Institutional Aspects of the South Eastern European Economy: Introduction, Trends, and Scope of the Study


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Accelerating growth and reducing poverty through the establishment of a stable, transparent, and uniform investment framework are key to restoring and consolidating peace and stability in South Eastern Europe (SEE). Low levels of domestic and foreign investment have constrained economic development in the region. Evidence from enterprise surveys and diagnostic studies, as well as from many anecdotal sources, shows that the cost of doing business in SEE is too high and discourages private investment.

South Eastern European countries and their development partners have recognized explicitly the importance of improving the investment framework in the region. All of the beneficiary members of the Stability Pact-which is a political declaration of commitment and a framework agreement on international cooperation among more than 40 partner countries and organizations-have committed to developing a shared strategy for stability and growth in SEE.1 As part of the Stability Pact, the countries of SEE intend to implement the Investment Compact, which includes important legislative and administrative commitments for advancing the region's economic and business environment.2 Improving the investment framework in SEE not only is important; it also is urgent for two reasons. First, the European Union (EU) has greatly expanded trade access to the single European market, both for the accession countries (Bulgaria and Romania) and for the five western Balkan states (Albania, Bosnia and Herzegovina, Croatia, the former Yugoslav Republic of Macedonia, and Serbia and Montenegro) and Moldova. Simultaneously, liberalization of intraregional trade has gained new momentum with thePage 2 signing of the Memorandum of Understanding on Trade Liberalization and Facilitation by Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Serbia and Montenegro, and Romania. Only if investment increases substantially will it be possible to seize the opportunities created by these developments.

The second reason for urgency is the close association of high unemployment rates and insufficient job creation with high rates of persistent poverty throughout the region, which endangers social stability and could thus undermine the prospects for growth.

In the study that is the focus of this book, we analyze eight countries (the SEE8): Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Romania, and Serbia and Montenegro.3 We cover the institutional impediments to investment and private sector development in the SEE8 and suggest policy reforms to ease these constraints. The premise of the study is that an institutional framework that is favorable for domestic and foreign investments is essential to achieve sustainable growth and alleviate poverty in the region.

In this chapter, we describe the recent economic trends in the SEE8 and their prospects for international and intraregional integration. We present our understanding of the role of the institutions and economic environment that affect enterprise development and growth in the SEE8 and describe the objectives, scope, and organization of the study.

Trends in the SEE8 Economies
Dynamics of Output by Sector

The recent progress in privatization and structural reforms in South Eastern Europe indicates that the region has recovered from the deep and lengthy recession of the 1990s. Most of the economies of the region have experienced relatively sustained growth, although in some cases that growth is still somewhat fragile, especially since the end of the Kosovo conflict in 1999 (see table 1.1).


Most of the 1990s were characterized by dramatic collapses of output. The occasional periods of economic stability were backed by subsidies to the state-owned industrial sector, which increased fiscal and current account deficits, or by extensive borrowing from abroad. In 2001, the SEE8 had reached only 74 percent of its pretransition (1989) level of economic activity.4 In comparison, in 2001 the five most developed Eastern European transition economies (the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia) had recovered and grown to a combined output of 115 percent of 1989 levels. Despite the slow and erraticPage 5 recovery in output since the fall of the socialist regime, by the end of the 1990s, growth rates in the SEE8 had been restored. In 2002, the region grew 4.2 percent, on average-faster than the 2.5 percent growth rate of the world economy. For 2003, the average regional growth for the SEE8 also was positive, at 3.5 percent (EBRD 2003).


The economic rebound of the SEE8 has been fueled primarily by private means as resources have moved from the state to the private sector. In 2002, the private sector generated at least one-half of the output across the region, except in Bosnia and Herzegovina and Serbia and Montenegro (see figure 1.1). The privatization of large-scale enterprises advanced slowly for most of the 1990s, which suggests that the emerging private sector and the small and medium-size enterprises (SMEs) were the vehicles of recent growth in the SEE8. Although SME privatization has been completed in most of the countries in the region, in Bosnia and Herzegovina, Moldova, and Serbia and Montenegro, ownership divestiture programs are still under way (EBRD 2002). At the same time, the role of foreign aid and loans has declined even in the western Balkans, where it constituted aPage 6 small share (7 percent) of the five countries' gross domestic product (GDP) in 2002 (European Commission 2003b, p. 10).


Despite progress with initial reforms such as small-scale privatization, price liberalization, and foreign exchange and trade liberalization, industrial output in the SEE8 has recovered on average only 45 percent of its 1989 level, except in Bosnia and Herzegovina, which registered only 12 percent recovery of its 1989 output level (UNECE 2002). Before the fall of the socialist regime, the industrial sector generated most of the output in these countries. However, traditional industrial sectors, such as base metals, textiles, footwear, and food processing, declined in many of the SEE8, partly because of the market transformation and the lack of competitiveness of many export sectors, and partly because of the war and regional conflicts of the Yugoslav succession. The failure to attract domestic and foreign investment has left large-scale manufacturing, especially the heavy industries such as metallurgy, heavy-machine building, and mining, with outdated equipment and technology. This lack of up-to-date technology has hampered the competitiveness of the region's industrial products.

Although the recovery of the industrial sector in the SEE8 has been anemic, in the past decade small-scale manufacturing has remained a major component of output. The recent industrial recovery throughout the region was led primarily by the export-oriented light industries for consumer goods such as food and beverages, textiles and clothing, leather goods and footwear, light machinery and equipment, chemical products, wood products, and electrical appliances.

The construction industry also grew in parts of the region. In the 1990s, it became one of the most dynamic sectors of the economies of Albania and Bosnia and Herzegovina. However, because it was funded primarily by remittances and foreign aid for rebuilding the countries that suffered from regional conflicts, the sector became heavily dependent on foreign projects. Construction financed by the domestic private sector in Bosnia and Herzegovina, for example, has been negligible since the war there ended in 1995 (EIU 2002). In the rest of the region, the construction industry was hit by the transitional recession but mostly recovered and grew in the late 1990s.

The acute need in the SEE8 for improvements in physical infrastructure, housing, and tourism suggests the potential for further development of the industrial sector, but growth in the region will require a favorable investment climate.


Agricultural output also shrank during the first decade of market transformation in the SEE8. On average, the agricultural sector made up lessPage 7 than 18 percent of GDP in 2001. Albania and Moldova were the only countries among the eight where agriculture represented a larger share of output in 2002: in Albania close to 33 percent of GDP, and in Moldova 25 percent of GDP (see table 1.1). The high level of agricultural output in both countries is due not only to their large rural populations, but also to the slower progress in the development of the services sector and industry restructuring. With the notable exception of Albania, agricultural labor productivity also declined substantially in the region since 1990.5

Although agricultural prices were liberalized early in most of the SEE8, the agricultural sector throughout the region suffered from a reform policy stalemate and from neglect. The decomposition of agro-industrial cooperatives and the restitution of land were often disrupted by political controversy regarding divestiture strategies and the pace of the process. Only in Bulgaria and part of Romania was restitution-the return of farmland to precommunist owners-used as a privatization strategy. In Albania, Moldova, and the remainder of Romania, a distribution strategy allocated farmland to either collective farm workers or the whole population.6 In the countries that emerged from the former Yugoslavia, privatization of land was not required because farmland was privately owned before 1990 (EBRD 2002...

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