Report No. 25625-UZ Republic of Uzbekistan Country Economic Memorandum April 30, 2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRJENCY AND EQUIIVALENT UNMTS (Exchange Rates effective Apoil 1, 2003) Currency Unit = Soum US$1 = Soum 968.69 (official exchange rate) US$1 = Soum 968.82 (OTC exchange rate) US$1 = Soum 1000.00-1020.00 (consumer goods/exchange bureau exchange rate) US$1 = Soum 1130.00-1150.00 (parallel market exchange rate) ACRONYMS AND ABBREVIIATUONS ARA Asset Restructuring Agency GNFS Goods and Non-factor Services BEEPS Business Environment and Enterprise IMF International Monetary Fund Performance Survey LPG Liquefied Petroleum Gas BPA Bank Privatization Agency LRP Labor Redeployment Program CBU Central Bank of Uzbekistan MOF Ministry of Finance COM Cabinet of Ministers MFER Ministry of Foreign Economic Relations CPI Consumer Price Index NBU National Bank of Uzbekistan CIS Commonwealth of Independent States OTC Over-the-Counter FDI Foreign Direct Investment PPI Producer Price Index GDDS Global Data Dissemination System SME Small and Medium-Size Enterprises GDP Gross Domestic Product SOE State-Owned Enterprise GKI State Committee on Privatization and TOE Tons of Oil Equivalent Support of Entrepreneurship VAT Value-Added Tax Vice President : Johannes Linn (ECAVP) Country Director : Dennis de Tray (ECC08) Sector Director : Cheryl Gray (ECSPE) Sector Manager : Samuel Otoo (ECSPE) Task Team Leader : Ritu Anand (ECSPE) UZBEKISTAN COUNTRY ECONOMIC MEMORANDUM SUMMARY REPORT TABLE OF CONTENTS EXECUTIVE SUMMARY .................... i-iv I. GOVERNMENT OBJECTIVES AND DEVELOPMENT OUTCOMES . II. GOVERNMENT POLICIES: ISSUES AND TRADE-OFFS .5 An Overall Assessment and Comparative Perspective III. STRATEGY FOR REFORM .23 Agricultural Reform Enterprises and Private Sector Development Banking Reform Energy Sector Reform Data, Public Disclosure and Transparency IV. IMPACT OF REFORMS AND MITIGATION OPTIONS .36 Social Effects of Exchange Rate Unification Compensation Mechanisms and Mitigation Options Fiscal and Output Impact of Reforms Conclusion APPENDIX 1. REFORM PROGRAM MATRIX ACKNOWLEDGMENTS This report was prepared by a team led by Ritu Anand based on background papers by Andriy Storozhuk (macroeconomic context), Sayyora Umarova (foreign trade), Mark Lundell, Joseph Goldberg, and Bekzod Shamsiev (agriculture), Peter Thomson, Raghuveer Sharma, Loup Brefort, and Marat Iskakov (energy), Alexander Kitain and Arye Hillman (enterprise and private sector development), Andrew Lovegrove and Michael Fuchs (banking), Branko Milanovic and Arvo Kuddo (labor markets and social impact of reform), and Joel Helmnan (information disclosure and transparency). The background papers are available from the World Bank upon request. The materials for the report were collected in the course of missions undertaken during March-July 2002. The report was discussed with the Uzbek authorities in January 2003. The authorities have recently adopted resolutions along the lines of some of the recommendations of the report. The authors of the report would like to thank the Uzbek authorities for their collaboration. Contributions to the report were also provided by Nancy Vandycke, Gary Fine, Bakhtior Abdullaev, Mario Gobbo, Dilnara Isamiddinova, Qimiao Fan, Evgeny Polyakov, Carolina Revenco, Roland Clarke, Jakob von Weizsacker, Leonid Koryukin, and IFC Country Office staff. Peer reviewers for the report were Alan Gelb, Christof Rosenberg (IMF), Dipak Dasgupta, and Zia Qureshi. The team is also grateful to Dennis de Tray, David Pearce, Samuel Otoo, Cheryl Gray, Pradeep Mitra, Kadir Yurukoglu and Robert Anderson for their support and advice. The production of this report was very competently handled by Dammika Somasundaram. EXECUTIVE SUMMARY 1. Upon independence in 1991, Uzbekistan inherited a difficult economic situation. The republic had one of the lowest standards of living in the Soviet Union. Its economy was reliant on the production of raw materials such as gold, cotton and natural gas, while heavily dependent on imports of food, oil and most manufactured goods. Other difficulties the Uzbek authorities had to contend with following independence included a rapidly growing population, especially .in rural areas where little off-farm employment was available, long porous borders which engendered security vulnerabilities, and a geographical position as a double land-locked country which imposed additional constraints on exports. 2. Against this background, the government adopted an import substitution development strategy that was intended to transform the economy from heavy dependence on agriculture and natural resources to a modem industrial economy. This strategy, which relied heavily on exchange and trade controls, directed credit and large public investments, achieved some objectives, notably energy and food self-sufficiency, early on and the country has had sustained growth for the past six years. Despite these achievements and an assured export base of cotton and gold and a comfortable international reserves position, this report argues that important goals have not been met and there are significant opportunity costs and risks to the development strategy. These problems call into serious question the sustainability of the development strategy. 3. Since 1997 exports have contracted and Uzbekistan has become an increasingly closed economy. Foreign direct investment has declined. As the exchange rate became misaligned, capital outflows increased. Against this, costly government guaranteed external borrowing was undertaken for investment projects with questionable returns because they are undertaken under distorted relative prices. While maintaining stability, the centralized decision-making and state-directives to all key sectors - agriculture, industry, energy, and banks - have discouraged private investment and employment generation. Most importantly, average incomes in Uzbekistan have improved little over the past 5 years. 4. Recently the government has begun to address some of the deficiencies in its policies. Since 2000, it has successively reduced exchange market distortions and the overvaluation of the official exchange rate, tightened its fiscal stance, and followed more conservative borrowing policies. However, there are significant fiscal risks as much of the government guaranteed debt could fall on the budget. Moreover, the real official exchange rate devaluation of 75 percent since early 2000 has caused a significant increase in external debt service costs in soum terms. At the same time, exports have not responded because of the remaining extensive controls on foreign exchange, trade, and firms and farms. A comprehensive reform program that addresses these structural constraints and rigidities needs to be implemented along with the planned current account convertibility. This report seeks to assist the government in articulating a phased medium-term reform program and the minimum set of critical reforms that are initially ii required to provide the impetus to growth as Uzbekistan moves to a more dynamic market-oriented economy. Priority reform agenda 5. The overriding objective of early reforms should be a decisive move to liberalize prices, production, marketing and distribution, coupled with the imposition of hard budget constraints. Given the need for a robust supply response, reforms need to be sufficiently comprehensive and deep to allow for rapid re-alignment of productive factors. The initial liberalization would be followed by further institutional reforms and restructuring in enterprise, banking, and energy sectors. 6. The report recommends that the government take the following steps during the first phase (e.g., the initial 12 to 18 months) of a new economic program: i. Liberalize the foreign exchange regime in conjunction with tight fiscal and monetary policies: At the inception of the program, the exchange rate should be unified by liberalizing access to foreign exchange for current account transactions and letting demand and supply determine the rate, with CBU intervention limited to smooth fluctuations. Bank interest rates should be raised to positive real levels. ii. Remove barriers to foreign trade: At the inception of the program, non-tariff barriers such as ex-ante import contract registration requirement, import price verification, most export bans (except perhaps on flour), and advance payment restrictions on imports should be eliminated, and export prepayment requirements should be replaced by time limits on repatriation of export earnings by domestic enterprises. B y the end o f the first p hase, the VAT should b e refunded on all exports', otherwise it constitutes an export tax of up to 20 percent. Import duty exemptions on inputs for exports should be uniformly applied. Import tariffs and excises on imports could be reduced more gradually in a second phase. iii. Enhance price and marketflexibility: At the inception of the program, price controls should be lifted except for natural monopolies and key foodstuffs (bread, flour). The planning and enforcement of material balances should be significantly reduced, and cash and mandatory crop plans should be phased out completely by the end of the first phase of the program to ensure that farms and firms can respond to market price signals. The rationale for industry and trade associations' distributing scarce resources to enterprises will be removed by foreign exchange, trade and price liberalization, but their control over enterprises should also be reduced by the end of the first phase of the program. According to the Tax Code, VAT is to be refunded on all exports, except those paid for in "soft" currencies. In practice, however, VAT is offset against other tax liabilities, but when VAT refunds due exceed outstanding tax liabilities, VAT cash refumds are not dully made. In addition, VAT on cotton exports is neither refunded nor set off against other taxes, representing in effect an export tax. Since wholesale trade companies are exempt from VAT exports going through such trade companies are not subject to VAT refunds either. iii iv. Induce commercial behavior by enterprises: The issuance of public guarantees on external and domestic lending and other forms of directed credit to enterprises should be discontinued at the inception of the program and the government should maintain its current policy of zero net external borrowing. Greater financial autonomy of shirkat members needs to be ensured by excluding unprofitable pudrats from sharing in shirkat's overall profits. Diagnostic credit audits of state banks should be conducted on an urgent basis and the independence and corporate governance of major state-owned banks should be strengthened by appointing a majority of independent members to their boards. Legal restrictions on enforcing financial discipline among energy consumers should be abolished and a policy of disconnections for all non-paying energy consumers established. In the next phase, an enterprise restructuring and reform strategy should be initiated in conjunction with bank restructuring, regulatory barriers to business development reduced further and privatization accelerated. v. Strengthen social protection: Funding for targeted social assistance programs should be increased. Part of this increased funding could come from the govermnent's planned elimination of social privileges linked to professional occupation. vi. Increase transparency: A clear and relatively low cost measure that would immediately signal the government's commitment to greater transparency would be the improvement in public information dissemination practices. At the inception of the program, detailed output, monetary, fiscal, external debt, foreign trade, BOP and social data should be published in accordance with the General Data Dissemination System (GDDS) standards. The practice of secret legislation and c lauses i n l egally-binding government resolutions, d ecrees, r egulations and instructions on economic matters should be ended by the time the first phase of the program is completed. 7. There are clearly political difficulties in instituting such an economic program as there will be those who will lose out as a result of a change in the status quo. However, against the "losers", there would be a large number of potential "winners". Those who would stand to gain are the large number of farmers, existing and prospective entrepreneurs, and the population at large whose incomes would grow significantly. Moreover, reforms become self-reinforcing and the dynamics of the reform process create opportunities for government to push forward with new reforms. A reform pace significantly more gradual than outlined above has the risks of not having a critical mass of complementary measures and thus not obtaining a positive supply response. While there will undoubtedly be some short-term costs of reforms, these will be outweighed by benefits in the form of increased investment (foreign and domestic private) and output, particularly in the agricultural sector. In addition, the strengthening of targeted social protection will reduce the immediate impact of the measures on the poor, and the government is moving in this direction, for example by steadily increasing child allowances. The enactment of these measures will enhance the image of Uzbekistan as a iv country committed to reform and hence increase its attractiveness to foreign investors. A medium-term structural reform program along the lines proposed in this Report would also receive strong financial support from the international development community. 