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The Road to Stability and Prosperity in South Eastern Europe
A Regional Strategy Paper

Chapter 4: Creating an Appropriate Enabling Environment for Private Sector Development

4.1   Social and political stability will be greatly enhanced through the achievement of sustained economic growth. In turn, sustained economic growth can only be achieved with a stable and certain environment for the private sector. As noted earlier, much progress is still required on domestic reforms to put in place a stable macroeconomic climate and a market economy. Ensuring that adequate progress is achieved on the reform agenda of individual countries is the sole responsibility of the respective governments. If the governments do not embrace this responsibility, "regional initiatives" will be ineffective. Without these domestic reforms to put in place an appropriate policy, legal and administrative framework, the private sector will not be able to play its role. In fact, in an environment lacking transparency and competition, the private sector may even develop into an obstacle to market-based efficiency and fairness.

4.2   Nevertheless, the Stability Pact partners have a crucial role to play in supporting the SEE countries in their reform efforts through regional initiatives designed to support the implementation of reforms and to magnify their impact. The ultimate goal of a regional approach to supporting private sector development is the creation of a vibrant private sector exchanging goods and investing freely across borders in a region that is integrated closely with the larger European and global economy. The clear prospect of future integration into European and global structures that underlies the Stability Pact would help to mobilize political resources for change, raise investor interest in the region and build confidence in the future stability of the business environment.

4.3   This Chapter looks in depth at regional initiatives that would facilitate the creation of a stable, transparent and non-discriminatory environment for private enterprises to take the risk of investing and producing in the SEE countries.³⁷ In fact, it will be the willingness of private entrepreneurs to take these risks that will transform the opportunities created by increased integration in the global economy into higher growth and employment generation. After this introductory section, Sections B and C discuss initiatives to improve the investment climate for both foreign and domestic investors, and to support small and medium enterprises, which are expected to be the main engines of growth and private sector development in the SEE region, as elsewhere. Section D discusses the role of privatization and private participation in infrastructure, and Section E concludes this Chapter.

B.  Accelerating Growth Through a Stable, Transparent and Uniform Investment Framework

4.4   The initiatives described in Chapter 3 to foster trade integration in the global economy are one key component of the effort to create a dynamic private sector that trades and invests freely across borders. Seizing the opportunities presented by an opening of trade, both within the region and with the broader international community, will be possible only if domestic and foreign entrepreneurs increase their investment dramatically. As discussed in detail elsewhere,³⁸ a sizeable and sustained increase in private investment will in turn require a significant improvement in the overall investment framework, including: adequate protection of property rights; fair and non-discriminatory taxation; market-based competition; sound corporate governance; and transparent, effectively enforced administrative practices.

4.5   Progress toward the establishment of these prerequisites has been made at different speeds in the SEE region, but has in general lagged behind the economies of Central Europe. As documented in the EBRD Transition Report 1999, survey results and other indicators of the quality of the investment climate reveal that the economies of South Eastern Europe are characterized by widespread perceptions of corruption and cronyism, and of unpredictability in the implementation of the regulatory framework by the public administration.

The Investment Compact for the SEE Region

4.6   Governments throughout the region must do much more to create the conditions under which the private sector will invest. With the objective to establish a stable, transparent and uniform framework for private sector investment, the Governments of the region, in collaboration with their partners in the Stability Pact, decided to pursue the implementation of the Compact for Reform, Investment, Integrity and Growth (referred to as the Investment Compact). The Investment Compact outlines a very ambitious agenda of legal, regulatory and institutional reforms, to establish fair and non-discriminatory treatment of domestic and foreign investors, with full protection of their property rights, not only by the letter of the law but also by its administrative implementation and judicial enforcement. The specific policy areas covered by the Investment Compact include: banking; capital markets; corporate governance; policies and promotion strategies for foreign direct investment; commercial law, including business licensing and formation; administrative efficiency and bureaucratic obstacles for private sector initiative; competition law and policy; fighting bribery and corruption; the system of justice; SME support; privatization; fiscal reform and taxes; and accounting regimes and practices.

4.7   The commitment of the Governments of South Eastern Europe to the introduction and implementation of the Investment Compact will be supported by Governments outside the region, international institutions and other donors. Following the finalization and approval of the Investment Compact by the Governments of South Eastern Europe, technical support and assistance to strengthen institutional capacity to implement it will need to be mobilized.

