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

Chapter 6: The Need for Strong Institutions and Good Governance

6.1   Much of economic development, social inclusion and regional stability in the SEE region will depend on strengthening of institutions, governance and in consequence lowering the level of corruption. Gradual integration with the European Union will require significantly more mature institutional structures, which are able to satisfy the economic, political framework conditions of the EU and to implement the "acquis communitaire". Given the importance that the prospect for European association will assume for peace and stability in the SEE region (see Chapter 1), the emphasis that will need to be placed on institutional development necessary to gradually become a sufficiently reliable partner in the EU integration process cannot be overemphasized. Institutions also play an essential role in poverty alleviation, by assuring that public services are delivered to all members of the population, including the poor. And institutions that provide access and representation to all members of society are the underpinning for multiethnic, socially diverse societies to operate peacefully and sustainable. Institutional weaknesses are often expressed through conflicts around participation in policy decisions, around services to be provided to different ethnic groupings, and around the languages used. While most of the institution building efforts in a society will need to take place on a national or subnational level, strong institutions are the underpinning of any regional developments, including regional integration. Almost all regional or supranational policies, such as the EU "acquis communitaire" will need to be implemented through domestic institutions. Functioning domestic institutions are needed to effectively implement regional initiatives and policies.

6.2   Good governance is more than luck and tradition. Good governance comprises a set of hard to change institutions which structure political and economic life.⁵¹ The significance of these state institutions can be seen in their contribution to the development of a robust market economy, the part that they play in the management of public finances and the delivery of public services, and in the protection from arbitrary action that they offer for the citizen.

6.3   The importance which institutions are playing in assuring that competitive markets can function is now widely recognized. Despite the difficulties of gathering empirical evidence, there is a proven relationship between strong institutions and growth. Good governance in the form of public institutions and policies that enforce property rights and contracts, providing the underpinnings for creditor and shareholder rights, and the regulation of infrastructure and finance, while restraining corruption, is now widely recognized as a necessary condition for long-term economic growth. Recent empirical work quantifies the costs of over-regulation, corruption, and other manifestations of weak institutions in terms of foregone investments and growth.⁵² Since economic growth contributes to lower rates of poverty, there exists a positive relationship between good governance and poverty alleviation because of the impact of governance on GNP growth rates and, as illustrated in recent empirical evidence, because good governance can have some egalitarian effects.⁵³

6.4   Clearly, many transition economies have experienced severe difficulties in establishing market-supporting institutions, frequently due to a weak financial sector. However, it is in the core public institutions of the government, in the services that it provides and in the legal and judicial protection that it offers citizens, that institutional weaknesses have persisted most stubbornly. For minority groups, the failure of public institutions to achieve social inclusion contributes to a vicious circle of mistrust and arbitrary action.

6.5   Corruption is a manifestation of weak institutions and good governance and strong institutions which reduce corruption underpin poverty reduction and improvements in the quality of life. A large and statistically significant positive relationship can be found between corruption and poverty.⁵⁴ The economic costs of corruption have been well documented.⁵⁵ A Business Environment and Enterprise Performance Survey commissioned by EBRD details that more than in any other region, small- and medium-size enterprises (SME) report corruption as an important obstacle to business development. Relative to large businesses, SMEs suffer more from slow bureaucratic procedures and corruption. Many firms therefore prefer to work in the gray economy.

6.6   Studies also show that corruption has a disproportionate impact on the poor.⁵⁶ The poor are hurt directly when they must pay unofficially for health care, education, and civil registrations. They are hurt indirectly when the quality of services erodes and when the budgetary allocation to social services contracts.⁵⁷ The poorest may suffer the greatest for their inability to pay the necessary bribes.

6.7   This chapter argues that the institutional environment in SEE countries is poor and that significant efforts need to be made to facilitate institutional development in order to achieve progress in economic and social development. Data coverage on institutional development is weak for SEE countries. Where governance-related data is available that can be compared to international comparators, SEE countries seem to be below averages. Within the region, Albania and Bosnia and Herzegovina tend to score worse than Bulgaria, Croatia, Romania and FYR Macedonia. Data presented below draws from a variety of sources for quantitative measurements (World Development Report Survey of Enterprises 1997, the EBRD/World Bank 1999 Business Enterprise Performance Survey, Transparency International, KKZ, International Country Risk Guide, Heritage Foundation, IMF Global financial Statistics, and the International Telecommunications Union-see Annex 1 to this chapter for data sources and descriptions).