8. The experience of countries in the process of transition from central planning to a market economy has shown that measures such as those described above produce a stable, predictable and transparent economic environment which fosters competition, innovation and development. The reform program does not mean the abandonment of social guarantees for the most vulnerable groups in society. Rather it implies that more resources will be properly targeted to these groups. It is in this way that the Government of Uzbekistan will be able to realize its fundamental goal of building a competitive socially oriented market economy. The alternative to implementing reforms of this type is slowing down of economic growth and eventually the need to implement reforms in a potentially far worse economic and social situation. UZBEKISTAN COUNTRY ECONOMIC MEMORANDUM I. During the past two years, the Government of Uzbekistan has been engaged in an intense discussion of its policies with the IMF and World Bank. In early 2002, the government and the IMF agreed a package of reform measures, underpinned by a Staff Monitored Program (SMP), which was expected to set the stage for a more comprehensive, medium-term program of reforms that could be supported by policy- based lending from the IMF and World Bank. While some successes were achieved, overall progress with the implementation of the SMP has been much slower than expected, and a recent spate of measures tightening controls over business activities appears to go counter to the spirit of economic liberalization embodied in the SMP. This Report seeks to assist the government in strengthening the consensus for reform and in designing a medium-term reform strategy that would help achieve the government's strategic objectives in an efficient and sustainable manner. 2. The Report comprises three sections. Section One presents key government economic policy objectives and compares them to outcomes achieved. Section Two provides an assessment of the economic and sectoral developments, and Section Three provides outlines of key sector reform strategies and their phasing and sequencing. The possible content and phasing of the medium-term strategy are illustrated in the Appendix. I. Government Objectives and Development Outcomes Government objectives 3. The government's development strategy is aimed at building a "socially-oriented , 2 market economy. The strategic objectives announced soon after independence included: * achieving economic independence by reducing imports through import substitution, including ensuring energy and food self-sufficiency, * diversifying the economy from its raw material orientation to a more modem and competitive industrialized structure, * increasing the country's export potential and foreign exchange reserves to have a strong, stable currency, and * expanding employment opportunities and raising living standards. The structural transformation of the economy was to be achieved through domestic investment in priority sectors and the attraction of foreign investment. 2 The strategy and objectives are drawn from Karimov, I., 1993, Building the Future: Uzbekistan Its Own Model for Transition to a Market Economy, Uzbekistan Publishers, Tashkent; and Karimov, I., 1995, Uzbekistan: Along the Road of Deepening Economic Reform. 2 4. Much has been achieved, as shown below. But Uzbekistan's economy now also faces many of the problems that forced the majority of developing countries that pursued similar import-substituting industrialization policies in the 1950s-80s to abandon them. Outcomes Achieving economic independence 5. The economy weathered a shallow recession after independence, compared with other CIS countries, and has had sustained moderate growth for 6 consecutive years, thereby becoming the first CIS country to attain its pre-independence GDP level. According to official statistics, the annual real GDP growth averaged 4 percent during 1996-2001. Given the annual population growth rate of 1.5 percent during this period, though, per capita GDP growth averaged 2.4 percent. Moreover, altemative IMF estimates of GDP indicate real GDP growth of just around two thirds of the official rate. In US dollar terms, GDP in 2001 was significantly lower than in 1996 regardless of the exchange rate used3. 6. The country achieved self-sufficiency in energy by 199S and in wheat by 1998. A close t o t hree-fold i ncrease i n c rude o il p roduction b etween 1 991 and 1 995 e nabled a reduction in petroleum imports from $475 million in 1992 to zero by 1996. Wheat production increased from less than 1 million tons after independence to a record 5.4 million tons by 2002, with wheat imports coming down from 3.8 million tons to a negligible amount. At least for wheat, however, the opportunity cost of this self- sufficiency has been high. Diversifying and industrializing the economy 7. Industrial growth has been low and not broad-based. Industry grew by only 1.7 percent on average between 1996 and 2001 despite large investments and implicit subsidies. By 2001, the share of industry had declined further to 14 percent of GDP from 17 percent in 1995 and about 25 percent in 1991-92. Industrial growth has been led by gas and non-ferrous metallurgy (mainly gold, copper) and to some extent food processing, which t ogether accounted for o ver half o f i ndustrial growth b etween 1 996 and 2001. 8. A number of new industries were promoted in consumer goods (cars, TVs, VCRs, etc) as well as in intermediate inputs (e.g. polyethylene)4. Technological modernization of some capital goods (such as agricultural machinery) was undertaken, and the production of oil and gas accelerated. The coming on-stream of these industries as well as increased production of hydrocarbons in fact partially offset the severe decline in output of the old, inherited industries which, in many instances, more than halved by 1995. 3 At the official exchange it was lower by 19 percent, at the parallel market rate - by over 50 percent. 4Among the largest new enterprises created have been the Uzdaewoo car assembly plant costing $0.6 bn., including around $ 0.3 bn. in external debt, and Shurtan Gas Chernical C omplex costing around $1 bn., including $0.8 bn. in external debt. 3 9. But some of these new industries ceased operation and some are operating at low capacity utilization. For example, Uzdaewoo is operating at 20 percent of capacity, Uzcasetractor is at 27 percent, Uzcasemash is at 5 percent, and the new Bukhara and modernized Fergana oil refineries are also operating well below capacity. The production of TVs and VCRs has virtually stopped. 10. Agricultural crop growth was driven by increases in wheat acreage and production, while cotton yields and cotton export volumes declined without any significant increase in cotton textile exports. Cotton yields have fallen by about 20 percent since the early 1990s and cotton export volume by about 30 percent. 11. Small, medium and micro enterprises contribute 15 percent of GDP, 5 percent of exports and 9 percent of total employment (or 14 percent offormal employment)5. The number o f S MEs i n Uzbekistan s tands at 1 1 p er 1 000 p eople c ompared t o o ver 5 0 i n Central European and developed countries. As in other countries, SMEs in Uzbekistan are concentrated in trade and catering (50-60 percent of their gross production) and then industry (15-30 percent), followed by construction. 12. FDI has been declining steadily since 1997 and net FDI inflow per capita at $3 is now the lowest in the CIS. The foreign exchange and banking controls, which hindered access to foreign exchange for purchases of imports and profit repatriation purposes6, together with the overall difficult business environment, has led a number of foreign investors to cut back their activities in Uzbekistan. Expanding employment and raising living standards 13. Formal employment fell both in industry and in agriculture and most of the increase in formal employment was in the budgetary sector. Formal employment in industry (large, medium, small and micro but excluding "individual entrepreneurs"7) fell from around 1 million in 1991 to about 650,000 by 2001. Employment in agricultural collective farms (shirkats) fell with farm restructuring, and 40 percent of the rural population is now dependent for their livelihood on small plots of average size of 0.2 hectare. Government budget financed jobs (health, education, social protection and administration) absorb 36 percent of employment in the fornal sector and have accounted for most of the increase in formal sector employment in the second half of the 1990s. 14. Employment generation by SMEs has been disappointing while informal 5 A ccording to o fficial statistics, individual e ntrepreneurs and d ehqan farmers accounted for another 1 9 percent of GDP and 41 percent of employment in 2001 (see para 14). However, data on the number of individual entrepreneurs is contradictory (see footnote 7), and dehqans are essentially small household plot, subsistence farmers (paras 13 and 14). 6Even though the existing FDI Law provides for unhindered repatriation of profits. 7 Individual entrepreneurs are excluded from fornal employment because of contradictory official statistics on the subject. According to the State Statistics Conunittee, there were 0.5 mnillion individual entrepreneurs in industry in 2001 (accounting for 44 percent total employment in industry!). However, the number of individual e ntrepreneurs o fficially registered b y the tax authorities was j ust a round 5 0 thousand. T his suggests that the number of individual entrepreneurs, reported by the State Statistics Committee and included in total emnployment numbers could be grossly overestimated. 4 individual entrepreneurship is widespread. Total employment in small, medium and micro enterprises, which had risen to over 1 million by 1996, almost halved in 1997, and has only gradually been increasing to about 800,000 by 2001. Individual entrepreneurs and subsistence farmers now produce 19 percent of GDP (of which half by dehqan farmers) and account for 41 percent of total employment (13 percent in agriculture and 28 percent other sectors) in 2001. The large and growing number of individual entrepreneurs signifies increasing informalization of the economy or a means of coping with unemployment or underemployment. Individual entrepreneurs also facilitate operations (e.g., marketing) of enterprises in the formal sector which is over-regulated. 15. Incomes and living standards of the population improved little since early 1990s. By 2001, GDP per capita at purchasing power parity in Uzbekistan was $2,440, the third lowest in the CIS8. The real average soum wage based on the GDP deflator changed little by 2001 compared to 1996, and in US dollar terms it declined. In 2001 the average monthly wage in Uzbekistan was $41 at the official exchange rate9 compared to $118 in neighboring Kazakhstan, whereas in 1994 the difference was less than $2010. Income disparities increased: the agricultural wage on which an estimated 2.2 million agricultural workers are dependent declined to 23 percent of the average industrial wage. An estimated 27.5 percent of the population lives below the poverty line with rural poverty a significant problem.'1 16. Living standards are supported by almost universal access to cheap energy, low food prices, and a costly social protection system. Since independence the government has pursued a program to expand household access to piped gas, and today 95 percent of households are covered with piped gas. The government intends to cover the remaining 5 percent of households within 3 years. Access to cheap gas, in addition to the already universal access to cheap electricity, has maintained welfare. Food prices, particularly bread, have been kept low by the state procurement system and export bans. A decentralized mechanism of targeting social assistance (mahalla system) with relatively high targeting efficiency (i.e. the benefit actually reaches the poor) has been in place since 1996. However, as a result of reduced funding, the number of beneficiaries of targeted social assistance is declining and the real benefits low and declining.'2 Pensions provide a significant support to low-income families. However, the pension system is expensive and may discourage formal employment: the combined payroll tax (including 2.5 percent mandatory insurance fee imposed on employees' wages) payable to the 8 Uzbekistan's GDP per capita at the official exchange rate in 2001 was $452, the fourth lowest in the CIS (after Moldova, Kyrgyz Republic, and Tajikistan). At less distorted commercial bank, indicative, or parallel market rates, its GDP per capita was under $300, the second lowest in the CIS. More disturbingly, while in most CIS countries US dollar GDP per capita has improved since 1999, in Uzbekistan it declined. 