4.8   The Stability Pact Working Table II agreed that a Coordination Group, supported by the OECD, would be charged with the development of a roadmap for the implementation of the Investment Compact. A draft roadmap was developed by the OECD in the autumn of 1999, setting out a three-phase approach (i) diagnosis of current investment conditions in the countries of the region; (ii) development of country-specific policy recommendations and the design of regional policy initiatives; and (iii) monitoring progress in policy implementation, improvement of the investment conditions and actual investment performance in South Eastern Europe. The finalization of the roadmap will continue to require the active participation of Governments, business communities, civil society, and international institutions. Emphasis will be needed in particular on the strengthening of public institutions—including both state and local administrations—which generally requires long gestation periods and sustained attention by policy makers. (This topic will be discussed in detail later in the report.)

4.9   The first stage envisaged in the draft roadmap involves collecting information on policy areas that are vital to reform, revitalization and reconstruction of the SEE economies through increasing local and foreign direct investment. On the basis of the currently available information, a few preliminary conclusions can be drawn at this stage:

• The SEE countries are in very different situations, with large variations not only among countries but also, within countries, among policy areas. The policy dialogue will have to reflect these differences, reinforcing the need for a country-specific approach that should be complemented by regional initiatives.

• Despite these differences, there is a strong need for regional initiatives right from the start, if the potential positive externalities of national reforms are to be fully exploited. Policy areas with a clear international dimension are prime candidate for regional initiatives.

• In many cases, key obstacles to a favorable investment climate and areas for priority action relate to implementation and enforcement of policies, rather than design and parliamentary enactment of policies. Institution building—specifically the capacity to undertake constructive action on an ongoing and progressive basis—therefore seems to be a critical and priority task.

• Timing and duration of the three phases of implementation envisaged in the draft roadmap of the Investment Compact will vary from country to country, reflecting their different stages of economic development, needs for technical assistance, capacity to engage in policy dialogue, and ability to follow through with implementation.

• Given the complexity of the task, managing the expectations and establishing realistic but tough timetables for action and results will be crucial to ensure public support in the countries and in the international community.

• Close cooperation among governments, international organizations and other agencies is essential for success. National project teams would therefore could be very useful to complement the overall implementation of the compact.

4.10   In addition to committing to the broad reform agenda outline in the Investment Compact, the Governments of the SEE region have agreed to take steps to ensure that: the countries will adopt international norms for business taxation, public procurement, and accounting standards; investment regulations will adequately protect health, safety and the environment; labor standards will be consistent with the 1998 ILO Declaration on Fundamental Principles and Rights at Work; the countries will embrace the OECD Principles of Corporate Governance and the OECD Guidelines on Multinational Enterprises; and a dialogue will be established between countries and the private sector, including civil society and labor unions. In addition, the new Stability Pact Anti-Corruption Initiative (see Box 6.4) includes commitments to fighting bribery and corruption of public officials—taking into account OECD and Council of Europe conventions—and to fighting money laundering—taking into account the recommendations of the international Task Force Against Money Laundering.

Additional Measures for the Restoration of Investor Confidence

4.11   The creation of a climate conducive to a strong recovery of private investment in SEE countries will greatly benefit from the establishment of a stable, transparent and non-discriminatory regulatory framework, along the lines discussed above, but the restoration of investor confidence will require more than the implementation of ambitious reforms. Measures to improve security in general, and in particular to facilitate the return of refugees and displaced persons and the rightful repossession of their assets, will all contribute to investor confidence. Initiatives to enhance economic cooperation in the broader neighborhood of South Eastern Europe—for example, the recently established Black Sea Trade and Development Bank—can also play an important role.

4.12   The maintenance of a stable macroeconomic environment will also be critical for the return of investor confidence. Low inflation and stable exchange rates are as necessary for private entrepreneurs to take risks as is a stable and transparent regulatory framework. As discussed earlier in the report, the SEE countries that have experienced periods of macroeconomic instability recently—Albania, Bulgaria and Romania—have also recorded particularly low levels of investment, below 20 percent of GDP. Progress made towards macroeconomic stability in the SEE region will thus need to be consolidated in order to provide a more predictable and more stable framework for private investment.

4.13   Finally, the international community can work with the Governments of SEE countries to devise mechanisms for the mitigation of political risks, in particular through the provision of insurance and/or guarantees. Political risk insurance facilities have been successfully implemented for Bosnia and Herzegovina and for Albania, and a new one is under development for FYR Macedonia. Building upon these experiences, the creation of a regional facility for the countries of South Eastern Europe is now being considered. A regional facility would in fact realize significant benefits in terms of risk pooling and economies of scale; would provide effective coverage for intra-regional trade; and would facilitate the cooperation with private political risk and export credit insurers—through the development of relations with investors and financiers, the sharing of information, and the marketing of guarantees.

