Doc. 8758

7 June 2000

European Bank for Reconstruction and Development (EBRD) and the progress of transition

Report

Committee on Economic Affairs and Development

Rapporteurs: Mr Jelko Kacin, Slovenia, Liberal, Democratic and Reformers' Group and Mr Stathis Kittis, Cyprus, Liberal, Democratic and Reformers' Group

Summary

For most of the 26 countries of operation of the EBRD, the transition to a market-based economy and pluralist democracy continues to be a painful and difficult undertaking, says this report. The Bank’s assistance to them therefore remains of great value, given the magnitude of the reform process, the long way remaining for some countries, and the new challenges ahead for the more advanced, especially the candidates for European Union membership. Poverty, social hardship and widening income inequality continue to beset many countries.

The Bank’s financial results in 1999 recovered significantly relative to 1998, the year of the Russian financial crisis. Maintaining this situation by finding the right balance between the geographical spread of projects and profitability will remain one of the EBRD’s key challenges in the years to come.

An important lesson from the first decade of transition is that economic crime, corruption and disregard for the rule of law can jeopardise the entire process. These evils, which largely result from weak state institutions, lead to flawed investments and hampered growth. Continued struggle against bribery, corruption and economic crime is therefore necessary, the report concludes, not least through intensified cooperation between the EBRD and the Council of Europe.

I.       Draft resolution

      1.        The Assembly has taken note of the report prepared by its Committee on Economic Affairs and Development on the activities of the European Bank for Reconstruction and Development (EBRD). It commends the Bank on its consistent, decade-long effort to assist the countries in transition in central and eastern Europe, as they steadfastly pursue a difficult overhaul of their economies and seek to perfect democracy in recognition of its vital importance to lasting development. Such assistance is of continuing value given the magnitude of the reform undertaking, the long way remaining for some of the countries of operation, and the new challenges facing those further ahead, especially those set to join the European Union. Poverty, social hardship and widening income inequality continue to beset many countries in the region.

      2.        The Assembly welcomes the Bank's increased emphasis on the building of strong public institutions and administrations capable of supporting markets and private enterprise, and its recognition that economic crime, corruption and the disregard for the rule of law will seriously jeopardise growth by distorting decisions and competition and by undermining morality. The EBRD and the Council of Europe should further intensify their co-operation in this field, which is increasingly considered as a top priority by the international community.

      3.        The EBRD's increasing focus on the promotion of new companies and the growth of small and medium-sized enterprises (SMEs) is to be welcomed, as are its support of local banks with an SME orientation and its close co-operation with local and regional partners. The Bank thus recognises not only the role of SMEs as the driving force behind innovation, growth and popular involvement in market reform but also the need to ensure a level playing field for their creation and development. To achieve this goal and speed up technological development in transition countries, the EBRD should widen its focus so as to also promote cooperation between SMEs and universities.

      4.        EBRD countries of operations depend vitally on strong growth in the developed market economies, especially in nearby western Europe. The Assembly therefore calls on the latter to pursue and accelerate their own structural reform process thereby permitting such growth to take place, and to refrain from any measures harmful to trade with countries in transition. Remaining trade barriers have to come down, especially in metals, textiles, mining and agriculture, as well as those resulting from unjustified or arbitrary anti-dumping duties.

      5.        The Assembly notes with satisfaction the Bank's recovery from its financial exposure in the wake of Russia's 1998 financial crisis, leading it to sign, in 1999, 88 projects totalling €2.2 billion in the totality of its 26 countries of operation. It underlines the Bank's sober conclusion from this experience that even the soundest project cannot succeed unless the state reliably discharges its administrative, legal and judicial role –and there is a proper macro-economic and social framework.

      6.        The Bank's operations must therefore increasingly be directed toward encouraging host country policies conducive to such a state of affairs. They include clear, non-discriminatory and stable business legislation; the overcoming of corruption and economic crime; the promotion of good corporate governance; enterprise restructuring; a strengthening of fiscal systems; and the building of an adequate social safety net.

      Russia plus eastern Europe

7.        Russia and eastern Europe may well be reaching a turning point in the transition process, provided structural reform, institution-building and the fight against economic crime and corruption can be pursued with the necessary resolve and lead to the restoration of confidence and credibility at home and internationally. It is therefore important that the Bank, a high-profile foreign participant of the transition, should remain committed to Russia and the countries of eastern Europe as a long-term, reliable partner. Building on its unique mandate and experience with transition, the Bank’s strategy should be to give comprehensive assistance to Russia and the countries of eastern Europe permitting the current credibility and confidence crisis in these countries’ social and economic life to be overcome. The Bank should, however, be particularly circumspect in its selection of projects and partners, so as to ensure good business conduct, implementation of commitments and a positive impact on the country's overall transition process.

      Southeastern Europe

8.        The Assembly welcomes the EBRD's position as the most important source of, and lead agency for, private sector finance in southeastern Europe. Considering the importance of private sector development for the realisation of the Stability Pact for the region, the EBRD therefore has a major role in assessing investment risks and opportunities also for others. In so doing, the Bank could usefully draw on experiences gained from its Foreign Investor Advisory Councils in Russia, Kazakhstan and Ukraine.

9.       The Assembly supports the Bank's 'bottoms-up' approach in south-eastern Europe, emphasising a better investment climate and support for SMEs, notably through setting-up micro-finance institutions, building SME finance capacity in local banks and an intensified policy dialogue to help reduce impediments to SME development. It encourages the Bank to commit itself more strongly to building up an equity portfolio in companies and local banks in order to promote good corporate governance.