9 $16 at the parallel mnarket rate. '° $49 vs. $3 1. " The poverty line is a food poverty line based on 2100 calories per person per day. 12 Funding for the low income benefit has fallen from almost I percent of GDP in 1995 to less than 0.1 percent of GDP in 2001 with the result that the number of recipients has fallen by almost two-thirds (from 886,000 to 317,000 households) between 1997 and 2001. 5 Pension Fund was reduced from 39.8 to 37.5 percent in 2003 but is still the highest in the cis13. Strengthenina export potential, international reserves and exchange rate stability 17. Exports have contracted since 1997, and little export diversification away from raw material exports has taken place. Uzbekistan was able to switch its exports (gold and cotton accounting for over half of exports) to hard currency markets soon after independence and exports grew steadily in the early years. Since 1997, however, merchandise exports have shrunk by 32 percent14. Although declining prices of cotton fiber and gold contributed to this, export volume also declined. N ew export products have been introduced but in value terms non-gold, non-cotton exports changed little between 1995 and 2001. Surveys of enterprises in transition economies show that Uzbekistan consistently ranks lowest on questions regarding links to global economy. For example, according to the 2002 Business Environment and Enterprise Performance Survey (BEEPS), the share of exports in total sales of surveyed Uzbek firms at 3.3 percent is one third of the regional average and the lowest in the region. Moreover, only 5.8 per cent of the Uzbek firms increased export sales between 1998 and 2001 and only 4.6 per cent started to export to a new country, both figures less than one third of the regional average. 18. International reserves are at a comfortable level but macroeconomic imbalances, though reduced, remain. Foreign exchange reserves have been maintained between $1.1-1.3 billion, or around 4-5 months of (suppressed) imports coverage since 1997. However, exchange rate and inflation developments suggest both external and internal macro imbalances. Since its introduction in July 1994, the official exchange rate has been devalued by 125 times (including by over 500 percent since early 2000). Inflation, though reduced from the levels of the mid-1990s, remains high at around 45 percent as measured by the GDP deflator and producer price index (PPI). 19. In sum, there have been some notable successes but some of the outcomes and trends suggest that the government's objectives are not being achieved and some of the developments raise concerns. The next section evaluates how government policies contributed to these positive and negative outcomes, and the issues and/or trade-offs that this experience raises. II. Government Policies: Issues and Trade-Offs 20. The government impleniented its industrialization and social development strategy through the state management of product and factor prices (maintaining an overvalued exchange rate, low interest rates and low prices of energy, raw materials, and " In addition, the Pension Fund also receives proceeds from a 0.7 percent general sales tax. See Uzbekistan: Living Standards Assessment, the World Bank, 2003 for more information on the pension system, as well as living standards and social sector developments in general. I The largest export declines took place in 1998-1999 when exchange rate distortions were greatest. Since 2000 merchandise exports in value terms have basically stagnated with small increases (5 percent in 2000) interspersed with small declines (7 percent in 2001 and 8 percent in 2002). 6 agricultural products) and central allocation of resources. Thus, although explicit subsidies financed by the budget were slashed from 20 percent of GDP in 1993 to less than 3 percent of GDP by 2001, implicit subsidies'5 through low energy, cotton and grain prices and an overvalued exchange rate stood at over half of GDP in 2001. Industry - particularly machine building, chemicals and petrochemicals - received about 40 percent of these implicit subsidies while households received 20 percent.' 6 21. Despite the significant implicit taxation of energy, agriculture, and exports, the investible surplus was not sufficient for the government's development program and the government resorted to considerable external borrowing. An ambitious investment program, financed to a large extent by foreign borrowing, was undertaken in energy (power, oil and gas), infrastructure (telecommunications, transport), non-ferrous metallurgy, machine-building, chemical and petrochemical, and, to a lesser extent, light and food industries. Since independence, external loan commitments for investment projects totaled about $6.6 billion, of which half is for industry (including energy), another third for infrastructure and ten percent for agricultural equipment. The efficiency of investment has not been high: the average incremental capital-output ratio during 1996-2001 was high (over 6). Besides state-guaranteed foreign financing, industry received privileged access to foreign exchange at an overvalued rate for its imports and debt-servicing. Some 85 percent of $1.3 billion of subsidized hard currency sales by the Central Bank of Uzbekistan (CBU) in 2000 and 2001 were for investment and intermediate goods imports by industrial enterprises. 22. A central element in the implementation of the government's strategy has been maintenance of the predominant role of the government. Although significantly reduced since m id- 1 990s, government expenditure through the state b udget and e xtrabudgetary funds'7 is around 37 percent of GDP. More importantly, the government continues to emphasize centralized management control of the economy and to allocate resources based on detailed planning of production, trade, and investments in all key sectors - agriculture, industry, energy. While entry of private small enterprises is officially 15 Implicit subsidies are transfers of economic resources from one sector of economy to another induced by government policies (e.g., as a result of prices set by the government below market levels) but taking place outside the explicit consolidated state budget. For example, energy utilities - rather than the state budget - are de facto covering a large part of the cost of the industrial and social subsidization policy of the government by supplying energy below full cost recovery levels. The size of implicit subsidies for each sector is estimated as a difference between the market price/opportunity cost and the state controlled price times the volume of resource provided to a sector at such controlled price. For example, foreign exchange subsidy to industry is calculated as the difference between the official/OTC and hypothetical market exchange rates times the amount of foreign exchange provided (including through foreign borrowing) to the sector at the official/OTC exchange rate. 16 Industry received major implicit subsidies through low energy prices, especially of electricity, as well as access to foreign exchange (received mainly from gold and cotton exports) at an overvalued official exchange rate, and publicly guaranteed borrowing, mainly from a broad. Households received subsidies through low energy prices, especially of natural gas and electricity, as well as controlled, below market prices of food, particularly grains. On a smaller scale, implicit subsidies were also provided to the energy and agriculture sectors (together around a quarter of total implicit subsidies), although they were outweighed by implicit taxes imposed on those sectors. 17 According to the GFS methodology. 7 encouraged, there is little scope for them to operate when access to assets and resources is monopolized b y t he s tate-controlled o r favored entities. E ven where p rivatization h as occurred or land has been given to private farmers on long-term leases, the state still largely directs their production and marketing, and directs resource flows to and from these e nterprises o r farms. T he p ervasive r ole o f t he s tate and m arginalization o f t he private sector, while maintaining stability, has significant costs for efficient resource allocation and growth. This centralized control over the economy is also reflected in infonnation flows, which are largely unidirectional - from economic agents up to central planners - with restrictions on the dissemination of economic information. This undermines the fundamental role of decentralized information flows in the fimctioning of a market economy. 23. The economy's growth was at the cost of growing macroeconomic imbalances until 2000. The govemment's reliance on administrative means rather than on market Table 1: Uzbekistan - Key Economic Indicators (in US$ million, unless indicated otherwise) Item 1996 1997 1998 1999 2000 2001 (2E0s0t2) GDP growth (percent)' . 1.7 5.2 4.3 4.3 3.8 4.5 4.2 GDP (at the official exchange rate) 13,949 14,745 14,989 17,078 13,760 11,270 9,714 GDP (at the indicative exchange rate) s 13,949 10,706 10,715 8,668 7,813 7,467 7,933 GDP (at the parallel market exchange rate) 9,495 6,662 6,559 4,125 4,245 4,515 5,713 Inflation (CPI end period, percent) 64 50 26 26 28 26 22 Inflation (PPI end'period, percent) 72 40 48 35 70 44 37 Inflation (GDP deflator, percent) 82 66 39 44 47 43 47 Nominal interest on household deposits (percent)/ 28 15 13 14 19 18 26 Consolidated budget balance/GDP (percent) -6.3 -2 2 -2.4 -2.5 -2.3 -2.0 -2.2 Real public sector balance/GDP (percent) d' -12 4 -2.5 -10.1 -9.9 -2.7 -3.9 -3.5 Merchandise exports 3,534 3,695 3,049 2,790 2,935 2,740 2,510 Merchandise imports 4,240 3,767 2,938 2,587 2,441 2,554 2,186 Current account balance -980 -584 -103 -126 216 -113 222 Increase in reserves (gross) 33 -480 1 74 31 -61 3 Foreign direct investment (net) 90 167 140 121 75 83 65 Total debt outstanding and disbursed˘' 2,357 2,864 3,473 4,777 4,419 4,684 4,763 Public and publicly-guaranteed debt outstanding and 2,201 2,337 3,072 3,833 3,865 3,924 4,032 disbursed u Total debt/GDP (percent, at the official exchange rate) 17 19 23 28 32 42 49 Total debt/GDP (percent, at the indicative exchange 17 27 32 55 57 63 60 rate) " Total debt/Exports GNFS (percent)' 61 72 103 154 130 146 161 Total debt service/Exports GNFS (percent) 9' 9 13 11 16 26 27 23 Official exchange rate (average, sums/US$) 40 66 95 125 237 432 769 Commercial exchange rate (average, sumslUS$) .. 74 107 160 450 682 879 Parallel market exchange rate (average, sumsfUS$) 59 147 216 516 767 1,078 1,308 Real official exchange rate change (percent) "' 7 -5 51 -5 -34 -31 3 Real parallel narket exchange rate change (percent) h -31 12 6 -40 33 -10 63 Source. Uzbek authonties, IMF and Bank staff calculations ' Based on official statistcs 2001 GDP numbers are preliminary. v The indicative exchange rate is defined as a weighted average of the official (60 percent), commercial (10 percent), and curb market rate (30 percent) rates v Annualized average simple monthly interest rate dv Including "non-budgetary" e xtemal p ubhc and p ublicly-guaranteed b orrowing b y enterprises, and c entral bank p rofits adjusted for v aluation and inflation. d US$0 46 billion of debt to Russia, which is in dispute, short-term debt, which fluctuated between US$0 I billion and US$0.6 billion, and pnvate non- guaranteed debt are included in all debt ratios. ' Including US$0 46 billion of debt to Russia, which is in dispute, and in 1999-2001 - $0.15 billion Societe Generale gold financing facility sl GNFS - Goods and non-factor services hi End-period, PPI-based Increase denotes appreciation. 8 price signals increased after the formalization of exchange controls in early 1997, comprising multiple exchange rates and restrictions on current account transactions. To save foreign exchange in the short-term, import substitution was encouraged, and export plans were enforced on enterprises so that foreign exchange could be allocated to enterprises whose imports were included in the plan. Adverse external factors worsened the terms of trade: gold and cotton prices fell steadily since 1996 and in August 1998 the Russian financial crisis hit. But instead of adjusting to the large devaluations in the Russian Federation and other CIS countries, which at that time accounted for close to 40 percent of Uzbekistan's exports, the government further tightened foreign exchange controls. The exchange rate became increasingly misaligned, and the parallel market premium over the official rate increased from around 90 percent in the summer of 1998 to 480 percent in February 2000.18 The official real exchange rate appreciated by over 50 percent in 1998, and as a result, the competitiveness of Uzbekistan's exports declined, especially vis-a-vis CIS trading partners. Yet, the surrender requirement on foreign exchange from exports was increased in early 1999 which, together with the overvalued exchange rate, placed an even higher tax on exports leading to further export contraction. The government responded by stricter rationing of foreign exchange, further compressing imports and advocating the "localization of production" viz. production of as many goods as possible domestically relying on local raw materials and intermediate inputs. 