaminski, HowAccession to
most CIS countries pursued large-scale liq-  I lker Doma, and Maria Soledad Martinez  the European Union Has Affected Ex-
uidation, and the Baltic states generally  Peria, Banking Crises and Exchange  ternal Trade and Foreign Direct Invest-
adopted a combination of liquidation and re-  Rate Regimes: Is There a Link? WPS  ment in Central European Economies,
structuring. The various strategies reflected  2489, November 2000, 42 pp.  WPS 2578, 2001, 43 pp.
the macroeconomic conditions and the level  To order: Armanda Carcani, Room H4-
of development in each country's banking  326, tel.: 202-473-0241, fax: 202-522-  During the reintegration of the Central Eu-
sector.                             2755, Email: acarcani@worldbank.org.   ropean countries into the world economy,
their proximity and accession to the Euro-
The Central and Eastern European coun-  Monica Das Gupta, Sunhwa Lee, Patricia  pean Union greatly affected first the flow
tries generally incurred higher fiscal costs  Uberoi, Danning Wang, Lihong Wang, and  of capital and then the flow of goods. Coun-
than the CIS countries but ended up with  Xiaodan Zhang, State Policies and  tries that adopted radical liberal reform and
sounder, more efficient banking systems,  Women's Autonomy in China, India,  had preferential access to EU markets have
with many of the recapitalized banks priva-  and the Republic of Korea, 1950-  benefited most, attracting foreign direct in-
tized to strategic foreign investors. The  2000: Lessons from Contrasting Ex-  vestment and convincing multinational cor-
approach of the CIS countries was less fis-  periences, WPS 2497, November 2000,  porations to locate production sites there.
cally costly but has left them with weak  34 pp.                         Author's Email: bkaminski@worldbank.org.
banking systems and low levels of inter-
mediation. The Baltic states appear to  State policies can have an enormous af-  Other World Bank Publications
have struck a good balance, incurring  fect on gender equity. They can mitigate
modest fiscal costs while making their sys-  cultural constraints on women's autonomy  Gillian Perkins and Ruslan Yemtsov, Ar-
tems sounder and more efficient.    (as they have in China and India) or slow   menia: Restructuring to Sustain Uni-
the pace of change in gender equity (as  versal General Education, April 2001,
Policy implications of the study include the  they have in the Republic of Korea). Poli-  72 pp.
following:                          cies to provide opportunities for women's
* Operational, financial, and institutional  empowerment should be accompanied by  Jorge Martinez-Vazquez and Jameson
restructuring should be undertaken in par-  communications efforts to alter cultural  Boex, Russia's Transition to a New
allel.                              values that limit women's access to those  Federation, World Bank Institute Learn-
* Financial restructuring should involve  opportunities. China has achieved the  ing Resources, 2001, 120 pp.
adequate recapitalization to deter moral  most gender equity, the Republic of Ko-
hazard and repeated recapitalization.  rea the least.                    Sergei M Guriev, Igor Makarov, and
* Operational restructuring should entail  To order: Monica Das Gupta, Room MC3-  Mathilde Maurel, Debt Overhang and
privatization to core investors (particularly  633, tel.: 202-473-1983, fax: 202-522-  Barter in Russia, February 2001.
to reputable foreign banks) The enterprise  1153, Email: mdasgupta@worldbankorg.
problems underlying banking problems                                     In this theoretical and empirical analysis of
must also be addressed.             Kirk Hamilton Sustaining Economic  the relation between barter and indebted-
* Fiscal costs were reduced when govern-  Welfare: Estimating Changes in Per  ness of Russian firms, the authors build a
*  TRANSITION, February-March 2001                              The World Bank/The William Davidson Institute © 2001



model in which a firm uses barter to protect  does not in itself solve the problems asso-  Kazakhstan, the Kyrgyz Republic, the
its working capital against outside credi-  ciated with aging societies.  Russian Federation, and Ukraine.
tors, even when barter involves high trans-                               Information: Christian Haerpfer, Institute
actions costs. During renegotiation, rational  Barry H. Potter and Jack Diamond, Set-  for Advanced Studies, Vienna, Email:
creditors agree to postpone debt payments  ting Up Treasuries in the Baltics, Rus-  haerpfer@ihs.ac.at.