10.        Governments throughout the region must do much more than has hitherto been the case to create the conditions under which the private sector will invest. The Assembly, in this context, recalls its Recommendation 1423 (1999) on South-eastern Europe: Economic reconstruction and renewal and its follow-up Colloquy "One Year of Stability Pact for South-Eastern Europe: The Way Forward" held in Dubrovnik in May 2000. Such conditions include:

i. transparent and effectively enforced laws protecting property rights;

ii. a tax system that raises resources without punishing honesty and success;

iii. administrative practices that minimise scope for corruption and cronyism and ensure a predictable and stable business environment.

11.        The Bank should tackle even more intensely the transition challenges related to cross-border co-operation, wherever possible in co-financing with other international financial institutions. Intra- and inter-regional infrastructure and development of trade facilitation should be a priority.

12.        The Bank should also develop a co-ordinated approach with the World Bank and other international financial institutions as well as with the European Union, in order to encourage the governments of the countries concerned to protect and enhance social and environmental priorities during economic restructuring.

13.        Finally, the Assembly encourages the Bank to reconsider its policy vis-à-vis the Montenegrin Government, in particular through the extension of existing cross-border investment projects into the territory of Montenegro, and by using grant financing in lieu of the Bank's own funds for project preparation as well as legal, regulatory and training projects.

II. Explanatory Memorandum by the Rapporteurs

Contents

I       Introduction

II.       Ten years of transition: lessons and prospects

III       Implementation of the Bank’s new priorities and the EBRD’s key role in the Russian transition

IV.       The role and mission of EBRD in the economic renewal of south- eastern Europe

V.        Concluding remarks

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I. Introduction

1. The European Bank for Reconstruction and Development (EBRD) was established in 1991. According to Article 1 of the Agreement establishing it, the EBRD's aim is to foster the transition towards open, market-oriented economies in central and eastern Europe as well as in the successor republics of the former Soviet Union. It is also to promote, through tailored investment strategies, private and entrepreneurial initiatives in countries committed to and applying fundamental principles of democracy and the market economy.

2. The EBRD has sixty members: 58 member countries and 2 institutions (the European Union and the European Investment Bank). Its main areas of action are the promotion of the private sector, the restructuring of financial institutions, the strengthening of the legal system and the development of the infrastructure necessary to support countries at different stages of their transition process.

3. In implementing its mandate, the Bank focuses on investing in the private sector, but it also takes into account the fact that a functioning market economy has to be supported by an effective institutional framework. Thus, the Bank's investments have to further the process of economic adjustment and institution building¹ in the region. In other words, projects have to have a "transition impact”.

4. At the initiative of the Committee on Economic Affairs and Development, a co-operation arrangement was concluded in September 1992 between the Parliamentary Assembly and the EBRD. The arrangement in particular foresees annual visits by the committee (together with representatives of certain other Assembly committees) to the Bank's headquarters in London for exchanges of views with the EBRD’s President and senior officials; the participation of the Bank's President in an annual debate in the Assembly on EBRD activities; and the exchange of information between the Assembly and the EBRD.

5. Since the conclusion of this co-operation arrangement, the Assembly has given its steadfast support to the EBRD in its effort on behalf of transition and has made numerous suggestions to it. Furthermore, the Assembly’s regular monitoring has permitted all of parliamentary and political Europe to gain a better understanding not only of the Bank’s activities and evolution but also equally of the overall development of the region where it is active.

6. At its meeting at EBRD headquarters in London in January 2000, the Committee on Economic Affairs and Development focussed on such things as the challenges of the new stages of transition started by the several countries of operations and their impact on the Bank’s activities; more specific issues such as EBRD’s response to the Kosovo crisis; and the implementation of the Bank’s new priorities.

7. The Rapporteurs are sure they express the feelings of the whole Committee in thanking the Bank’s former President, Mr Horst Köhler, most warmly for the excellent welcome he and his colleagues gave us on this occasion and for the very fruitful discussions we had with them. They also wish him every success in his new function as Director General of the International Monetary Fund. The Rapporteurs also had the opportunity to meet with several officials of the Bank outside the Committee's official meeting. In addition, one of your Rapporteurs, Statis Kittis, on the Assembly’s behalf attended the Annual Meeting of the EBRD held in Riga on 21 and 22 May. All these talks and events have fed into the present report. Finally, the Committee warmly congratulates the Bank’s new President, Mr Pierre Lemierre of France, on his appointment to succeed Mr Köhler and looks forward to meeting him in person.

II.       TEN YEARS OF TRANSITION: LESSONS AND PROSPECTS

8. Many a pessimistic forecast made of a year ago have not materialised, either for the global economy or the region. Not only is the world economy gaining further strength, but Central and Eastern Europe and the Commonwealth of Independent States as well has shown remarkable resilience against external shocks.

9. Even Russia's economy grew by 2% in 1999, marking the country's first period of significant growth since the collapse of communism. Of course, we know the main reasons for that: higher oil prices and a sharply depreciated rouble. Though Russian GDP is likely to grow by 2-4% annually over the next two years, the basis for sustainable growth remains weak and highly vulnerable to uncertain external conditions unless accompanied by more comprehensive structural reforms. (For instance, every $ 1 decline in oil prices leads to an estimated $750 million reduction in Russian export earnings, with a severe impact on budgetary revenue.) Without a sharp reduction in capital flight, Russia could still face debt-servicing difficulties over the next few years given the low level of international reserves. Thus there is still an urgent need for structural change and an improvement in the investment climate in Russia. However, the rapid pick up of industrial output has shown that private initiative and market forces have taken root in that country and are beginning to sprout.