24. The lack of exchange rate adjustment was accompanied by an expansionary fiscal stance. Although the consolidated state budget deficits have been between 2 and 3 percent of GDP since 1997, Figure 1 public sector deficits including Parallel Market Premium and Capital Outflows, 1996-2092 all public and publicly- 5C guaranteed borrowing by 5 a_ enterprises and banks, were - I _ _ much higher. In 1998-99, the nX -03 real public sector deficits, -M _ _ - _ _ _ _ _ including state enterprise _A borrowing, were as high as 10 2\ percent of GDP.20 Higher public - _ _ _ - _ ) _ _ sector investment accounted for . _T most of the increased deficits. so _ A7 Despite thie considerable real official exchange rate . . vk J appreciation in late 1998 and I 'Nt otercnanWderrorsandomb9ons perBOPrih I-)te] 1999 and expansionary fiscal Source- 117hek authorities and the World Rank 18 The commercial bank rate at which only a relatively small share of foreign exchange transactions took place was devalued somewhat faster than the official rate but the gap between it and the parallel market rate also increased substantially - from 65 percent in mid-1998 to 300 percent in February 2000. 19 By 2001 contingent liabilities such as "non-budgetary" external public and publicly guaranteed debt of enterprises and banks accounted for 72 percent of external public and publicly guaranteed debt outstanding. 20 8-9 percent of GDP in nominal termns. . The real public sector deficits include "non-budgetary" public and publicly-guaranteed borrowing by enterprises, and central bank profits adjusted for valuation and inflation. 9 policies, the external current account deficits were only 0.7 percent of GDP - contained by administrative restrictions on foreign exchange for importers. However, unidentified flows in the capital-account which indicate unregistered imports and capital flight increased considerably at the same time reaching 4-6 percent of GDP in 1998-99, closely reflecting the increasing parallel market exchange premium (see Figure 1). In effect, external debt was accumulated at the same time as capital flight of similar magnitude was taking place, pointing to an unsustainable balance of payments position. 25. Since the spring of 2000, the authorities have taken steps to adjust. The official exchange r ate h as b een devalued b y o ver 5 00 p ercent and i n M ay 2 002 t he e xchange bureau market was substantially liberalized. Consequently, the real official exchange rate devalued by 75 percent and by 2002 it was at a more depreciated level than during the effective convertibility in 1995 and most of 1996. While the devaluations (together with an appreciation of the parallel market exchange rate since May 2002), have substantially narrowed the gap between the official and parallel market rates, the parallel market premium, however, still stands at around 20 percent in March 2003 indicating that access to foreign exchange has not been completely liberalized. In addition to ex-ante registration of import contracts by the MFER, requirements for conformance certificates, import price verification for all imports, limits for advance payments for imports and export pre-payment requirements are undue impediments to trade. 26. In 2000-2001 a significant fiscal adjustment accompanied by a mirror improvement in the external accounts took place. The real fiscal deficit was reduced to less than 4 percent of GDP and unidentified capital outflows declined to under 2 percent of GDP by 2001and further in 2002. The underlying reductions in state budget expenditure which have taken place since 1997 continued, but more importantly, there was a large decline in state enterprise investments by 8 percentage points of GDP. Extemal public and publicly-guaranteed borrowing has been substantially cut back since 2000, as the cost of new borrowing increased and terms worsened: commercial and bilateral credit commitments fell by two-thirds of their levels in 1998-99. Indeed, annual loan commitments in 2000 and 2001 were the lowest since independence. In 2002 the government's more conservative borrowing approach was formalized with external borrowing limited to debt service due in the year. 27. These improved borrowing policies were also accompanied by reduced reliance on money financing of the budget in 2001 and 2002. However, annual inflation has remained at 43-47 percent as measured by the GDP deflator. High inflation and large exchange rate devaluations together with low trust in the banking system and restrictions on access to cash resulted in a steady decline in monetization of the economy with reserve money declining from 11 to 6 percent of GDP between 1996 and 2001. An increase in real interest rates and exchange rate stability will be needed for an increase in the demand for money. 28. The macroeconomic policies followed have been costly to the economy. The exchange rate misalignment for a protracted period has been damaging to exports and economic growth and has driven much economic activity underground and contributed to 10 capital flight. It has also resulted in declining foreign investment. The export tax through surrender requirements at the overvalued exchange rate constrained private sector exports. Of the 26 percent decline in export value between 1997 and 2001, only around half can be attributed to the fall in world prices of cotton and gold; the volume of exports s hrunk b y 1 3 p ercent. B alancing d emand and s upply i n t he foreign e xchange market with an overvalued exchange rate required severe import compression: between 1997 and 2001 merchandise imports in value terms slumped by 32 percent, and declined by another 14 percent in 2002. Uzbekistan is now the most closed economy in the CIS in terms of both exports and imports. While during the Soviet period, Uzbekistan was close to the average, the closed nature of the economy has steadily and significantly increased since then, contrary to the trend of other CIS countries. 29. Uzbekistan's external borrowing has been at high cost. The implicit dollar interest rate on external debt (estimated as annual interest paid to mid-year public and publicly-guaranteed external debt stock) in 2001 was 5.8 percent, not much lower than in the mid-to-late 1990s. With the average cost of borrowing remaining well above the official real GDP growth rates since 1994, one of the key conditions of external debt sustainability is not met - that the real interest does not exceed the growth rate of the economy if a debt spiral is to be avoided. The debt dynamics would lead to a rising debt- output ratio, unless there is a sufficient non-interest current account surplus.2 In other words, GDP growth would have to be almost 6 percent to maintain a constant debt-GDP ratio, if there is a non-interest current account balance - or even higher if there is a deficit. It is, thus, essential for Uzbekistan, together with exercising the borrowing restraint, to pursue more forcefully policies that would promote export and economic growth and help ease its extemal debt burden by "growing" out of it. 30. There are significant risks. Contingent liabilities such as "non-budgetary" public and publicly guaranteed borrowing by enterprises make the state budget vulnerable. The risk posed by domestic public guarantees on bank lending to enterprises is small, since the real value of such contingent liabilities has been eroded by inflation, and by end 2001 they amounted to only 3.3 percent of GDP. However, with 85 percent of extemal public and publicly guaranteed debt service taking place outside the budget, there is a looming liability on the government. Uzbekistan is vulnerable to other risks arising from its extemal debt, in particular interest rate and exchange rate movements as about half of Uzbekistan's debt is at floating interest rates and around 45 percent of debt is denominated in currencies other than US dollars while its exports remains mainly in US dollars. 31. The need for consistent, credible macroeconomic and structural policies. Uzbekistan's industrialization drive and growth strategy has relied on import-substitution and significant foreign borrowing. Such a growth strategy is sustainable only if external 21 Strictly, the short-term capital outflows should also be included in the non-interest current account. If the real interest rate on external debt, r, is 5.8 percent and GDP growth rate, n, is 4 percent and the debt-GDP ratio, b, is 40 percent, then debt-GDP would increase by (r-n)o b = 0.72 percentage points. Or, to maintain a constant debt-GDP ratio, there would have to be a non-interest current account surplus of 0.72 percent of GDP. 11 borrowing generates economic growth and brings about an increase in export potential. Thus far, the signs are that the strategy has not yielded clear benefits. Instead of taking off, exports have actually contracted. Despite a hefty real exchange rate depreciation of 75 percent since the beginning of 2000, exports have still not responded because of the remaining extensive controls on foreign exchange and trade, and structural distortions. The environment for private investment needs to be substantially improved to attract foreign direct investment, which has been less than 1 percent of GDP over the past five years. 32. The sluggish response points to the importance of not just devaluing the official exchange rate, but actually liberalizing the exchange regime to eliminate the remaining implicit tax on exports and allowing free access to foreign exchange which would also benefit potential exporters. But it also underscores the importance of achieving macroeconomic stabilization and addressing other structural constraints and rigidities in the economy - like price controls and state planning - through the comprehensive liberalization of the economy for the benefits of the current account convertibility to fully materialize. 33. The enterprise sector is little exposed to competition: it functions under centralized production targets and state distribution systems, little import competition, extensive price regulations, and soft budget constraints. Industry is to a large extent still subject to central planning through the system of "value and material balances" for industrial associations and enterprises of all forms of ownership through which around 60 key commodities as well as foreign exchange and domestic cash are distributed by the state. The government provides directives for industry through industry and trade associations and holding companies that coordinate and facilitate enterprise activities. While membership of an association is in principle voluntary, access to scarce resources (including official allocations of foreign exchange and investment funds) is dependent on the association. Since associations are vertically as well as horizontally integrated (i.e. association members provide themselves with inputs as well as providing output to others under state plans), not being a member of an association can result in a producer facing difficulties in receiving supply of inputs, or the prices paid for inputs can be above the prices available within the association. The associations therefore are mechanisms for centralized control over industry, and are impediments to production outside of the associations. Associations are also sources of monopoly power through centralized marketing of the outputs of member enterprises. In early 2003, the government moved to reduce the role of associations in enterprise management22. However, on the other hand, a set of government resolutions in late 2002-early 2003 aims to create a centralized wholesale trading network under the aegis of Uzbeksavdo and Uzbekbirlashuv state associations. Small and medium sized enterprises may also be members of industry 22 A Presidential Decree issued in January 2003 envisions a reduction in associations' mterference in enterprise operations, expansion of market-based input supply and marketing mechanisms for enterprises within associations, limits on the powers of state trustees in the management of enterprises with state stake, and a sell-off of state shares in enterprises where the state holds stakes of up to 25 percent. Decisively implemented, the decree could be a step towards reducing the associations' control over the enterpnse sector. 12 associations but many operate outside of government monitoring and industry associations, and also function in a dual informal economy where cash-based transactions are outside the scope of government. According to enterprise surveys, the role of the state is very prominent and Uzbek firms face considerably less pressure from domestic and foreign competitors than other firms across the region. In the BEEPS, on average more than 34 percent of domestic sales by Uzbek enterprises went to the government or government agencies (excluding SOEs) compared to an average of just over 10 percent across the region and Uzbek firms identify fewer competitors than in any other country in the sample with the exception of Azerbaijan. 