B.  Weak Public Sector Institutions - An Impediment for Private Sector Development

6.8   SEE countries have weaknesses in those public sector service functions, including credible and consistent regulation and infrastructure necessary for private sector development. According to the EBRD/World Bank 1999 Business Enterprise Performance Survey, the quality of the investment climate in Bulgaria, Romania, and Croatia (the only SEE countries included in the survey) registers in the bottom half of the transition economies. Croatia ranks just above Bulgaria, Romania has been ranked towards the very bottom. In the institutional infrastructure component, which measures perceptions of the Judiciary, Corruption, Street Crime and organized Crime, Croatia is rated 1.62 on a scale of 0 (major obstacle) to 3 (no obstacle), Bulgaria 1.49 and Romania 1.48. This compares to Hungary (2.34), Slovenia (2.23), Czech Republic (1.97) and Poland (1.7).⁵⁸ As Chapter 2 indicated, overall it is taxes and regulations that are viewed as one of the most important barriers to SME development. Business licensing is particularly problematic across the region.

6.9   The problem for investors is a combination of weak legal and judicial institutions, providing little confidence that contracts will be enforced, and over-ambitious policies that presume strong oversight mechanisms coupled with a robust and efficient judiciary. The continuing extensive involvement of the state in productive sector is not only inappropriate but also diverts public sector resources to the wrong type of interventions. Most of the productive sector remains in public ownership in FRY. Privatization of large scale enterprises has been slow to advance in virtually all SEE countries, with the exception of Albania, where most large scale enterprises have been closed.

6.10   A functioning financial sector is central to a market economy by enabling payments, savings and investment. The financial sector in Southeastern Europe remains comparatively underdeveloped in delivering these services of financial intermediation to the real economy. Based on EBRD Transition Indicators, the regulation of financial institution in the region received and average score of 2.2 on a scale of 1 to 4, compared to 1.8 for the CIS and 3.1 for CEE countries. Across the region, lending to the private sector is limited and banks are not fully playing their role as financial intermediaries. Banking systems in most countries remain dominated by a lack of competition; restructuring is hampered by slow privatization. As a result in many of the countries, the banking sector is highly concentrated and carries a high proportion of bad loans. Bank management in the region is often inexperienced in the core activities of providing credit in a market economy. Institutional weakness in the judiciary and law enforcement place constraints on commercial lending. For instance, commercial banks suffer from weak protection of creditor rights, in particular as it concerns their ability to collect collateral, discipline the management of firms in default on loans, or effectively pursue bankruptcy and liquidation through courts.

C.  Checks, Balances and Social Cohesion

6.11   Institutions that promote social inclusion have measurable benefits. There is strong suggestion that democratic institutions impact on poverty as measured in terms of infant mortality rates, literacy rates and other objectively measurable outcome indicators.⁵⁹ Inclusion at the community level also brings benefits. There is some evidence that participation in both local and national decisions helps improve the quality of projects⁶⁰ and on the welfare of vulnerable groups such as women and their children.⁶¹

6.12   Balancing diverse and competing interests is a key task of the state and inclusion is an important foundation. Social exclusion contributes to a vicious circle of poor governance, arbitrary state action and continuing mistrust. As noted in Chapter 5, poor property rights for sectors of the population encourages the retention or distribution of "temporary" rights as a perquisite for political loyalty which could reinforce the position of political leaders and contribute to polarized extremist politics.

6.13   Holding the executive to account rests on two foundations: answerability and enforcement. First, there must be some bodies or groups that the executive must answer to. Complaints about the behavior of the executive from the electorate, legislature, interest groups, judiciary, political parties, procurators office, the media, audit body, civil society groups, local government and the donors must matter. Second, the executive must be required to change course in certain circumstances. If the answers that it provides are not seen to be satisfactory then, in some situations, it must be possible to enforce alternative behavior. Those levers provide the foundations for horizontal accountability, or relationships between the executive and those players of more or less equal power, and vertical accountability, or relationships where power is predominantly on one side. In developed democracies vertical accountability is provided by the electorate, and by competition for resources between levels of government. The legislature and the judiciary provide formal horizontal accountability, but crucially, informal horizontal accountability is provided by NGOs, interest groups, and an informed media.

6.14   As a region, South Eastern Europe is not homogenous. However it is the general weakness of civil society and the independent media, combined with other weak state institutions, which provide public officials the opportunity to promote their own interests, or those of friends or allies, at the expense of the general interest.