10. According to EBRD forecasts, growth in the 26 transition countries as a group is likely to reach 5% by 2003. Moreover, there are transition countries such as Poland, Hungary and Slovenia that have achieved double-digit productivity gains over the past few years and are now expected far to outstrip the 5% average. Investors see these well-advanced countries as stable places to put their capital. In some of these countries a rapid adjustment is already well underway. For example, a recent EBRD study comparing manufacturing performance found that Polish private firms invested more than Spanish firms and that they are clearly exploiting the scope for catching up with countries with even higher productivity levels.

11. A careful assessment of the situation must of course go beyond these quantitative projections. The EBRD in its latest Transition Report takes stock of the past decade in its 26 countries of operation and the assessment is, on balance, positive. Ten years after the fall of the Berlin Wall one can see clear progress in the transition process. Faced with dramatic change and great uncertainty, the people in the region have on the whole demonstrated remarkable courage and determination to overcome the legacies of old regimes and to build a new market-orientated and democratic order. Exceptions such as Belarus and Turkmenistan are mere exceptions to the rule. There has been substantial progress in price and trade liberalisation, as well as in small and large-scale privatisation. In 20 of the 26 countries the private sector accounts for over half the aggregate output, while in countries such as Hungary, Estonia or the Czech Republic the figure is 80% or close to western European levels.

12. Most of central Europe's economies are now looking far better equipped to compete in the real world. The direction of trade has been fundamentally reversed, which helps explain why the economies once tied so closely to the Soviet Union proved so surprisingly immune to the Russian financial crisis of 1998. Another encouraging feature is the new free-market consensus. By the mid-90's the Czech Republic, Estonia and Latvia were the only ex-communist countries where ex-communists had not recovered power in government. Yet in none of them was the course towards privatisation and free enterprise abandoned. And all this from the most humble of market economy beginnings. When the transition started, most companies had virtually no accounts. There were no stock markets, no private banking system, no securities and exchange commissions, and virtually no mechanism for buying and selling property. In the Soviet Union there were not even public telephone books or street maps. In 1987 Mikhail Gorbachev daringly gave permission for three hairdressers in Estonia to go private. Now Russia has 900,000 small businesses.

13. However, any sober stock taking should not overlook the weak points of transition. Even in the most advanced countries, the process of restructuring old industries - such as coal, steel and agriculture - is sluggish. Yet, the less advanced countries still need to work on the basics: for example, to enforce the rule of law, to build up a sound financial sector and adequate infrastructure.

14. Indeed, for most of the countries in the region the transition to market-based economy and democracy has been earth shattering. It has also resulted in considerable loss of income and social hardship. Personal incomes, for example, have now recovered to the 1989 level in only four countries - Hungary, Poland, the Slovak Republic and Slovenia. In much of the CIS, especially Russia, incomes are barely half the former level. This represents a more significant deterioration in the standard of living than that suffered by the West during the world economic crisis of the 1930's.

15. This experience, coupled with the perception of at times extreme inequalities in the distribution of gains and losses from reform, has shaken the confidence of many people in the reform process. In this regard it is interesting to note that the European Commission's 1999 survey showed that the level of dissatisfaction with the transition was as high as 76% in Russia, 72% in the Czech Republic, 67% in Slovakia, 66% in Hungary and 61% in Poland. This could prove to be a source of political fragility.

16. Weaknesses in transition manifest themselves not only in poorer economic performance but also in heavier social burdens. These have been particularly severe in Russia and Ukraine. Income inequality and poverty have increased in many parts of the region. Income differentials have widened considerably and in a number of countries the degree of inequality now approaches that of the most non-egalitarian countries in the world. This is most notably the case in Russia, where inequality is now comparable to some of the most non-egalitarian Latin American countries. Macro-economic instability has been a major factor behind the increase in income inequality in Russia, reflecting the vulnerability of people living on pensions and public transfers. Social conditions in Russia have deteriorated sharply as a consequence of the August 1998 crisis. In 1999, real wages declined by 20%, real disposable incomes fell by 15% and over 30% of the population were below poverty line (defined as $40 a month).

17. It is evident that every transition country has to define its own new 'social contract', and with it the balance between individual and collective responsibility. Accordingly, the history and culture of the particular country influence the development of institutions, rules and behaviour. It would not be credible, however, to suggest that different transition paths and transition results have been inexorably determined by history, geography or culture alone. At the end of the day, political will and the will of different political parties to work together toward a common goal have helped determine the outcome. True, countries with success stories like Poland, Hungary and Slovenia have had a better starting position. However, there are other examples, such as the Baltic States, which had started their transition with many structural features similar to those of Belarus, Russia and Ukraine. Their experience has strongly demonstrated the benefits of good policy reforms and an outward-looking orientation. Other countries were less decisive in implementing reforms and have lost precious time. They now face particularly great economic and social problems.

