Institutional Reform Progress to Date and Remaining Challenges in South Eastern Europe


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As shown in chapter 1's review of the economic trends in South Eastern Europe (SEE), output recovery and integration of the region into the world markets have been insufficient for sustainable growth. A successful transition process hinges on a well-functioning institutional environment for investment that safeguards property rights and contracts, supports dayto-day business transactions, creates jobs, accelerates poverty reduction, and helps integrate the region into the world economy.

To assess the progress of institutional reform and to highlight the remaining challenges, we present in this chapter an overview assessment of each of the four core issues that will be analyzed in detail in the book: competition, regulated infrastructure utilities, corporate ownership, and resolution of commercial disputes.

The chapter is organized as follows. First, we review in the aggregate the state of market institutions that influence the business environment in the eight countries that are the focus of this study (the SEE8). Next, we present a more disaggregated analysis of the institutional impediments and the reform progress to date of the eight governments in each of the four policy areas. The last section sets the stage for the in-depth comparative analyses in chapters 3 to 6.

Aggregate Assessment of the Business Environment in SEE

The snapshot analysis of the business environment in SEE based on the two European Bank for Reconstruction and Development (EBRD)-World Bank Business Environment and Enterprise Performance Surveys (BEEPS1 and BEEPS2) suggests that the 2002 investment climate in the region has improved in comparison with the climate in 1999. Figure 2.1 presents how the surveyed SEE8 enterprises perceived in 1999 and 2002 the relativePage 34 importance of policy-related problems in each of the four thematic areas described above. The responses of the enterprises are averaged by country and are normalized on a scale from 1 to 4, with 4 representing the most severe obstacle. The chosen graphical representation is particularly effective because it allows us to capture (a) intertemporal variations in the perceptions of the surveyed firms, (b) changes across and within countries with respect to each policy issue, and (c) the severity of the problems in the four areas of the study.


As figure 2.1 shows, access to regulated infrastructure utilities has significantly improved in the eight countries.1 Nonetheless, remnants from the old system, such as inefficient pricing, cross-subsidies, and lack of competition on the utilities market, have caused bottlenecks for the development of the private sector and have discouraged investment in SEE. Moreover, for countries such as Albania, access to regulated utilities still represents one of the major obstacles hindering expansion and growth of enterprises.

One striking observation from figure 2.1 is that, almost universally, corporate governance problems and access to financing remain rated among the most prevalent obstacles throughout the region. In the areaPage 35 of corporate governance, implementation of international accounting standards and financial audits has been the weakest in FYR Macedonia, Romania, and Serbia and Montenegro. This finding reflects a low level of transparency in privatization and a high level of state interference in FYR Macedonia and Serbia and Montenegro. For Romania, the finding is related to the low number of enterprises to adopt independent financial audits before 2003. A change in legislation at the beginning of 2003 required all companies listed on the Romanian stock exchange to adopt local accounting standards that are based on international accounting standards (IAS). Enterprises in Bulgaria and Moldova experience more obstacles in obtaining access to financing than the other countries in the region do. Financial regulation has been stringent with respect to bank lending in Bulgaria, especially after the crash of the banking sector in early 1997, and banks generally use more conservative methods in making loans now than they did during the period of lax lending before the crisis.

The business disputes data in figure 2.1 indicate that the judicial systems in the SEE8 have only slightly improved from 1999 to 2002. The region's weak institutional and governance capacity, including its inability to enforce its laws and regulations, is widely recognized. As the competition indicator in figure 2.1 shows, barriers to entry are also perceived as a major obstacle to business development in the SEE8. The problem is most pronounced in Albania and Moldova. There is limited cross-country variation in the area of exit barriers in the eight countries in 2002. The presence of subsidies and arrears has gradually declined since 1999, most likely because of an improved institutional environment, which includes the enforcement of bankruptcy and liquidation.

Figure 2.2, which is based on the EBRD transition indicators, shows the progress the countries have made in carrying out institutional reforms in each of these four policy areas during 1999 and 2002. Compared with the performance indicators shown in figure 2.1, the transition indicators in figure 2.2 show a somewhat stronger cross-country and intertemporal variance. The leaders in terms of institutional reforms are Bulgaria, Croatia, and Romania. FYR Macedonia and Moldova are still lagging behind but have made more progress than Albania, Bosnia and Herzegovina, and Serbia and Montenegro. Relatively speaking, FYR Macedonia has substantially strengthened its institutions to reduce barriers to entry and exit. In contrast, Albania, Bosnia and Herzegovina, and Serbia and Montenegro have made no progress on competition policy reform since 1999.

In the area of business dispute resolution, Bulgaria, Moldova, and Romania have adopted more comprehensive commercial legislation; these countries have the highest scores in the region (see figure 2.2). Albania and Bosnia and Herzegovina have also improved their commercial law frameworks to promote investment and growth; however, the observed progressPage 36 must be measured against poor initial conditions in 1999. As figure 2.2 shows, Romania has the highest rating on the infrastructure indicator for 2002, although Albania and Bosnia and Herzegovina have made the strongest steps forward in improving their infrastructure regulatory frameworks. In the area of corporate governance, the indicators in figure 2.2 suggest that much more effort is needed in all countries if they are to achieve substantial improvements in hardening budget constraints and promoting more rigorous and transparent financial accounting and auditing practices.


A comparative analysis of the two sets of indicators-the one derived from the perceptions of the business community through BEEPS1 and BEEPS2 (see figure 2.1) and the one reflecting the institutional assessment (see figure 2.2)-reveals two interesting features. First, policy seems to have been appropriately targeted on the underlying institutional problems. In the case of entry and exit, reforms appear to be more advanced in Bulgaria and Croatia, the countries where the obstacles are rated the highest (as evident in figure 2.1). Similarly, Albania and Bosnia and Herzegovina have targeted institutional reforms in the infrastructurePage 37 sectors in response to low access to utilities. Second, these countries appear to have carried out reforms to alleviate the barriers in ways that have limited effectiveness. This issue will be explored and presented in more detail in the following section.

Institutional Impediments to Investment and Growth

All eight countries face institutional impediments to investment and growth, but the severity is different in each country. In this section, we will discuss these impediments as they relate to the four core issues: competition, regulated infrastructure utilities, corporate ownership, and resolution of commercial disputes.

Interenterprise Competition

To encourage interenterprise competition, the SEE8 need to concentrate reform efforts in four areas: (a) eliminating impediments to business entry and growth, (b) hardening budget constraints and removing exit barriers, (c) strengthening the bankruptcy regime, and (d) reforming the tax code.


New small businesses, especially in trade and services, have emerged rapidly in the 1990s across the region. Entrepreneurs have engaged in small-scale, labor-intensive sectors of the economy such as textile, footwear, timber, and furniture making, often through subcontracting and processing for foreign firms. Many of these new firms were created through the breakup of larger enterprises and through the sale of smaller units as small-and medium-scale privatization picked up momentum in the second half of the 1990s.2

As noted in chapter 1, because of the layoffs caused by the transitional recession, self-employed workers (for example, sole proprietors) and employees in small and medium-size enterprises (SMEs) have, in the past decade, become the main new job drivers in the SEE8. For example, self-employed workers in Romania accounted for 25.4 percent of total employment in 2001.3 The share of the self-employed in the other countries is smaller, but still significant.

As figure 2.3 shows, throughout the region, job creation among the surveyed firms is significantly higher for de novo and privatized enterprises than for state-owned enterprises, which...

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