C.  Initiatives for SME Development

4.14   Small- and medium-sized enterprises (SMEs) have a crucial role in the transition process. Already SMEs make up the vast majority of private businesses operating in the countries of South Eastern Europe; and, because of their size and adaptability, they are likely to be the largest source of employment generation in the next few years. As in more mature market economies, a vibrant SME sector will eventually become not only a source of employment, but will also be a key source of innovation, entrepreneurship, and productivity growth. The development of dynamic SMEs also creates a group with a strong interest in social stability and a healthy market economy. For these reasons, improving the business environment for SME development is a key objective of the policy framework for all SEE countries.

4.15   SMEs are likely to benefit greatly from the improvement of the business climate in the direction envisaged by the Investment Compact for the SEE region. International experience indicates that SMEs are at a strong disadvantage—as compared with larger enterprises—when the investment framework is opaque and uncertain, public officials have large discretion in the administration of regulations and incentives, and entry and/or competition are restricted.

A Three-Pillar Strategy for SMEs

4.16   An effective strategy directed to promoting SMEs and the active support of governments from the region will however be necessary. In fact, while many SEE countries have already seen strong growth in SMEs, SMEs still face substantial obstacles. As noted earlier in this report, a comparative study of constraints faced by SMEs³⁹—conducted in 1998 and covering Poland, Slovak Republic, Romania, Ukraine and Russia—clearly identified access to finance, complex tax systems and administrative burdens as the principal hurdles; institutional infrastructure to support SME information, legal and training needs was also generally found to be weak. In particular, the study found that Romania—the only SEE country in the sample—compared well with the CIS economies, but had severe shortcomings compared to Poland and Slovak Republic: limited access to credit, low levels of trust in the court system to enforce claims, and the need to pay significant bribes for access to basic public services. Evidence for other SEE countries has also revealed patterns similar to those found in Romania.⁴⁰

4.17   As discussed in detail elsewhere,⁴¹ an effective strategy to promote SMEs in the region must simultaneously tackle the three "pillars" of (i) finance; (ii) improvements in the business environment; and (iii) the strengthening of SME support networks.

4.18   Finance. Throughout the region, SMEs lack adequate access to credit and equity finance. This lack of access stems from the weaknesses of banking institutions in the region, the absence of capital markets, and the weak legal framework for credit and collateral. Supportive action from the international community is needed to address these weaknesses in the institutional infrastructure and in the incentives of financial intermediaries. One option in this area is to work with existing financial intermediaries with the potential to reach SMEs and with the commitment to develop SME finance into a core part of their business. These will often be banks with wide branch networks or a regional basis, such as savings and cooperative banks.⁴² An effective strategy would be to provide technical assistance in the specific skills required for SME finance and to provide finance, on appropriate terms and maturities, to these financial intermediaries. Another option is the establishment of new institutions, e.g., regional equity or small-enterprise development funds. These funds could elicit sorely needed equity funding in combination with technical support for SMEs in the SEE region. Successful examples include the IFC’s Mekong Project Development Fund (MPDF) in Vietnam, Lao PDR and Cambodia. The MPDF is a facility (supported primarily by bilateral donor funds) to advise small- and medium-scale enterprises on preparing business plans and arranging financing for new investments, as well as investing in such enterprises.

4.19   Improving the SME Business environment. As discussed above, the costs imposed on SMEs by a hostile business environment are generally more severe than those suffered by larger firms. Thus, SMEs can also expected to greatly benefit from the establishment of an efficient and non-discriminatory investment framework, along the lines set out by the Investment Compact for the SEE region. In particular, the establishment of fair and transparent tax systems, and a regulatory framework that allows SMEs to take advantage of the opportunities offered by privatization, could greatly contribute to the development of this sector. Strong commitment by the Governments of the region, on the one hand, and technical support and assistance from the international community, on the other, will be crucial. An active policy dialogue through IMF and World Bank-supported programs with authorities at different levels of government—since many obstacles are local in nature—would also help to realize these reforms. The establishment of business advisory councils, as called for under the Stability Pact, would make an important contribution to this process by ensuring that policy makers and international institutions receive feedback and proposals from the private business community.

4.20   Support networks. SMEs are at a disadvantage—often because of limited linkages with other firms, insufficient technical or financial resources, and lack of access to information—not only when starting up but also when entering new markets, or expanding their activities. Their support requirements are often specific to stages in a small business’ development cycle: how to transform ideas into business plans, how to find partners for expansion, etc. Assisting small businesses in "helping themselves", whatever the nature of the challenge, is a promising area for partnership between SEE Governments and the international community. The EU has been active in this field, as have several bilateral organizations and the proposed regional equity fund would also provide such support as noted above. Another example is the EU Phare program, which provides technical assistance to chambers of commerce and other business associations in transition economies. A different example is the German Business Cooperation Program which aims at the development of company-to-company linkages between German and foreign SMEs. The EBRD TAM program’s activities are a successful example of how managerial assistance can help steer SMEs through the challenges of adjustment. The recently created Balkan Enterprise Facility, supported by the IFC and the donor agencies of Austria, Canada, Germany, Greece, Netherlands, Norway, Slovenia, Sweden and Switzerland, plans to contribute to building managerial and technical skills and facilitating access to knowledge and information for SMEs. These examples must be built upon.