18. Another important lesson to be learnt from the past decade is that corruption and disregard for the rule of law pose grave problems for growth. They are mostly the results of weak state institutions, resulting in a flawed investment climate and unacceptable behaviour on the part of some individuals. Here lie the main obstacles to stronger economic growth in a number of the transition countries. Risks to transition stem not least from the kind of liberalisation and privatisation that have been implemented without enough attention paid to the regulatory environment or to corporate governance. This has encouraged behaviour facilitating tax evasion, capital flight, the looting of public resources and the disregard for the rule of law and good governance. Ultimately, cynical plundering by vested interests can destroy the social foundation of institutions and behaviour that supports markets and private enterprise.

19. As stressed by Mr Köhler, going forward therefore requires finding the right balance between the freedom of markets and an appropriate regulatory environment. Corruption is not just a problem in the "East". Too often one or the other Western partner is involved as well - despite the existence of various international codes of conduct such as the UN declaration against corruption and bribery, the Council of Europe's Working Group on corruption, the OECD's Working Group on bribery, the EU's policy against corruption, not to mention the recommendations of such private groups such as "Transparency International" or the "Centre for Innovation in Corporate Responsibility".

20. Clearly the world has done much to formalise an approach to combating corruption. The Rapporteurs believe that the international community should now make a new effort to take ownership of these rules and guidelines. A global economy will need a global ethical basis and these efforts should be taken for what they really are: the basis and sine qua non for sustained economic growth.

21. Building sound institutions that support markets and private enterprise therefore remains a fundamental challenge of transition. In this context Mr Köhler pointed to the specific problem of "state capture". The term commonly refers to the extent to which government policy-making is unduly influenced by a narrow set of interest groups. Russia's governance problems, for example, are often blamed on the so-called "oligarchs" who have urged the state to grant them privileges and exemptions that undermine market-orientated institutions at a high cost to the rest of the economy. States "captured" by powerful vested interests have a tendency to side-step reforms intended to improve governance and reduce distortions in the economy.

22. As was stressed in last year's transition report, a decade of transition has transformed the interaction between state and enterprises. The state no longer uses plans and commands to direct firms, but dealings between the state and firms nevertheless remain close. The EBRD survey shows that the process of "de-politicising" enterprises remains very incomplete in all transition economies. The reform process has resulted more in a change in the form rather than level of state intervention - or, for that matter, in the cost imposed on firms through the necessity to bribe and spend time with government officials.

23. The evidence has also shown that the degree of state "capture" by private interests is an important determinant not only of market reform such as privatisation and liberalisation, but also of quality of governance. States with weak central governments such as Armenia and Georgia have some of the highest bribe levels, the report says. However, companies in central Europe also often pay bribes, even if the payments are less important than in the former Soviet Union.

24. The transition report also suggests that weak institutions are a main obstacle to economic growth in a number of transition countries. Moreover, the absence of a well-functioning tax system, especially in the CIS region, places severe fiscal constraints on the state at a time when its need for a minimum of resources is at its most critical. More serious still is the level of state authority in many transition countries. Many governments face extremely low levels of public confidence and trust. This undermines their authority to establish institutions that can effectively alter the behaviour and practices of the population.

25. New firms are the driving force behind the economic growth in transition economies and concerted efforts should be made to create an even playing field for their birth and expansion. As Mr Köhler stressed before the Committee, policies for promoting SMEs are central to a successful transition. SMEs are a key source of growth and innovation and they impart flexibility to economies undergoing structural adjustment. By bringing capitalism "close to people" - into their neighbourhoods and homes - they are at the heart of economic, political and social transition. Their success is also vital to the restructuring of old enterprises and to the necessary "hardening" of their previously too loose budget constraints, particularly in the industrial and agricultural sectors. It is also important for building a strong domestic constituency in support of market reforms. By broadening the private sector, SMEs counter concentration of economic power and can thereby reduce the extent of "rent-seeking".

26. To ensure the durability of the market economy and democracy, the second decade of transition requires first and foremost further progress in institution-building and strong, sustained economic growth. The main responsibility for the first objective lies with the countries in transition themselves. However, for the achievement of the second objective western economies can make a crucial contribution. When Poland suffered a downturn in 1998 and early 1999, it was not so much because of the Russian crisis or through any fault of its own, but because of a fall-off in business with western Europe. Clearly, the best thing the West can do for the transition countries is to ensure their own sustained growth and to open their own markets.

27. In this regard, the Rapporteurs fully agreed with Mr Köhler that transition must be a two-way street. As the transition countries take steps to restructure, innovate and thereby expand their exports, the more mature economies of the West have their own work cut out for them. They have to dismantle significant remaining trade barriers, such as the arbitrary application of anti-dumping duties and other forms of protection, in particular in metals, textiles, mining and agriculture. There is an opportunity to create a "win-win" situation in Europe as a whole, provided that sustained progress in transition is accompanied by more reform energy also in the EU.

28. In this context, the Rapporteurs wholeheartedly support the decision of the EU Helsinki Summit of December 1999 to offer accession negotiations to a much wider group of candidate countries. This will give an enormous boost to the transition process. It will give new impetus to political change, require discipline in implementing reforms and provide a strong incentive for the creation of healthy democratic and market oriented institutions. It must only be hoped that the candidate countries will not neglect trade and co-operation with each other as a result of such a focus on the EU.