6.15   There are some promising examples of country-level actions in increasing oversight of government by the business community through regional and national trade associations. The development of regional networks of supreme audit institutions is a promising initiative. There are some groundbreaking attempts by civil society groups, such as Coalition 2000 in Bulgaria, which has developed a common program of practical actions, with active participation of government and national NGOs.⁶²

6.16   Civil society could play an important role in helping to develop social capital. Stronger social capital in SEE countries is required in order to provide voluntary compliance with established laws, trust, cooperative behavior and basic codes of conduct. Social capital can be seen to be fundamental to the development of institutions. While weak social capital can undermine the functioning of institutions, strong institutions in themselves can also foster the development of social capital.⁶³

D.  Building a Stronger Public Sector

6.17   Corruption is one of the symptoms of weak public institutions. Poor service quality and erratic regulation is equally a product of a weak institutional base.

6.18   The degree to which governments can not achieve consistent policies in the face of conflicting political interests can be seen in the differential performance on some basic indicators of reliable policy.

6.19   Improvements in service delivery and policy-making will emerge from three key sets of institutional reforms: (i) reforms in the budget process; (ii) improved public administration and civil service; and (iii) reforms in the legal and judicial systems to assure the rule of law and to provide a check on arbitrary state action.

6.20   Improvements in the institutional arrangements for budget formulation and execution are fundamental. In common with the wider region, especially FSU, countries in the South Eastern Europe have generally found it difficult to establish a process of budget formulation that establishes genuine policy contestability. Reform of budget preparation requires shifting central agency responsibilities from a central planning and control function, to a role in which aggregate fiscal discipline is maintained both in budget formulation and execution and a less directive, more collaborative process is developed to encourage bottom up preparation of policy and budget options, from sector agencies and policy units. The story is mixed on the former but fairly uniformly weak on the latter.

6.21   Transparency in budget execution is essential. The successor states of former Yugoslavia have shown a range of divergent paths out of the ZPP system, which previously carried responsibilities for treasury functions, payments systems, some statistical functions, and interface with parastatals, among others. Some countries have attempted to develop treasury systems as stand alone agencies, while removing the payments system responsibilities that belong to the central bank and banking sector, while others have aimed at a more conventional treasury function within the central Finance ministry. In most cases there have been some common problems in establishing treasury operations as a transparent, non-discretionary function that are focused purely on implementation of an approved budget. The broad institutional objective does not differ from non-Yugoslav cases (e.g., Albania) but there are some distinctive features of the task of dismantling the ZPP system.

6.22   Public institutions can only function with a strong civil service and functioning public administration. Civil servants need incentives for adequate performance, which requires the establishment of merit-based bureaucratic career paths. Many of the civil services in the region lack a structured civil service, established and managed according to merit principles and evaluated according to performance and not subject to arbitrary political interference. Size, as far as the limited data indicates, is not a particular problem, but salaries are.

6.23   In relation to legal and judicial reforms, considerable progress has been made across the SEE region in designing a legal framework. In the case of commercial law, an extensive legal framework is in place in most SEE countries (with the exception of Albania and Bosnia and Herzegovina), although some fine-tuning is still needed. However, the enforcement arrangements remain an area of concern. Court proceedings often remain time-consuming and inefficient. Regulators often fail to use their enforcement powers against liquidators, directors, banks, and other financial intermediaries. Failure to take prompt corrective action, coupled with time-consuming court proceedings, means that creditors, investors and shareholders are often left with nor real or effective legal recourse. Poor contract enforcement has supported a "non-payment culture".

6.24   A regional center for judicial training could build on the experiences of the regional working groups on legal approximation established under the Cooperation Agreements in Albania and FYR Macedonia. The Council of Europe and other have highlighted the significance of regional training for judges, and the potential of networks of Presidents of Supreme Courts.

6.25   Monitoring of corruption and other key aspects of government performance must be stepped up. There is a growing consensus that corruption in all its forms must be identified and credibly deterred. However, in addition to deterrence there could be some positive incentives provided for government progress towards stronger institutions that conform more to EU and OECD norms. Based on indicators available, corruption in SEE countries is high. The Transparency International Corruption Perceptions Index places-among a total of 99 countries ranked-Bulgaria, FYR Macedonia and Romania on country rank 63, Croatia on rank 74 and Albania on rank 84. This compares to Slovenia (rank 25), Hungary (rank 31), Czech Republic (rank 39) and Poland (rank 44).⁶⁴

6.26   Important programs to combat corruption in the region are already under implementation. A comprehensive program has been formulated in Albania after the completion of a survey on corruption. This program is presently under implementation. Corruption surveys and programs are being prepared also for Bulgaria and Bosnia and Herzegovina. In Bulgaria, this will supplement and support the Government's own program and the survey work undertaken by Coalition 2000.