34. Price regulation and controls remain quite extensive in the economy, notwithstanding t he I iberalization m easures u ndertaken b y t he government s ince 1 991. Besides price controls on socially significant goods (such as sugar, flour and bread, butter and vegetable oil), utilities, and strategic goods (such as metals, cotton, cement), prices of cereals and livestock products are kept low due to export bans. In addition, price regulations still cover some 270 goods produced by 440 enterprises which are defined as monopolies, a definition based on existing market share rather than barriers to entry (two- thirds of these enterprises have a market share between 35-65 percent and the rest above 65 percent). Almost one-third of the large industrial enterprises were classified as monopolists due to the lack of import competition. The price regulation covers a range of durable and other consumer goods (about 50 items), services (90 items) and various industrial inputs. Over the past year, the government has moved to gradually reduce the number of export bans and enterprises designated as monopolists. 35. Privatization of small enterprises was largely completed by 1995. However, privatization of large and medium enterprises has proceeded slowly. Of the total number of large and medium industrial enterprises, less than 20 percent of those corporatized were fully privatized, but there are several hundred in addition not yet corporatized. Most of the corporatized firms have been partially privatized by sale of shares to managers and employees. Over time, managers increased their ownership (a process which was also significant in Russia) and many of the shares targeted for sale to the public or foreign investors were not sold. In addition, untransparent mutual and cross- ownership of enterprises is another source of anti-competitive behavior: in practice, shareholdings in privatized companies can be quite concentrated, with a few or even single individuals having a controlling interest. In almost all the partially privatized firns the government retains just over 25 percent shareholding which allows it to exercise control over decisions made by the enterprise through state trustees. While this enables the state to exert governance, it has also impeded restructuring as these enterprises continue to rely on state support. The government started case-by-case privatization in 1998, but to date only one large privatization transaction has been completed although a few others are now in advanced stages. Besides the overall economic environment, including currency inconvertibility, other key problems have been the unwillingness of the government to offer majority stakes, barriers posed by industry associations, inflexibility with respect to valuation and pricing of the transactions, unclear property rights, difficulty of enforcing contracts, and the lack of a clear, transparent legal and regulatory framework for some of the infrastructure and public utilities sectors. 13 Recognizing the latter, the government is initiating sectoral reform in infrastructure and utilities. 36. Since 1999-2000 the government has taken several measures to encourage SMEs, including most prominently the introduction of a unified and simplified taxation for small enterprises, streamlining registration, reducing business inspections, subsidized credit, and an end to foreign exchange surrender requirements for exports by SMEs of their own production. Despite the reported growth in recent years, SMEs represent a slim layer between large enterprises and the substantial informal sector, accounting for only 9 percent of employment (or 14 percent of formal employment) and 15 percent of GDP in 2001. Compared to the SMEs, the number of sole entrepreneurs had boomed until recently. The movement of economic activity towards individual entrepreneurs is likely to a significant extent a direct consequence of the regulations imposed on the formal sector of the economy. The informal sector allows escape from reduced but still heavy and complicated taxes, including the high payroll taxes, arbitrary interventions by local authorities as well as foreign exchange, trade and banking regulations. Part of the informal sector also originates in the incentive to understate the number of employees of an enterprise to qualify for the tax benefits of a smaller category of enterprise. In the summer-fall of 2002, the government attempted to reduce the shadow economy through an administrative clamp-down on importers of consumer goods and individual traders, temporary closure of some bazaars, and restrictions on activities individual entrepreneurs can engage in. This contributed to some appreciation of parallel market exchange rate but drove thousands of entrepreneurs out of business and created shortages of some consumer goods. 37. Overall enterprise performance has been relatively weak, with industrial growth averaging 1.7 percent annually between 1995 and 2001, despite a relatively high investment in industry - on average 10 percent of GDP (or 62 percent of industrial value added) over the same period - and significant subsidies through the exchange regime. There has been some continued labor shedding over this period, which has salvaged productivity somewhat but capacity utilization is low, even in a number of new industries. Little infornation is available at the firm level. Enterprise financial data on a sample of the largest borrowers of some medium-sized banks suggest that enterprises are highly leveraged and their profitability was an average of 3 percent.23 Debt overhang may have reached dangerous levels for a number of companies, although these results need to be treated with caution. Inter-enterprise arrears and offsets are reportedly significant but reliable data are not available. Tax and wage arrears24 are not that large according to official data, but there may be a significant problem looming of non- performing bank loans, particularly after the large exchange rate devaluations since 2000. 23 This is based on data received in 2001 of a samnple of 55 enterprises that are the largest borrowers of three of the medium-sized banks. Updated data, including of enterprise borrowers of the largest bank, NBU, were not provided. The results need to be interpreted with care since the quality of the data is poor and accounting practices may be non-standard. 24 According to the household survey though, the incidence of wage arrears is quite significant, particularly among those working in agriculture (54 percent of workers report wage arrears), construction (34 percent) and industry (21 percent). 14 38. The banking sector was the conduitfor on-lendinig the stage-guaranteed foreign loans and these loans now account for about 70 percent of the banking system loan portfolio, predominantly concentrated in the NBU and to a lesser extent in some medium-sized state banks. The banks continue to report such loans as performing since they are state guaranteed and consequently banks have no incentive to evaluate their credit risk. While data are not available to assess the creditworthiness of the borrowers, it is quite likely that the fiscal liability from these state-guaranteed loans will be high as many enterprises that have borrowed do not sell their goods or services at equivalent world prices and, as noted above, many are under-utilizing their production capacity. In addition, there has been a massive exchange rate devaluation since early 2000 (of over 500 percent) and the govermment is now rightly concerned about its impact on the borrowers' ability to repay. There are already signs that banks may be experiencing liquidity difficulties: there has been a rapid growth of accrued interest on NBU's balance sheet between 1999 and 2001. Besides the potential liquidity risks to banks, state directed lending and pervasive governent interference stunts the development of banks as effective financial intermediaries. Even where banks are lending without guarantees, an analysis of some medium-sized banks has indicated that there may be significant under-provisioning for credit risks and there is consequently a high probability that a number of banks are capital impaired, despite reporting profits and adequate capital. 39. Excluding state-sponsored lending, the level of financial intermediation is low, comparing unfavorably in depth with other transition countries. Mobilization of household deposits is also low at 2.2 percent of GDP at the end of 2002 and growing very slowly, reflecting the minimum necessary for households to operate rather than households' interest in saving or trust in banks 'This is likely due to the fact that banks still operate as an ann of the govermment to perform its resource distribution and tax enforcement functions, with adverse consequences on depositor confidence. The CBU- administered "cash planning" system often resulted in depositors not being able to access their deposits on demand. In February 2003, the authorities resolved to abolish cash plans and now need to ensure adequate cash supply to commercial banks to avoid deposit withdrawal problems. Instead of the abolished centrally administered cash plans to manage liquidity and contain inflation, a more active interest rate policy would be appropriate. Currently, real interest rates on soum-denominated deposits are negative. In addition, with the apparent aim of reducing tax avoidance and currency speculation, banks are instructed to monitor and block accounts to enforce tax legislation or to maintain restrictions on cash withdrawals from enterprise bank accounts. Such regulations undermine trust in the b anking system and encourage p eople to keep their money out of banks, severely constraining resource mobilization. 40. Thus, despite significant progress in recent years towards providing a regulatory framework for the financial system, the Uzbek financial sector is far from making anything like its potential contribution to resource allocation and economic growth and real reform of the banking sector has yet to begin. 41. In pursuit of it objectves of stabilizing cotton eport revenues, achieving wheag self sufficiency and keepingfood prices low, the government has maintained state 15 controls over production/planting, procurement and pricing of key "strategic crops" - cotton and wheat - which account for 80 percent of cultivated land, retained state agricultural input supply and marketing monopolies, and restricted trade by banning exports of key agricultural commodities (cereals and livestock) and importing most key foods (sugar, vegetable oils) in a centralized manner through a state trading company "Uzbeksavdo". Production and domestic markets in some agricultural sub-sectors such as livestock, fruits and vegetables have been liberalized, and a process of farm restructuring is taking place. About 20 percent of the cultivated area has been transferred to private farms which, however, are also subject to mandatory cropping plans and state procurement. F ailure t o c omply w ith the p lans may r esult i n the e xpropriation o f t he private farm land by the state. Whilst these set of policies have achieved relative output stability and agricultural production is back to its pre-independence level, incentives to improve efficiency remain low. 42. In the past, the total value of the implicit tax on cotton production through depressed output prices significantly below world market prices tended to significantly exceed the total value of input subsidies, thus imposing a heavy net tax on cotton production. With state procurement prices for cotton increasing while world market prices have been declining in recent years, net implicit taxation of the cotton sector has been reduced. However, the distorted input and output prices that lead to waste and large allocational inefficiencies clearly remain a problem constraining growth. 43. Besides distorted relative prices, mandatory cropping plans also lead to inefficient land use and choice of crop. In order to achieve self-sufficiency in wheat, both collective (shirkats) and private farms were required to produce more wheat at the expense of cotton production. Despite the fact that the increased wheat production allowed the government to save over US$450 million by dramatically reducing wheat imports, the net annual economic loss due to the wheat-cotton substitution is estimated at $60 million in 2002 since the value of cotton yield per hectare at world market prices is higher than the value of wheat yield. The net present value of cumulative economic losses from the wheat-cotton substitution since 1994 are estimated at over US$ 2 billion. Additionally, the conversion of land from feed crops to wheat (fodder area is now one-third its level of 1991) also reduced fodder production which, together with a sharp decline in the imports of mixed fodder, has reduced livestock productivity. Moreover, recent intemational developments have undercut the rationale for wheat self-sufficiency as wheat prices have declined and neighboring countries have a wheat surplus. Yet, farmers cannot respond to changes in prices as they must comply with state cropping and production plans. 