III        IMPLEMENTATION OF THE BANK'S NEW PRIORITIES AND ITS KEY ROLE IN THE RUSSIAN TRANSITION

29. The EBRD is a project finance bank with a public mandate. It is the biggest single investor in the transition countries. Although 1999 has been a difficult year for the Bank, its financial results have improved significantly relative to 1998. Recovering from the Russian financial crisis of 1998, the Bank in 1999 signed 88 projects totalling €2.2 billion. The Bank’s operating profit before provisions was € 203.6 million, resulting, after a €160.9 million provisioning charge, in a net profit of €42.7 million. This result compares with a net loss of €261.2 million in 1998. Some 50 per cent of commitments in 1999 were in the ‘early and intermediate’ transition countries (37 per cent in 1998) while advanced countries accounted for 40 per cent (same level than in 1998). Around 10 per cent were committed in Russia, significantly less than in 1998 (23 per cent), in reflection of the financial crisis.

30. In 1999 the Bank defined a new medium-term strategy, placing increased emphasis on the promotion of entrepreneurship and competition, with a particular focus on SMEs, the financial sectors and municipal infrastructure. In addition, drawing on lessons learned, the Bank is intending also to work on the investment climate, from the perspective of investors. EBRD is, for example, actively participating in foreign investment advisory councils in several transition countries. There are plans to move the Bank closer to the countries of operation by putting more bankers - or decision-makers - in the field. The business plan of the Bank for the next three years calls for annual investment in the transition countries of € 3 billion - which means the Bank will remain by far the biggest individual investor in the region for some time.

31. As part of its revised medium-term priorities, the EBRD continued its strong support of the financial sector by investing €735 million in 32 projects. In support of its new strategy for small and medium-sized enterprises (SMEs), the Bank provided credit lines to banks and equity funds for 'on-lending' to SMEs totalling €454 million. Micro-finance banks were established in Albania and Kosovo. New equity commitments were € 664 million, including investments in Armenia, Tajikistan and Ukraine, where projects are expected to have a significant impact on the transition process.

32. Identified as one of the EBRD’s key priorities based on its central role in the transition process, infrastructure accounted for approximately one-third of the Bank’s commitments in 1999, with €665 million devoted to 24 projects. The 12 new transport projects, worth €315 million, were mainly in the Baltic states, Ukraine, Moldova, the Caucasus and Central Asia. The Bank consolidated its support to the power and energy sector by investing €155 million in projects in Albania, the Baltic states, Georgia, Ukraine and Central Asia.

33. In its Resolution 1192 (1999) the Assembly called on the EBRD to re-examine its so-called policy of ‘unified pricing’, which is the practice of applying the same loan conditions to countries with widely different risk profiles. At the London meeting of the Committee on Economic Affairs and Development in January, Mr Köhler informed the Committee that the Bank had discussed this extensively, but had not yet completed the policy review. During the review important political and technical arguments had been raised against modifying the current uniform margin of 100 basis points over LIBOR for all sovereign exposures. However, the Bank may establish criteria within the framework of the existing policy, which would allow management to present projects to the Board with lower margins on an exceptional basis.

34. The repercussions of the Russian financial crisis on its neighbours should - along with the Kosovo and Chechnya conflicts - remind us that Russia matters, whether positively or negatively. The country is still trying to shake off the consequences of August 1998, when the default on debt service payments dealt a severe blow to investor confidence and economic development. As stressed by Mr Köhler, against the background of the Russian crisis and the country's severe and lingering problems with corporate governance brought to the fore in its aftermath (both in the private and the public sector), it is difficult for the EBRD to carry out business as usual in Russia.

35. Although Russia is by far the biggest client of the Bank and has the greatest share of signed commitments in the Bank’s portfolio (20% or €2.7 billion), the level of annual new commitments in that country has fallen to its lowest level in recent years (from approximately €700 million in 1996 and 1997, €500 million in 1998, and €164 million in 1999). Indeed, only 10% of newly committed projects went to the country in 1999. Major changes to the investment climate and in the field of good governance will be needed to regain the confidence of investors. Accountability of state institutions is very weak. Key reforms to develop the proper institutional framework of a market economy are seriously lagging behind. In some areas there have even been reversals of previous reforms.

36. There has also been a major devolution of power to the regions since the start of the transition. Unfortunately, the relationship between the centre and the regions has been governed by an array of bilateral treaties and ad hoc arrangements that continue to generate conflict and confusion regarding the separation of powers and responsibility at different levels of government. This is especially true for the system of fiscal federalism. Inconsistencies between local and federal legislation are common. This, in combination with other economic, geographical and historical factors, has resulted in sharp differences in the nature of the business conditions across regions.

37. Despite improving macroeconomic conditions the Russian business environment continues to be very difficult. Arbitrary and highly discretionary application of the legal and regulatory rules has oppressed the investment climate. This has also been the single most important cause for the erosion of the 'rules of the game' across the economy and society. As a result, business conditions are largely unpredictable.

38. Similarly, the development of SMEs in the Russian economy remains stunted. SMEs account for only 10% of GDP and employment, in comparison to more than 45% in other advanced transition economies. Their collective voice in the policy and business environment has been extremely weak. The problems of crime, corruption and bureaucratic discretion in Russia exact a heavier toll on SMEs than on other types of firms. As a result, SMEs have a strong incentive to remain in the shadow economy. Consequently, their role in promoting economic and political competition and enhancing civil society has been substantially diminished.

39. Corruption, meanwhile, is undermining the prospects for that great country. In Russia we have the specific problem of so-called 'grand' corruption. Powerful firms and private businessmen have “captured” important parts of the state, leading to an 'unholy alliance', indeed fusion between politics and private interests. Lee Wolosky of the Council of Foreign Relations writes in the March/April edition of Foreign Affairs writes: "The oligarchs dominate Russian public life through massive fraud and misappropriation, particularly in the oil sector… In enterprises they control, no outsiders are safe. Before their wealth, the law is impotent. This is plunder masquerading as free enterprise”.