6.27   Under the Stability Pact an Anticorruption Initiative has been announced during the OSCE summit in Istanbul in November 1999.⁶⁵ The Initiative defines three different objectives: (i) economic objectives; (ii) public integrity objectives; (iii) civil society objectives. The different objectives provide for catalogue of different measures to be taken.

6.28   The institutions which comprise 'governance' can be characterized in three broad groups. There are institutional arrangements that in effect make up the basic architecture of the state. These include the relationships between the executive, legislature and judiciary, and the arrangements for the transfer of power between successive governments including voting arrangements and electoral laws. There is every reason to believe that these institutional arrangements are fundamentally involved in creating or preventing corruption, even though it is difficult to point to the exact linkages.⁶⁶ There is also a series of institutional arrangements that are more technical and potentially 'tractable' through external interventions. These include public expenditure management arrangements and budgetary processes, inter-governmental relations including fiscal transfers, civil service pay and personnel management and legal and judicial arrangements. In addition there are the institutions of civil society, the NGOs and the media, that place pressure on governments to improve accountability.

6.29   There are two clear lessons from experience with governance reform: institutional reform is very difficult, and even the seemingly 'tractable' institutions such as budgetary processes or legal and judicial arrangements are hard to fix.

6.30   These difficulties arise, in part, because reform arrangements are often technically complex and can fail in any number of ways.⁶⁷ More noteworthy is that all institutional and governance reforms upset prevailing interests. Interests presently vested in the status quo understandably will oppose changes likely to adversely affect them. Resistance can come from civil servants that feel threatened by a loss of influence, or interest groups that fear that their normal points of access to influence will be cut off, or legislators in some settings who will worry that reform will enhance executive power and thereby diminish their own.

6.31   In summary, although governance reforms are generally described in terms of efficiency, they are not Pareto optimal: they produce losers as well as winners. The typical makeup of these would-be winners and losers can give rise to a daunting collective action problem. Institutional reforms tend to impose direct and immediate costs on relatively small, privileged groups that can be expected to act collectively in defense of their interests. Meanwhile, the same reforms promise only uncertain benefits to a dispersed and unorganized population. Compensating the losers may be a way out of this political dilemma. However, reforms designed to enhance economic efficiency tend to come at the expense of instruments that facilitate political consensus, including the side payments available to cut deals and pay off otherwise recalcitrant players. Despite these commonly observed difficulties, reform of 'state architecture', 'tractable', and 'civil society' institutions is possible. But there are three important caveats concerning participation, ownership and information.

6.32   Participation within government is important. Engaging effectively with the arrangements concerning these three types of institutions within government requires a constituency for change. Beyond the usual rhetoric concerning political will, it is crucial to build partnerships with those who must implement the reforms. The participation of key players (court clerks in the case of judicial reform, senior officials in the case of changes in employment arrangements, etc.) is key.

6.33   Participation from civil society and the service recipients and stakeholders is crucial. Placing pressure on government to perform requires building constituencies among those that would benefit most from improved services. International partners and donors cannot invent and sustain genuine grassroots associations. However, donors have demonstrated an ability to empower the "voice" of established or incipient groups by brokering discussions with government representatives, and facilitating contacts with like-minded domestic and/or international counterparts.

6.34   Participation rests on information-transparency matters and indicators can be a powerful device for conveying information. Information is essential for interested parties within and outside government to reach consensus about the nature of a governance problem and agreement over how to measure improvements. For both government officials and stakeholders, a modest but credible and regularly published set of indicators provides some benchmark data against which they can judge their own experiences and assess concrete improvements. Only with adequate information will it be possible to benchmark progress in governance reforms and guard against program "capture" by societal groups that were not the program's intended beneficiaries.

6.35   Broadly speaking, beneficiaries care about performance and public officials care about the institutions. The trick is to find indicators that will have resonance with these different constituencies. The indicators should ideally respond in a timely fashion to improvements in governance, and be relatively resistant to manipulation or distortion from extraneous events.

6.36   The development of a set of agreed measures and indicators to monitor progress in the implementation of such measures would help in assessing institutional progress in the region. This would respond to the reality that data in the SEE regions is sparse, and would provide a common set of targets to aim for. This would be accompanied by continuing determined focused assistance for priority institutional reforms such as budget management.