rather than destroy the firm's working capi-  sia, and other Countries of the Former
tal. Debt restructuring reduces barter but  Soviet Union, OP No. 198, 42 pp.  Global Barometer Surveys
does not eliminate it completely. Firm-level
evidence from two independent surveys is  Working Papers                  In a major new intercontinental initiative,
consistent with the model's predictions.                                  the Global Barometer surveys-which
Stanley W. Black, Obstacles to Faster  have been conducted in 55 countries in
Pietro Garibaldi, Mattia Makovec, and  Growth in Transition Economies: The  Europe, Africa, and Latin America since
GabriellaStoyanova, From Transition to  Mongolian Case, WP/01/37, 2001.   1991-will be linked and extended to
EU Accession: The Bulgarian Labor                                         East Asia, including China. Global Ba-
Market During the 1990s, March 2001,  Peter S. Heller and Christian Keller, So-  rometer surveys are nationwide random
80 pp.                               cial Sector Reform in Transition Coun-  sample surveys. Questionnaires cover
tries, WP/01/35, 2001.               governance, participation and democ-
Vietnam: Country Framework Report                                         racy, institutions and corruption, political
on Private Participation in Infrastruc-  Centre for the Study of Pub-  participation, safety from violence and
ture, January 2001, 76 pp.           lic Policy (UK) Publications  theft on the street and at home, civic cul-
ture, poverty and prosperity, participation
International Monetary Fund   To order: Center for the Study of Public  in multiple economies, economic expec-
Publications                         Policy, University of Strathclyde, Glasgow  tations, relative affluence, social capital
GI 1XH, Scotland, tel.: 44-141-548-3217,  and use of informal networks, attitudes
To order: IMF Publication Services, 700  fax: 44-141-552-4711, Email: o.j.rober  toward the market economy, and struc-
19th Street, N.W., Washington, D.C.  tson@strath.ac.uk, Web site: http:// turaltransformation.
20431, United States, tel.: 202-623-7430,  www. cspp.strath. ac.ukl.      Information: http://wvw.gIobaIbarometerorgI
fax: 202-623-7201, Email: publications
@imf.org, Website: http://www.imf.org.    New Europe Barometer Omnibus  Stephen White, Public Opinion in
Survey                               Moldova, 2001, SPP 342.
Occasional Papers
This survey, forthcoming this fall, covers 10  The first major social science survey in
J. Schiff, N. Hobdari, A. Schimmelpfennig,  European Union accession countries (Bul-  Moldova incorporates all the standard
and R. Zytek, Pension Reform in the  garia, the Czech Republic, Estonia, Hungary,  Barometer questions on politics, econom-
Baltics: Issues and Prospects, OP No.  Latvia, Lithuania, Poland, Romania, Slovakia,  ics, and social conditions, facilitating com-
200, 2001, 39 pp.                    and Slovenia) plus Belarus, the Russian Fed-  parison with other former Soviet republics
eration, and Ukraine as well as Croatia,  and Romania.
The Baltic countries have taken important  Serbia and neighboring Balkan countries as
steps to shore up the long-term financial  appropriate. Topics include eaming money  Neil Munro and Richard Rose, Elections
health of their pension funds by preparing  in unofficial economies, corruption and crime,  in the Russian Federation, SPP 344.
to implement a three-pillar scheme. But  destitution and prosperity, migration in search
fundamental questions about the design  of work, health, support for democratic and  S. White and R. Rose, Nationality and
ofthefullyfunded scheme remain. Forex-  undemocraticformsofgovernment, andthe  Public Opinion in Belarus and Ukraine,
ample, a tax-financed move from a pay-  European Union and NATO. Richard Rose  SPP 346.
as-you-go pension system toward a fully  and Christian Haerpfer directed the project.
funded plan would tend to increase aggre-  Information: i.m.rogerson@strath.ac.uk.  CESTRAD  Publications
gate savings, while a debt-financed reform
would reduce aggregate savings. A move  Survey of Living Conditions in Eight  To order: Centre for the Study of Transi-
to a fully funded pension scheme imposes  CIS Countries: Life Styles and Health  tion and Development Institute of Social
important costs, in particular on the cur-                                Studies, P.O. Box 29776, 2502 LT
rent generation and the budget. Introduc-  This survey covers living conditions in Ar-  Kortenaerkade 12, The Hague, The Neth-
tion of a mandatory fully funded scheme  menia, Belarus, Georgia, Moldova,  erlands, tel.: 31-70 -4260545, fax: 31- 70-
© 2001 The World Bank/The William Davidson Institute                         TRANSITION, February-March 2001  m



4260799, Email: cestrad@iss.nl, Web  and low household income is beginning to  Slovene Privatized Companies,
site: http:/hvwwwiss.nl/cestrad.    take its toll, however. Children whose fami-  Working Paper No. 7, 2000, 16 pp.
lies are not able to contribute toward their
Fatos Tarifa and Max Spoor (eds.), The  education or health care face the risk of  Jeffrey David Turk and Hedvika Usenik,
First Decade and After: Albania's  being excluded from access to these vital  Buyer Supplier Relationships in the
Democratic Transition and Consolida-  services. Families are unable to protect  Engineering Industries in Slovenia
tion in the Context of Southeast Eu-  children from the negative outcomes asso-  and Comparisons with Hungary, Work-
rope, December 2000.                ciated with transition. Governments need  ing Paper No. 8, 2000, 22 pp.