40. Second, there is the ‘de-monetisation’ of the economy. As the most recent economic survey of Russia from the Organisation for Economic Co-operation and Development notes, non-cash receipts at 200 industrial companies peaked at over 50 per cent of the total in August 1998, before falling to 43 per cent in April last year. Why should organisations prefer to avoid cash? Part of the answer is that non-cash transactions disguise subsidies, mostly for energy. Also, these transactions are a way for regional and local governments to cheat the federal authorities by operating without bank accounts.

41. The dominance of the oligarchs and the de-monetisation are both consequence and cause of today's distorted, semi-market economy. Behind them, however, lies the collapse of the state. Vladimir Mau, director of the Russian government's Working Centre for Economic Reform, notes in a pamphlet responding to western critics of the reforms: "The fundamental feature of Russian post-communist reforms is that they were implemented at a time of weak state power”.

42. What the Russian leadership now has to deliver is a 'level playing field'. It has to build a judicial system based on democratically enshrined laws, where disputes are settled in a fair and transparent manner. Russia needs well-trained civil servants who are truly committed to serving the common good. The government must re-appropriate that part of the country's resource wealth that is necessary for it to discharge its normal functioning. It must cut the oligarchy down to size. It must raise sufficient taxes to cover expenditure and pay its civil servants enough to reduce corruption. It must establish an effective legal system, with workable property rights. It must create a normal cash-based economy and harmonious relations with lower levels of government.

43. The Rapporteurs fully agreed with the conclusions of Mr Köhler, that neither cynicism nor a wait-and-see approach can help the situation. Nor should we think for a minute that reforms could simply be bought with cash. At present, the international community faces a resentful country and a suspicious elite presiding over a dysfunctional state and a distorted economy. We need to develop an approach for Russia based on a partnership of mutual respect and honesty. This means that we have to accept that Russia must find and take its own path further to develop its market economy and democracy. And there must be honesty, in the sense that the developed market economies should not promise what they cannot deliver, and the international community should speak up frankly about problems.

44. It is obvious that Russia is facing a turning point in its transition process. The Bank, a high-profile foreign participant of the Russian transition, should remain committed to Russia as a long-term reliable partner at this difficult time. Moreover, given its special mandate, its higher risk taking capacity and experiences with the transition process, the potential role of the Bank and the associated responsibilities are greater than ever.

45. The Rapporteurs believe that the Bank’s main strategic orientation in the immediate future should be to assist Russia in the overcoming of the current confidence/credibility crisis that permeates its society and economy. The EBRD is well placed to bring about - through its activities - genuine and sustainable improvements in the confidence building process.

46. The Rapporteurs fully realise the difficult trade-offs that the Bank has to arrive at in its projects between geographical balance and profitability - or, put otherwise, the difficulty in reconciling strict investment criteria with politically inspired goals. Or we might call it the dilemma of striking the right balance between investment banking and development banking. It is more important than ever for the Bank to be circumspect in its choice of partners. The Bank’s clients will have to demonstrate acceptable business conduct; a impact potential on transition through the proposed project; and credibility as regards their meeting the commitments entered into. The Bank should aim to develop longer-term strategic partnerships through a range of different operations and instruments with clients with a consistently good track record.

IV       THE ROLE AND MISSION OF EBRD IN THE ECONOMIC RENEWAL OF SOUTH-EASTERN EUROPE

47. The EBRD as the lead agency for private sector development is concentrating on five areas: trade finance where the Bank has established a guarantee facility; small and medium-sized enterprises, where it offers 'micro-finance' and other support programmes; equity funding; investment risk mitigation; and financial support for local contractors. The aim in all these areas is to identify common obstacles faced by private investors (local and foreign) and to disseminate solutions representing 'best practice'. The Bank has provided Euro 2.7 billion to the region to date and has been the largest investor in the private sector in the six countries constituting it.

48. Moreover, the Bank tries to encourage regional co-operation through projects in trade facilitation and infrastructure development. It has established a trade finance programme in which commercial banks in the region can participate. Similarly, the Bank has participated in a large number of foreign equity investments in the banking sector, including in Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Romania and in the "former Yugoslav Republic of Macedonia". Participation in certain planned bank privatisation in Croatia and Romania can further strengthen this involvement in 2000.

49. The officials of the Bank told the Rapporteurs that the political will expressed in the Stability Pact, combined with the commitment of the governments in the region, has started to bear fruit. The volume of signed projects in the three smaller, most affected countries increased by 86% in 1999 over the year before. Similarly, the Bank is proposing that a political risk fund be set up to mitigate the risks faced by foreign direct investment in the Kosovo province. So far € 65 million has been raised from donors for a Balkan region's special fund. The EBRD has been active in Kosovo even though the territory of which it forms part, namely the Federal Republic of Yugoslavia, is not a member of the EBRD. (Cooperation funds are administered by the EBRD, but unlike ordinary capital resources and Special Fund resources, they are not resources of the Bank for the purposes of the Agreement Establishing the Bank.) This is because in mid 1999, the Board of Directors of the EBRD concluded that exceptional circumstances existed in Kosovo entitling the Bank to use cooperation funds to support EBRD activities in Kosovo. In making that judgement, relevant considerations included the passing of Resolution 1244 by the United Nations Security Council and the presence of UNMIK in Kosovo. The EBRD is not currently active in Montenegro, where the above considerations do not pertain and where the Board of Directors has not made a determination that exceptional circumstances exist enabling the use of cooperation funds to support EBRD activities there. The Rapporteurs feel that the EBRD should be encouraged to assess fully the situation in Montenegro and to consider the feasibility of extending cross-border investment projects onto the territory of Montenegro and to use cooperation funds for project preparation as well as legal, regulatory and training projects.