Capacity Building for SME Support and the Need for Grant Financing

4.21   An active policy for the development of SMEs—beyond improving the investment framework—requires significant investments in capacity building, especially in private institutions. Financial intermediaries and support networks require specific technical assistance to develop SME-specific skills; and micro-banks consume approximately US$1.5-2.5 million for the first two to three years before commercial viability is established. Corresponding needs for grant financing will thus be large; and while the EU, US and other bilateral donors have already made available significant technical assistance and cofinancing, further funding may become necessary. Flexible funding and disbursing conditions will greatly facilitate the administration of grants and reduce the organizational cost of TA utilization. Efforts on the part of the international community to simplify and harmonize their procedures for grant financing of technical assistance could thus greatly increase its speed and effectiveness. These results can also be obtained through initiatives to pool donors funding for technical assistance—as for example the Balkan Enterprise Facility mentioned above.

D.  The Role of Privatization and Private Participation in Infrastructure

4.22   As discussed earlier in this report, privatization has advanced significantly in South Eastern Europe, especially with regard to small-scale enterprises. The privatization of large- and medium-size enterprises has recorded less progress, and has generally benefited insiders; both results stem from the persistence of soft budget constraints and the reluctance of some countries to privatize "strategic" sectors—including public utilities, infrastructure and enterprises where large redundancies are expected. Overall progress—together with the growth of private enterprises—has resulted in the public sector accounting now for less than 50 percent of GDP in all countries except Bosnia and Herzegovina (where it still accounts for about 65 percent of GDP).

4.23   Public utilities and infrastructure—especially telecoms and power—are, however, sectors where rapid progress towards commercialization first and eventually privatization could yield very significant benefits. Financing needs for rehabilitation and modernization are in fact very large, and unlikely to be fully met by the public sector; in addition, sustained improvements in efficiency in these sectors—as needed to lower costs for consumers as well as businesses—require also the introduction of competition or at least contestability. International experience strongly indicates that—both to attract private participation and to translate it into benefits for consumers and producers—a sound regulatory framework, providing predictable treatment of investors and adequate contestability—is necessary. The international community can assist—and is already in the process of assisting—the countries of South Eastern Europe in the establishment of the appropriate regulatory framework, and additional assistance in this area should be given high priority.

4.24   The establishment and consolidation of macroeconomic stability, the implementation of trade liberalization, and improved access to EU and regional markets will offer new opportunities for higher growth and employment. Seizing these opportunities will require a dynamic private sector, willing to take the risk of investing and producing in SEE countries, and the mobilization of significant foreign investment.

4.25   The initiatives outlined in this Chapter are aimed at accelerating the development of a dynamic private sector in the SEE countries through the establishment of an efficient and non-discriminatory investment framework, active policies to promote SMEs, and an intensification of efforts to privatize remaining public enterprises and to develop private sector participation in the provision and financing of infrastructure. The role of the international community is to support these reforms and magnify their impact through regional initiatives. Several initiatives are already under implementation, but their continuation and intensification remain a priority, and will require increased financial resources as well as improved mechanisms for delivery of technical assistance and its financing.

³⁷   This Chapter draws extensively from documents prepared by the EBRD and OECD, as well as from work undertaken by the IFC.

³⁸   EBRD, Promoting Private Sector Led Growth and Integration in South Eastern Europe, An EBRD Perspective, September 1999 and subsequent implementation papers.

³⁹   Johnson/McMillan/Woodruff (1998).

⁴⁰   E.g., a survey of SMEs in Albania conducted by the EBRD in mid-1999, and evidence relating to Bosnia and Herzegovina (work by USAID and the EU Representative Office).

⁴¹   EBRD, Promoting Private Sector Led Growth and Integration in South Eastern Europe, an EBRD Perspective, September 1999 and subsequent implementation papers.

⁴²   The main focus should be on debt instruments, since this is the area in which the broadest immediate benefits can be obtained. However, a comprehensive approach should also cover equity instruments, which, while reaching fewer companies by number than many debt facilities, are usually associated with the provision of a highly intensive and hands-on form of support.

Table of Contents | Next-> Chapter 5: Social Inclusion and Social Change-Conditions for Peace and Prosperity in the SEE Region

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