44. Incentives within the collective farms remain poor. The profit sharing arrangements in shirkats (which still cultivate 69 percent of the land) limit their productivity as efficient shirkat members (pudrats) have little financial autonomy and cover the losses of less e fficient ones. On the other hand, dehqan (household) farms, which are not subject to state directives and are more productive, are constrained by insufficient access to land and inputs. In these ways, a number of avenues of increasing productivity, crop diversity, and rural incomes are blocked off. 16 45. The current financing system of centrally directed tranches through the Fund for State Agricultural Purchases under the MOF25 largely ensures uninterrupted supply of inputs and wage payments and has reduced arrears. However, it also limits commercialization of agricultural production to essentially barter exchange of inputs for agricultural crops and precludes private entry in provision of inputs such as fertilizer, agrochemicals, machinery services as well as credit are effectively available only from the state and only for the planned production of grain and cotton. Coupled with low input prices, this system has discouraged more efficient input use. Fertilizers are sold domestically at a discount of 25 percent and more compared to world market prices (at the indicative exchange rate). But more significantly, irrigation is very heavily subsidized and since water use is not metered, efficiency of water use is low. Almost the entire agricultural production in Uzbekistan relies on a pumped irrigation system and the estimated average capital cost of the irrigation and drainage infrastructure is very high - $3,500 per hectare. To sustain this infrastructure, a minimum annual investment of approximately $260 million would be needed, about half of which is for on-farm infrastructure. 46. In downstream agro-processing industry, many enterprises are subject to state ownership and control, marketing restrictions, and export bans (cotton fiber, edible oil, flour and cereals, silk products, tanning industry) and continue to struggle with serious liquidity problems, resulting in poor prices to farms and substantial delays in payment. 47. In sum, the current array of agricultural policies and programs constitutes a working system in Uzbekistan, but one which is inefficient. Put simply, the policies regulating agricultural pricing, state procurement, marketing, farm autonomy, and land tenure prevent a more efficient combination of land, labor, and capital that would raise agricultural efficiency and rural income. Furthermore, it is unclear whether the agricultural sector can afford these inefficiencies in light of the mounting investment backlog for the irrigation system. 48. Uzbekistaa pays a high price for igs energypolicy. As noted above, Uzbekistan borrowed heavily to finance the development of the oil and gas sector. Since independence, the energy sector has received roughly $1.5 billion in foreign loans under government guarantees, which contributed to the modernization of the petroleum and chemical industries. To ensure the ability of the energy sector to continue servicing these loans, however, the cost recovery levels in the sector must be increased. Currently oil and coal are sold at a fraction of world market prices (at an indicative exchange rate, the domestic wholesale crude oil, price is one-quarter its export parity price, and the retail coal price is less than 20 percent its export parity). Electricity prices charged to all sectors also remain a fraction of long run marginal cost (an average tariff of 0.8 cents/kWh against about 3.5 cents/kWh) as do gas prices (the retail gas price is one-third of its long run marginal cost). In early 2002, the authorities adopted a medium-tern energy price program reportedly envisioning quarterly energy price increases totaling 25 In 2003 the government is imtiating in a number of regions a pilot program of financing private farms through direct commercial bank lending at subsidized interest rates but it is unclear whether it represents a major departure from the old system. 17 26 around 50 percent per annum in nominal terms. As part of the program, electricity tariffs were raised by over 50 percent in 2002. Such real energy price increases would need to b e continued to s ubstantially improve the financial situation oft he s ector. In addition, energy non-payment would need to be addressed. The authorities declined to provide non-payment data but interviews with enterprises indicate that in some energy sub-sectors non-payments exceed 50 percent of total billings, and barter offsetting schemes are common. As a result of low cost recovery and reinvestment, the capital stock in parts of the energy sector has been run down and is in urgent need of rehabilitation or replacement. According to a recent study, required investment in thermal power plants alone could exceed $1 billion in the next 3 to 5 years. The cheap energy prices buttress the massive energy inefficiency. The energy intensity of the Uzbek economy remains very high (2.2 TOE/1OOOUS$ in 1999), over three times as high as in countries like the USA or Malaysia, and far above the levels of Kazakhstan or Russia. 49. Efficiency of energy use needs to be further improved. Gas distribution losses are currently estimated at over 20 percent, at least 15-18 percentage points above industry standard. Technical and commercial losses reported by Uzbekenergo anount to 18 percent of electricity generated, almost twice the 10 percent level routinely achieved elsewhere. In addition to the very low prices and problems with non-payment of bills, inadequate metering of energy consumption further reduce the incentives to use energy efficiently. In the gas sector, only 6 percent of the 3.5 million households who have been given access to the gas network have meters. In the electricity sector, it is likely that many meters need replacement due to age and increased loads. Recognizing the seriousness of the problem, the government has decreed an ambitious program for metering all household gas consumers within the next 3 years. However, given the current low level of net resources that the gas distribution company, Boskommungas, generates, lack of finances (an additional $120 million is required) is likely to delay the program. 50. In sum, the rich fuel endowment is currently used to provide highly subsidized energy to the entire economy - industry, agriculture, transportation, and households, benefiting rich and poor alike. Unfortunately, this current form of handing over the benefits of the resource endowment to the enterprises and population is inefficient and unsustainable; inefficient because valuable energy is wasted on a massive scale and unsustainable because of the mounting levels of quasifiscal activities in the energy sector, estimated at $2.1 billion in 200127. The known resources of oil and gas will be exhausted rapidly if the wasteful use of energy continues and new exploration and development of reserves is not undertaken due to lack of funds. At current production levels, the officially reported gas reserves provide a reserve-to-production (R/P) ratio of about 33 years (i.e. existing proven reserves will last for 33 years). While this is a relatively high ratio, it has declined from an estimated 42 years in 1997. Similarly, the oil R/P ratio has 26 The government did not share the program with the Bank. 27 Quasifiscal deficits in the electricity and natural gas sub-sectors due to low tariffs, operating inefficiencies and non-payments for energy supplied accounted for around 80 percent ($1.7 bn.) of these quasifiscal activities. 18 declined from 13 to 11 years over the same period. Modifying the current energy policy to make it more efficient and sustainable while protecting the poor from adverse effects of energy price increases is one of the major policy challenges for the country. As the elimination o f e nergy s ubsidies m ay c ause b ankruptcy o f m any s trategically i mportant enterprises, their restructuring, and improvements in the general business environment to attract new investments, should be accelerated. 51. Uzbekistan 's current practices on the dissemination of information on economic and social development to its own pmblic and to the international comm unite8 are not compatible with the government's stated desire to move towards a well governed market economy. Strong remnants of the Soviet system for controlling information flows continue to severely restrict public access to information. 52. Though the Constitution establishes the right of citizens to obtain information from government institutions, this is counteracted by excessively broad legislation on state secrets that gives authorities significant discretion to define what falls under state secrecy provisions. Moreover, the legislation and resolutions defining what constitutes state secrets are themselves classified as secret. This "double bind of secrecy" creates considerable uncertainty about the definition of state secrets in practice and eliminates the possibility of any oversight over the secrecy regime. It also provides a strong incentive for excessive caution and self-censorship in releasing information to the public and other government agencies. This is reinforced by a network of "first departments" within all government agencies and key state enterprises which implement the secrecy provisions. As a result, the quality and integrity of information flows throughout the system is reduced. Furthermore, state legislation and decrees - or their parts - can themselves be declared secret, undermining the transparency of the legal regime. While the government has recently eliminated the State Secrets Inspectorate with responsibility for the media censorship, the network of information regulators throughout government agencies and enterprises remains. 53. Against this background, it is not surprising that Uzbek official statistics only contain a narrow set of indicators, with extremely limited circulation, that fall well short of the international standards recommended under the IMF's General Data Dissemination System (GDDS). While there are legitimate national security concerns that lead all countries to restrict access to some forms of information, Uzbekistan defines an unusually broad range of information on economic and social development - with no clear threat to national security - as secret. Data in such areas as macroeconomic performance, fiscal policy, banking and monetary statistics, foreign trade, debt, and poverty levels - publicly available in most countries of the world - continue to be subject to secrecy provisions or limited circulation in Uzbekistan. The quality and integrity of published data are also subject to question, as access to complementary data that would allow for proper verification is restricted. 28 Uzbekistan is one of only 4 countries in Europe and Asia that do not provide enough data for a page in the IMF's International Financial Statistics. The others are Afghanistan, North Korea, Turkmenistan and Tajikistan. 19 54. Consequently, more than ten years after the collapse of the Soviet Union, Uzbekistan still has an information environment based on a presumption of secrecy rather than a presumption of openness, the hallmark of transparent and accountable government. The costs of maintaining attenuated information flows have become more substantial as the government accelerates market-oriented reforms. 55. A stable and attractive investment climate is undermined by lack of economic information necessary for investment, pricing and production decisions, by difficulties in obtaining financial information on enterprises being offered for privatization, and through the practice of secret clauses and resolutions that creates an unlevel playing field for competition. The efficiency and effectiveness of government decision-making also suffers as analytical or research departments of ministries have trouble obtaining necessary data from other ministries or even from other units within the same ministry. The restricted information environment has effectively cut off independent research which is an important channel into the decision-making process. 56. Restricting information flows also imposes significant costs for the integrity of government at all levels. Numerous studies have shown that there is a direct link between the extent of government accountability and the incidence of corruption. This is particularly true with regard to financial accountability. Without a clear public record of government financial flows and accounting statements of major state-owned companies, the risks of the misuse of public resources increase dramatically. All efforts to curb corruption begin with measures to increase the transparency of government. 57. Concerns about access to information seriously damage the international image of Uzbekistan among foreign investors and donors. On indicators of voice and accountability based on a wide range of international surveys29, which encompass the extent of transparency of government and the degree of civil society participation in government processes, Uzbekistan ranks worse than 87 per cent of the 175 countries included in an aggregated set of these surveys. 