50. The EBRD's new micro-lending bank set up in Pristina - the first bank licensed in Kosovo since last year's conflict - is there to meet an urgent demand for financial services. The micro-enterprise bank has been founded at the initiative of several international financial institutions and investment companies, among them the Commerzbank AG, the EBRD, the International Finance Corporation (IFC) and the Kreditanstalt für Wiederaufbau. It has an initial equity of € 2.3 million. A substantial part of the funding is provided by the Dutch and German governments.

51. The EBRD is the largest investor in the private sector in the "former Yugoslav Republic of Macedonia". The Bank has committed € 177 million of its own funds in the country, mobilising a total investment of nearly € 400 million. Last year's new commitment to the country were € 47.4 million, a 69% increase from the previous year. These investments included financing for the expansion of the country's telephone network, privatisation of Stopanska Banka, the expansion of a pharmaceutical plant and the extension of trade guarantee facilities to local banks. As in other countries, the EBRD has also developed a strong 'pipeline' of further projects and expects to exceed its 1999 investment commitments in the year 2000.

52. There cannot be sustained growth in south-eastern Europe without a very large increase in investment. The region today invests 15% of its GDP or less, while central Europe, for example, invests 25 to 30%. There should be no illusion that public money, foreign or domestic, will do the trick. The vast majority of investment will have to be made by the private sector. Governments throughout the region must do much more to create the conditions under which the private sector will invest. These include:

i) laws that protect property rights and that are market-oriented, transparent and effectively enforced;

ii) a tax system that raises resources but does not discriminate against success and honesty;

iii) fair market-based competition, including low or at best no hurdles to market entry, the imposition of the necessary financial discipline on firms and the enforcement of bankruptcy when needed;

iv) a framework for the sound governance of firms, including protection of the rights of minority shareholders and creditors and;

v) administrative practices to minimise the scope for corruption and cronyism and that ensure the predictability and stability of the business environment.

53. All these factors are closely associated with progress in transition. Indeed, there is a strong correlation between transition success and the level of foreign direct investment in the economies of transition.

54. Governments across southeastern Europe have to varying degrees implemented market-oriented reforms over the past decade. However, their resolve has wavered at times and achievements have lagged well behind those of most central European countries. Throughout southeastern Europe, the quality of the investment climate - especially relating to corruption and the interaction with the public administration - registers in the bottom half of the economies in transition.

55. There is the perception that cronyism and unpredictability characterise the collection of taxes and other acts of public administration in some of these countries, with smaller businesses carrying most of the burden. Some countries have been more effective at implementing reforms than others. Nevertheless, many of the fundamental challenges are the same. The single most effective contribution to the economic objectives of the Stability Pact is for governments to take determined action in each of the areas listed above. Without it, other measures risk being ineffectual.

56. According to its mandate, the Bank has adopted a "bottom-up" approach in south-east Europe, placing emphasis on supporting SMEs and improving the climate for investment. The Bank has developed a wide range of instruments to promote SMEs, such as start-up loans in co-operation with local banks (micro-loans) and an intensified policy dialogue to help reduce impediments to SME development. For instance, a new unit has been established in the banking department to promote the SME work of the Bank and to support implementation of the strategy.

57. With its place at the core of any strategy for promoting stability and development in the region, the private sector cannot be a mere bystander in the current international effort, or a simple addressee of policies, institutional changes and finance. Hence the importance of involving the private sector directly within the framework of the Stability Pact. The Rapporteurs believe that the EBRD - as the largest source of private sector finance in the region and with excellent business contacts - should seek to join and improve existing initiatives and orient operations along the lines of the Stability Pact. In so doing, the EBRD can draw on the experience gained in the creation of so-called foreign investor advisory councils in Russia, Kazakhstan and Ukraine.

58. The economic integration of the region - within its own confines as well as with the general European economy - is a central objective of the Stability Pact. Given the small size of markets, integration clearly offers benefits for investors: Romania's GDP is less than a quarter of Greece's. Those of Albania, Bosnia and Herzegovina and the "former Yugoslav Republic of Macedonia" combined are only one-third of Romania's. At present, trade between neighbouring Bulgaria and Romania represents only about 1% of their total trade, while trade with other countries in the region is not much greater. Albania has virtually no trade with the region.

59. While, in the first decade of transition, it was more or less natural for countries to re-orient their trade towards the West, they now also need to increase regional co-operation and trade among themselves. The Rapporteurs believe that the Bank should therefore, through its projects, seek to tackle even more intensely than so far the transition challenges related to cross-border co-operation. The strengthening of intra and inter-regional infrastructure and trade should be a priority. There is a substantial scope in this area for co-financing opportunities with other IFIs.

V. CONCLUDING REMARKS

60. There are several lessons to be learnt from the transition's first decade. Firstly, we must recognise that transition is a complex and difficult undertaking, involving as it does the entire society. Transition is, at its core, about shaping institutions, mind-sets and behaviours. Only years of experience will help the people fully grasp that freedom for the individual means more than just rights and advantages. It also means duty, risk and responsibility. Therefore there should be more support for institution building, and institution maintenance.