to intervene, both to protect the future hu-
Fatos Tarifa (ed.), The Breakdown of  man capital of their countries and to mini-  This paper analyzes cooperation be-
State Socialism  and the Emerging  mize the multiple risks children face during  tween Slovene engineering companies
Post-Socialist Order, February 2001.   transition.                       and their buyers and suppliers. It explores
the extent and nature of these companies'
UNICEF Innocenti Research   Bruce Bradbury, Stephen Jenkins, and  integration into the international produc-
Centre Publications                 John Micklewright, Child Poverty Dy-  tion networks and the factors contributing
namics in Seven Nations, Innocenti  to cooperation. Engineering companies
To order: UNICEF Innocenti Research  Working Paper No. 78, June 2000,45 pp.  are increasingly becoming involved in
Centre, Piazza SS. Annuziata, 12, 50122                                  more long-term relationships with their
Florence, Italy, tel.: 39055-20330, fax:  This paper compares child poverty dynam-  buyers and suppliers.
39055-244-817, Email: florence@un  ics using panel data from Germany, Hun-
icef.org.                           gary, Ireland, the Russian Federation,  Institute of Public Finance
Spain, the United Kingdom, and the United  (Croatia) Publications
Jane Falkingham, From Security to Un-  States. It examines flows into and out of
certainty: The Impact of Economic  the poorest quintile of the children's income  To order: Institute of Public Finance,
Change on Child Welfare in Central  distribution. There is significant uniformity  Katanciceva 5, 10000 Zagreb, Croatia,
Asia, Innocenti Working Paper No. 76,  in patterns of income mobility and poverty  teL.: 385 148 19 363, fax: 385 1 48 19 365,
May 2000, 38 pp.                    dynamics across the seven countries, ex-  Email: martina@yf.hr, Web site: http://
cept for Russia, where children in the mid-  wwvw jfhr
Adopting a multidimensional view of child  1990s were much more likely to move into
well-being, the author examines indicators  or out of the the poorest quintile than were  Ljubinko Jankov, Banking Sector Prob-
of poverty based on incomes and expen-  children in the other countries studied. This  lems: Causes, Resolutions and Con-
ditures, statistics on health, education, and  trend will probably subside once the Rus-  sequences, Occasional Paper Series
personal development, and social inclu-  sian economy stabilizes.        No. 10, March 2000.
sion or exclusion of children. The data
show that although children are at the heart  Santosh Mehrotta, Integrating Economic  M. Faulend and V. Sosic, Is the Unoffi-
of Central Asian culture, they were among  and Social Policy: Good Practices from   cial Economy a Source of Corruption?
those who suffered most from economic  High-Achieving Countries [Including  Occasional Paper Series No. 9, Decem-
transition. Two out of every five Central  Cuba], Innocenti Working Papers No. 80,  ber 1999.
Asians is under 18.                 UNICEF, Italy, October 2000,41 pp.
Predrag Bejakovic and Alastair McAuley,
Child poverty rates exceed those of the  Institute for Economic          Welfare Policy and Social Transfers in
general population. Child nutritional status  Research  (Slovenia)       Croatia, Occasional Paper Series No. 8,
is poor, and levels of stunting and wasting  Publications                May 1999.
are close to those observed in parts of
Sub-Saharan Africa. Yet infant mortality  To order: Institute for Economic Research  Katarina Ott and Anto Bajo, Public In-
has fallen and remains low in comparison  Publications, Kardeljeva ploscad 17, 1000  vestments in Croatia, Occasional Paper
to other low- and middle-income countries.  Ljubljana, Slovenia, tel.: 01-530-3800, fax:  Series No. 7, March 1999.
Immunization programs reach almost the  01-530-3874, Email: recnikm@ier.si, Web
entire population, and primary school en-  site: http:/vIwww.ier.si/      Katarina Ott (ed.), A Citizen's Guide to
rollments have been maintained at a rea-                                 the Budget, 2001, 57 p.
sonably high level. There are signs that the  Janez Bester, Takeover Theories and
combined impact of low social spending  Prediction Models: The Case of
*  TRANSITION, February-March 2001                              The World Bank/The William Davidson Institute ©D 2001



Bibliography of Selected Articles
Postsocialist Economies             EU Enlargement as Seen from the East  Brizendine, T. China's Steel Sector in
(Survey). East European Constitutional Transition. China Business Review
Gelos, R.G, and R. Sahay. Financial Mar-  Review (Hungary) 9(4):62-108, 2000.  (United States) 28 (1): 22-27, January-
ket Spillovers in Transition Econo-                                     February 2001.
mies. Economics of Transition (United  Hanousek, J., and N. Libor. Czech Paral-
Kingdom) 9 (1): 53-86, 2001.        lel Capital Markets: Discrepancies and  Li, X. Government Revenue, Govern-
Inefficiencies. Applied Financial Eco-  ment Expenditure, and Temporal Cau-
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(D 2001 The World Bankffhe William Davidson Institute                      TRANSITION, February-March 2001   0



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