58. Whatever security advantages may come from restricting information flows must be weighed against the considerable trade-offs that hinder Uzbekistan's market reforms and hold back further integration into the global economy and international institutions. Many countries have found that opening access to information on economic and social development is a low-cost and high-return strategy for building greater credibility behind the government's reform program both at home and abroad. Greater openness in these areas can be designed so as not to threaten legitimate needs to restrict access to information regarding military and national security concerns. An Overall Assessment and Comparative Perspective 59. The government strategy and policy choices have resulted in some growth and stability. But there are some issues of concern. First, the unsustainable macroeconomic 29For fiurther information on this database and related papers, see the website: www.worldbank.or2/wbi/governance. 20 policy course until early 2000 has been costly and its fall-out must be dealt with decisively. The exchange rate and fiscal adjustments, and corresponding sharp reduction in foreign borrowing, that the government has undertaken since 2000 were positive corrective measures but the fundamental structural distortions causing the macro- imbalances have not been eliminated. For example, the financial situation of banks and enterprises needs to be urgently assessed and an enterprise and banking restructuring and reform strategy agreed and launched. A lesson that has emerged from the recent financial crises of Indonesia, Thailand, and Russia is that the seeds of macroeconomic crisis get sown over several years. 60. Second, U zbekistan c an and should grow faster t o accommodate i ts p opulation growth, to raise per capita income growth and expand employment generation opportunities. This calls for a reconsideration of its current strategy. As the experience of transition countries shows, what is at issue is not so much the pace of reform, but the clarity of direction and the consistency and resolution with which they are implemented (see Box 1). Allowing greater decentralized economic decision-making based on market forces a nd a n o utward o rientation e nabled h igh s ustainable g rowth b ased on increased productivity. A country does not have to be at the verge of a macroeconomic crisis to undertake reforns. China opted for reforms even when it had relative macroeconomic stability and rapid growth, but it changed from growth due to more input use to growth .due to increased efficiency of input use. By doing so, it was able to increase consumption levels of its population. It introduced incentives and decentralization gradually but in all spheres of economic activity: to firms making production and marketing decisions; to foreign trade corporations in selection of export products; and to fanrers in selecting crops. Uzbekistan needs to modify its strategy to overcome problems encountered, to move decisively towards a market economy and to unlock its potential. The next section presents a strategy for reform, incorporating lessons of experience of other transition countries. 21 Box 1. Alternative Approaches to Transition from a Centrally Planned to a Market Economy Countries have chosen a different pace and path to a market economy, and started from different initial conditions. Poland's well-known "big bang" or "shock" Economic Transformation Program (ETP) in 1990 was a fundamental break with the central planning approach of the past. In contrast, China's approach was gradual - in terms o f time, not depth of reforms. When China launched its economic reform program known as "open door" policies in 1978, it was not impelled to reform due to a macroeconomic crisis. On the contrary, the 1949-79 period had witnessed considerable achievements, in terms of strong growth, savings mobilization, and human and physical capital. But there was dissatisfaction with the "extensive" growth model that required increasing levels of investment to generate growth, but little if any improvement in productivity, thus preventing significant gains in personal consumption. Vietnam's reforms, which started with the announcement of doi m oi in 1986 and accelerated in 1989, were more urgent as the centralized system of management had led to severe economic and social problems in the 1970s and 1980s. The impact of the reforms has been quite spectacular in these countries -- per capita real income growth has averaged between 5 and 8 percent annually (see Table 2). The incidence of poverty in Vietnam halved within a decade to 37 percent, and in China consumption levels more than doubled and the poverty rate declined from 28 percent in 1978 to under 10 percent in 1984. All these countries have several problems that still need to be tackled, but they succeeded m sustaining high economic growth, raising living standards, increasing productivity, and expanding ermployment opportunities in a growing and dynamic private sector within the fist ten years of their transition (see Table 2). The common features of achievements and underlying policy choices are summarized below. Table 2: Comparative Economic Performance of Economies with Alternative Models of Transition (period averages In percent, unless Indicated otherwise) Uzbekistan Poisnd Chuia Chma VIetnam 1996-2001 1994-2001 1979-1989 1990-2001 1991-2001 GDP growth 40 49 96 94 73 Industry 16 6.2 10.5 12.4 11.7 Agncultitre 2 9 -0.2 5 4 41 4.6 Services 4.2 4.7 12 3 8 4 7.1 GDP growth per capita 2 4 4 8 8 0 8.2 5 6 Gross domestic fixed investmcnt/GDP 30 22 29 34 25 Ineretwotal capital output rato 7.4 4 6 3.0 3.6 3.4 MerchandLse exports growth -3 5 11.3 149 14 9 24 0 Merhandineimportsgrowth -25 136 155 131 244 FDi per capita(USS) 4.7 139.6 1 1 23 1 7.5 FDI/GDP 12 3 8 0 4 3.9 5 0 Broad mnoney/GDP (begmning of period) 19 35 25 73 20 Broad noney/GDP (end of period) 12 45 66 158 42 Eniploymnent growth 1 3 0 4 2 6 1 1 1 8 Populatson gmwth I5 01 14 1 1 1 7 Eniploynment.population ratio change -0 2 0.4 1.1 0.0 0 1 Atlas GNI per capita (USS. beginmg of period) 630 2,370 260 350 120 AtlasGNIpercapita(US$;endofperiod) 550 4,310 370 910 410 Source Unmfed Survey 2002 and World Development Indicators Macroeconomic stability has enabled a steady increase in savings and financial deepening, and is a prerequisite for a conducive business environment * In Vietnam, there was a five-fold increase in domestic savings from 3 percent of GDP to about 17 percent between 1990 and 1 996, with most of the increase being non-government savings. In China, household and enterprise bank deposits shot up from 19 to 48 percent of GDP between 1978 and 1989. * While they had high investment rates, these were largely financed through domestic savings, and to a lesser extent, FDI. China's investment was overwhelmingly financed through domestic savings during the 1980s. Vietnam relied more on FDI. Productivity improved remarkably. * Much of the increase in China's post-reform growth was due to productivity gams, which accounted for 3-4 percentage points per annum of growth (from close to zero during 1949-79). 22 o Vietnam had similar productivity increases with improved efficiency accounting for an even larger share of output growth because investment rates were lower. o Poland had productivity increases during the mid-1990s along with employment increases, but this changed radically a fter the Russian c nsis when r estructuring and improvements i n productivity were primarily accomplished by lay-offs. Both China and Vietnam, predominantly agricultural countries (with more than 70 percent of the labor force at the start of reforms), liberalized the most important sector, agriculture, early and decisively. They were able to reap large productivity gains from these first partial reforms, increase income and savings, and so build momentum for further reforms in a self-reinforcing process. o Land was not privatized yet agricultural land reform has been the smgle most important factor m their agncultural growth and remarkable reduction in poverty. Both countries de-collectivized agnculture and distributed land universally for family farming on long term leases, China under the household responsibility. system and Vietnam through land use certificates that now even entitle the transfer, exchange, lease, inhentance and mortgage of the land use nght. o Prices were I iberalized in Vietnam, as in Poland. I n China, a dual-track pricing approach was followed under which households were obliged to sell a fixed quantity to the state procurement agency (which they could even purchase from the market for resale to the state), but they were not subject to mandatory cropping plans and were free to produce and sell as they considered profitable and retain any profit. o From being a marginal importer, Vietnam became the world's second largest exporter of rice. Crop and livestock diversification also took place. Another aspect is the creation of conditions for rapid entry of new firms, including in the service sector, which started to compete with state enterprises. o China's approach relied on its system of decentralized local governments and fiscal federalism. Local govermnents were given permission to pursue a Rural Township and Village Enterprises (TVE)-based development strategy to help absorb labor released by the agricultural reforms. Local governments had incentives to compete and the consequent explosion of TVE activity resulted in progressive diversification of industrial ownership away from SOEs. This underpinned the expansion in industry and tertiary sectors, and the rapid increase in exports. And by 2000, less than 50 percent of the labor force was in agriculture. o In Vietnam, most new jobs were created in the services sector and there was slow growth of the formal private sector in industry, partly because of the biased incentive framework towards SOE- dominated capital-intensive production and remaining regulatory restrictions on new firm entry. Following the policy shift in 2000, there has been a dramatic private sector response in terms of new enterprises (a three-fold increase) and capital, albeit from a small base. o In Poland, small enterprises have been growmg rapidly (64 percent between 1994-99) and now account for 65 percent of total emnployment (excl. agriculture). All these countries opened up to international markets. Indeed, the promotion of external trade was central to their programs although the sequencing and pace differed. o The growth and diversification of foreign trade have been among their most notable achievements. The surge in agricultural production created an exportable surplus, but more importantly, light manufacturing increased rapidly as a share of growing exports. o All these countries maintained broadly competitive exchange rates, after a large initial devaluation in Vietnam and Poland to the black market rate when they unified in 1989 and 1990 respectively. China had significant real exchange rate depreciation durng the 1980s, and the black market premium was only 7 percent in 1991. In 1994 it unified the official rate to the black market level. o Vietnam e liminated many trade barriers and enabled a rapid increase in enterprises engaged in trade. All quotas and targets which, together with domestic production targets, were at the base of the central planning system have been progressively eliminated. China progressively reduced the proportion of imports and exports under the mandatory plan and authorized thousands of tradmg companies to operate. Prior to unification, it relaxed exchange controls and permitted exporters to sell their retained foreign exchange to importers at a market rate. Both countries also allowed duty-free imports used as inputs for export, which proved enormously successful. 23 III. Strategy for Reforms 61. The government faces a number of challenges. Without sustained, rapid, broad- based growth, c urrent I iving s tandards m ay n ot improve and t hus m ay not b e s ocially acceptable. There is a large and growing young population entering the labor force30, and youth unemployment is high. Uzbekistan has several advantages, notably, it is energy self-sufficient and has hard currency export markets for gold, cotton, and other natural resources. But unless it can diversify and increase its exports, it will be highly vulnerable to world price movements on cotton and gold, and its economic growth will be constrained. Moreover, there is little room for further external borrowing unless exports and economic growth take off. By providing the right incentives, growth can initially come relatively quickly from agriculture and new small firms, with low capital requirements. Given the constraints on foreign borrowing, increasing reliance will need to be placed on increasing domestic savings and foreign direct investment (FDI). But these will depend on a credible economic reform program, with consistent policies and a track record of their actual implementation. 