61. On the other hand, growth has strengthened in much of central and eastern Europe and the Baltic region (CEE) and the Commonwealth of Independent States (CIS) during the past 12 months, if one is to believe the Transition Report Update released on the eve of the Bank’s Annual meeting in Riga, from 21 to 22 May 2000. However, the reasons for this recovery differ markedly among countries, according to the Report, while foreign investors have become more discriminating. And whereas foreign direct investment into central Europe has remained stable, investors have become more cautious towards Russia and other CIS countries, if one excludes the natural resources sectors in some of these countries.

62. As Ricardo Lago, the EBRD’s Acting Chief Economist, said during the Bank’s Annual Meeting: "While we should be encouraged by the strong economic turnaround in the region and the improving business environment, we cannot afford to become complacent. Many of the core challenges of the transition remain, and need to be tackled quickly and resolutely."

63. Secondly, even today the speed and direction of transition depend largely on conditions that prevailed at the start of the process and which varied widely from country to country. This being said, every country had, and still has, the opportunity to correct the course. A number of countries in the region have defied difficult initial conditions and achieved real success. Others were less decisive in implementing reforms and have lost precious time as a result. They now face particularly great economic and social problems.

64. Thirdly, corruption and disregard for the rule of law are grave problems that undermine the climate for investment. Successful accomplishment of the transition process will require a continued struggle against bribery, corruption and economic crime. The EBRD and the Council of Europe can and will work together in this endeavour, which is increasingly considered a top priority for the international community.

65. The EBRD is a project finance bank with a public mandate. The Committee's exchanges of views with the EBRD's President showed both the dilemma faced by the Bank in trying to reconcile political directives with market risks, and Mr Köhler's strenuous efforts to fulfil the Bank's double mandate. Finding the right balance between geographical distribution and profitability of the Bank's projects remains one of the EBRD's key challenges.

66. During the Bank’s Annual Meeting in Riga, governors also made frequent reference to the Bank’s realigned operational priorities. Thus, there was particular emphasis on the role the Bank can play in promoting smaller businesses. It was generally acknowledged that the development of a dynamic SME sector lies at the heart of the economic transition. Governors also stressed the importance of contributing to restructuring processes, sound corporate governance and the maintenance of a strong equity focus. They also welcomed Mongolia as the Bank’s 61st member and the decision by Australia to subscribe to the Bank’s capital increase.

67. Under the new stewardship of Mr Lemierre, the EBRD plans to increase its annual level of investments to at least EUR 3.0 billion over the next few years, with the goal of doubling its operating assets. The Rapporteurs believe it should achieve this increase without in any way sacrificing the quality of its projects - their impact on the transition process and their profitability. Nor should this increase come at the expense of the Bank’s political mandate. A country’s failure to embrace multi-party democracy and pluralism should lead to a reduction in EBRD operations. Under its board-approved country strategies for Belarus and Turkmenistan, the Bank has adopted a graduated approach, in which the scope of its involvement is tied to the progress these countries make in the implementation of democratic principles.

68. Finally, the Rapporteurs feel that the Bank's day-to-day activities should reflect even more than they do today the future key challenges to transition. These are to build an institutional, legal and policy framework capable of serving a well-functioning market economy; to limit, nay, do away with, fraud and corruption; to promote good corporate governance; and to stimulate the development of new enterprises.

Reporting committee: Committee on Economic Affairs and Development.

Budgetary implications for the Assembly: none.

Reference to committee: standing mandate

Draft resolution unanimously adopted by the committee on 23 May 2000.

Members of the committee: Degn (Chairperson), Valleix, Elo, Brunhart (Vice-Chairmen), Akgönenç, Aliko, Andreoli, Attard Montalto (Alternate: Agius), Billing, Blaauw (Alternate: Duivesteijn), Blattmann, Bojars, Bonet Casas, Braun, Budisa, Calner, Clinton-Davis, Cunliffe, Cusimano, Eyskens, Frey, Freyberg, Gonzalez Laxe, Gryzlov, Gül, Guma, Gusenbauer (Alternate: Schicker), Gylys, Haupert, Hoffmann, Jung (Alternate: Durrieu), Kacin, Kestelijn-Sierens, Kirilov, Kittis, Lazarenko (Alternate: Kosakivsky), Leers, Liapis, Lopes Cardona, Lotz (Alternate: Barsony), Makhachev, Mateju, Mitterrand (Alternate: Goulet), Moynihan-Cronin (Alternate: Connor), Niculescu, Nikologorsky, Paterkalishvili, Pereira Coelho, Popescu, Popovski, Prokes,  Puche, Ragnarsdottir, Rigo, Schmitz, Squarcialupi, Stepova (Alternate: Skopal), Stoyanova, Tallo, Townend, Tsekouras, Vasile, Westenthaler, Wielowieyski, Zapfl-Helbling.

N.B. The names of those members present at the meeting are printed in italics.

Secretaries of the committee: MM. Torbiörn, Mezei and Ms Ramanauskaite.

¹ Following the terminology of the EBRD Transition Reports, the term “institutions” is used in this report to include: the functioning of the state and the behaviour of its officials, including the issues of corruption and personal safety: the regulatory and legal framework and its effectiveness; the structure and functioning of enterprises in particular their market orientation; financial institutions; and political and social institutions including the democratic process, the freedom of the press and a social safety net.