6.37   This section proposes four concrete sets of actions. First, on the premise that the Pact can only meet its aims if it has, and is seen to have, effective monitoring capacities, it outlines how an innovative 'governance measurement' program could be developed by the international organizations and Governments collaborating through the Stability Pact. It outlines how eye-catching but robust measures can be developed in relation to 'state architecture', 'tractable' and 'civil society' institutions and then widely publicized. It also suggests how these might be used to provide incentives on governments towards reform.

6.38   Second, it proposes that a basket of regional advisory services be provided through the Stability Pact, although undertaken on the ground by the International Financial Institutions and other donors and partners. These services would be provided to governments at their request, and could include experts review panels on legislation, a regional procurement advisory office, a regional training facility for senior officials, and a public audit regional support team.

6.39   Third, it proposes that regional and national technical assistance programs be coordinated through the Stability Pact. This would require a light touch as there are many diverse activities and donors would resist additional levels of negotiation. However, the scale of technical assistance that is and will be flowing into the region is such that the risk of overlap and lack of coordination is considerable.

6.40   Finally, this section proposes that a rapid start be made on the governance measurement program. The World Bank is offering collaboration with two key donor partners in an Institutional and Governance Review for the region. This analysis could launch the first set of indicators on a regional governance web site within six months.

6.41   The first action proposed is that the international organizations and Governments from outside the region involved in the Stability Pact and in the associated Anti-corruption Initiative develop and widely publicize a common set of indicators and benchmarks. The explicit intention will be to provide maximum publicity to performance measures and indicators of institutional progress, encouraging comparison between countries and over time. International organizations and Governments may in time wish to link some of their technical and other assistance to improvements in key measures. Donor coordination mechanisms might be developed around the indicators that provide incentives for more rapidly reforming countries.

6.42   The framework proposed is that a common set of indicators of government performance and institutional progress are prepared and extensively publicized under a 'governance measurement' program. Government performance indicators relate to services and interactions with government that the public and businesses directly experience, while indicators of institutional progress are intrinsically more technical and likely to interest government officials more than civil society. These indicators of institutional progress will not remove the role that judgments play in assessing institutional reforms.

6.43   The costs of launching this 'governance measurement' program would be modest, particularly if the emphasis on data collection is in self-reporting by governments, with the burden of proof falling on the country in the event that any data is challenged by any of the Stability Pact members. However, the cost is not insignificant and operational funding will be necessary to support the key monitoring functions including both active monitoring functions (undertaking surveys, etc.) and passive (e.g., receiving appeals).

6.44   Annex 2 to this chapter provides an illustration of the measures that would be developed and publicized. It shows some likely indicators for the 'tractable' institutions. Robust methodologies already exist for the majority of these indicators and some international comparative datasets are available. Similar indicators would be constructed for the 'state architecture' and 'civil society' institutions. The Annex also shows the methodology for the institutional measures and the growing international constituency for their development and use, coordinated via the Development Assistance Committee of the OECD.

6.45   On the second proposal, the basket of essential regional services be provided directly through the Stability Pact could include expert review panels on legislation with capacities to respond to government requests for the review of laws, regulations and amendments to ensure compliance with Stability Pact objectives. A regional procurement advisory office, could assist in guiding procurement for major and regional purchases and develop procurement capacities in countries.

6.46   In addition a regional joint training facility for senior officials could provide a much-needed boost to the development of professional public services. By providing a multi-country facility for training at very senior levels in administration and policy development, this institution could encourage convergent policies could assist in building communication channels among civil servants of the respective centers of Government.

6.47   A Public Audit Regional Support Team could respond to the reality that the process of creating an Independent Supreme Audit Institution has proved difficult throughout the region. Such a Support Team could be called on by the existing state audit bodies or governments in response to immediate concerns and could assist in both filling the immediate needs for technical assistance, and developing state capacities in the longer term.

6.48   The third proposal is that regional and national technical assistance programs be coordinated through the Stability Pact. As noted, this would require a light touch as there are many diverse activities and donors would resist additional levels of negotiation. However, the volume of technical assistance that is needed by governments in relation to issues as diverse as policy formulation and policy coordination, governmental information systems, capacities of national Parliaments, budget execution and procurement, civil service management, and capacities at sub-national levels of government suggests that then risk of overlap and lack of coordination is considerable.

6.49   Finally, and as a kick start to the development and explicit use of measures of institutional progress to provide incentives for reform, the World Bank is proposing to undertake a regional Institutional and Governance Review, in collaboration with two key donor partners. The results from this political economy and institutional analysis would launch the first set of indicators on a regional governance website.

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