62. In late 2001 the government agreed with the IMF on a Staff Monitored Program (SMP) covering the first half of 2002. Under the program, limits on purchases of cash foreign exchange by individuals were raised and access was significantly liberalized31, some formal restrictions on access to auction foreign exchange market were removed32, the official exchange rate was gradually devalued and the parallel market premium reduced, restrictions on cash withdrawals from bank accounts by individual entrepreneurs and enterprises were eased, the number of goods subject to export bans was reduced by three, the number of enterprises designated as monopolies as well as the number of monopoly products was reduced. In the agricultural sector, state procurement prices of grain and cotton were raised in real terms, and the amount of grain left at the disposal of farmers after state procurement was increased. The gap between the parallel market and official exchange rates declined from over 100 percent at the beginning of 2002 to around 60 percent in June 2002. Despite an extension of the SMP for two months, however, the key objective of the SMP - exchange rates unification and liberalization of foreign exchange regime - has not yet been fully achieved. In March 2003, the parallel market premium remained at around 20 percent. In addition, the government took a number of measures that in fact go against the spirit of economic liberalization embodied in the SMP. These include restrictions on consumer goods imports, domestic retail and wholesale trade, and bank transactions by enterprises and individuals. 63. Partial measures, as have been taken since 2000, with some apparent backtracking, are not likely to yield a significant response in exports, reversal of capital 30 Over half of Uzbekistan's population is under 20 years of age. 31 However, the exchange bureau rate (like other legal exchange rates) is still administratively set and the gap between it and the parallel market rate persists. It can currently take a few weeks of standing in line for a person to purchase cash foreign exchange from an exchange bureau. 32 Including the streamlining of ex ante import contract registration and the elimination of the list of consumer goods for which allocation of foreign exchange is not reconmmended. 24 flight and attract FDI. For that, full current account convertibility is important, in conjunction with consistent fiscal and monetary policies, as well as removing key structural impediments and providing appropriate market-based incentives. 64. This section discusses the transition strategy - the rationale for as well as sequencing and inter-linkages of reforms in the key sectors. The attached matrix (see Appendix I) translates this medium-term strategy into illustrative actions over different phases. The precise duration of the different phases is difficult to gauge, and will depend on government capacity, technical and political economy factors, as well as the availability of intemational financial assistance. However, the phases need not be strictly sequential. 65. A minimum set of critical reforms are needed to rovide the impetus to growth as the Uzbek economy moves towards a more decentralized market economy. The first priority is to get the key relative price, the exchange rate, "right" by liberalizing the foreign exchange regime and introducing current account convertibility. A competitive real exchange rate and convertibility are critical to the entry and operation of enterprises, both domestic and foreign. Second, barriers to trade need to be reduced so that export potential can be realized and imports needed for production and exports can be obtained easily. Third, prices in the domestic market should generally reflect international prices, so that resources are channeled into profit-making activities, inputs are efficiently used, and competition is enhanced. Fourth, the central planning and allocation of resources will need to be phased out: appropriate pricing is not sufficient if firms and farms do not have the ability to make independent decisions, nor if resources are absorbed by existing and not necessarily efficient enterprises. Finally, the transfer of ownership should take place in a more competitive and business friendly environment. 66. The government has already devalued the official exchange rate very substantially. Thus, liberalizing the exchange regime now should not lead to further significant devaluation if tight fiscal and monetary policies are followed. All formal and informal restrictions on c urrent account transactions should be lifted, so that access to foreign exchange is available to all, not only to those who previously had foreign exchange quotas or limits. The government has decided that it will have a freely floating exchange rate, which is likely to be a more sustainable policy than past attempts to maintain an overvalued peg. Tight monetary and fiscal policies will require structural measures to reduce expenditures as well as imposing hard budget constraints on enterprises, including the discontinuation of issuing public guarantees on their domestic and external borrowing. The government's current policies of zero net borrowing should be maintained. In the medium term, a comprehensive public expenditure and tax reform should be undertaken to rationalize public sector operation, reduce the tax burden and simplify the business environment.33 67. As domestic demand declines with tight fiscal and monetary policies, the only non-inflationary source of growth is exports. Export-led growth is key to improving Uzbekistan's creditworthiness as well. Thus, implicit and explicit export taxes (such as 33 Details of such a reform will be elaborated in the forthcoming Public Expenditure Review. 25 non-refund of VAT on exports) should be eliminated, a level playing field created and export bans removed. Where export bans have been used to maintain domestic food prices below intemational levels, appropriate social assistance should be targeted to only the v ulnerable. A s b arriers to foreign exchange access are e liminated, tariff and non- tariff barriers will become more binding. Non-tariff barriers should not be used as a means of protection and tariff protection introduced to contain imports, especially of non- food consumer goods during the foreign exchange market liberalization, should be gradually reduced. The tariff regime should also be streamlined to eliminate differential treatment of importers by size and type of activity. In order to promote exports and remove the inherent anti-export bias of the import regime (tariffs on final goods make import substitution more profitable whereas tariffs on intermediate goods or inputs increase production costs), the government should consider a duty drawback or duty exemption mechanism during the initial stage so that exporters can compete on international markets. This proved enormously successful in China as also in other East Asian countries. In the medium term, the government needs to be more active in securing access for Uzbek goods to developed countries' markets, as well as move towards the WTO membership. Agricultural Reform 68. The agricultural sector could be the leading driver of economic growth in Uzbekistan as the supply response to liberalization and improved incentives in agriculture is often quick. Countries such as China and Vietnam witnessed remarkable increases in agricultural growth during their early phase of reforms after farm households were provided with appropriate incentives. This led to further crop diversification and expansion of the livestock sector (without threatening food security) and significantly reduced poverty while raising overall economic growth. 69. State procurement pricing of grain and cotton at the world market levels is a first step, and the government has been moving towards higher farm gate prices. This process will need to be completed with exchange rate liberalization so that administered procurement prices are set at border price levels at the market exchange rate. 70. However, output pricing alone will not be sufficient for a rapid and strong supply response. The phenomenal growth in agriculture in China and Vietnam was grounded in reforms that createdfarm households as autonomous economic units. The Government of Uzbekistan is accelerating the transformation of unprofitable shirkats into private farms which, although still subject to mandatory cropping plans, have stronger production incentives than shirkats. But shirkats, which account for more than half of the cultivated land and the farm employment, also need clear incentives. Shirkat members should be given greater financial autonomy and the joint liability of pudrats in meeting state procurement quotas should be discontinued. Unless the mandatory cropping plans are lifted, there is little scope for more efficient crop patterns and crop diversification. Also, given the high productivity of dehqan (household) plots compared to other types of farms and importance of these plots in providing for a rural family's living, raising the 26 legal maximum size of the plots (and rescinding the minimum size of private farms) would be advisable. 71. Agricultural markets liberalization is needed to provide appropriate incentives to farmers and to bring dynamism into the downstream processing of agricultural products. State procurement quotas for wheat and cotton should be further reduced and farms given freedom to dispose of the products over the state procurement levels at their own discretion and prices for these products should be liberalized. Centralized export plans and "material balances" for grain, cotton fiber and by-products through which the state currently rations the products must be eliminated. Export bans should also be lifted to give domestic producers access to foreign markets. Various other export constraints such as the export surrender requirement for traders (i.e., non-producers), differential trade regimes for legal entities and individuals, and export contract registration will need to be removed to facilitate exports of agricultural products. 72. In parallel to the reduction in state procurement and agricultural price liberalization, private sector involvement in the agro-processing industry, marketing infrastructure, storage and transportation services, and tolling arrangements for cotton should be encouraged. Once private enterprises are more active in these markets, privatization of the cotton ginneries, oil producing plants, grain milling enterprises should proceed over a two to three year period. 73. Over time, there should be a reduction in the role of government in agricultural financing and input supply. In parallel with the government's policy of agricultural price liberalization and reduction in state procurement, there should be an evolution in the role of the Fund for State Agricultural Purchases to gradually make room for the private provision of agricultural credit. Even with the reduction in state procurement, the level of financing by the Fund may have to be maintained in the first one to two years - before being gradually reduced - in order to supplement working capital to farms before substantial amounts of commercial credit, input suppliers' credits, and advances by output purchasers outside of the state system begin forthcoming. To allow for greater participation of the private sector in input supply, the share of total farm advances which could be used at farms' own discretion (now about 10 percent) including for cash withdrawals, should gradually be increased. Input prices also need to be raised to world prices at the liberalized exchange rate. This will at the same time increase efficiency of input use. This should be done immediately for fertilizers and agrochemicals. 74. In the medium-term, the single largest subsidy to agriculture -irrigation - needs to be addressed. The government should adopt policies towards introducing volumetric charges for water to reach cost recovery of at least operations and maintenance of secondary and tertiary canal systems. For preparation of eventual imposition of effective water charges, the government should take the following steps now: (a) create the legal basis for organization of farmers into self-governing water user associations; (b) start installing tamper-proof water flow measurement devices and practices at all levels of the system; and (c) prepare the legal basis for a volumetric water charge, separate from the land tax. 27 75. Several recommendations called for above are likely to either reduce fiscal revenues (e.g., by proposing increases in state order prices), or increase fiscal expenditures (e.g., on effective irrigation and drainage maintenance). To partially offset these fiscal losses, a substantial increase in the land tax, by 200-300 percent, would be feasible. Although the explicit taxation of agriculture through the unified land tax is fairly low, the government continues to maintain a tax on cotton by not zero-rating the 20 percent VAT on cotton exports. As this forms a large part of implicit taxation of the cotton s ector, this non-zero-rating should b e d iscontinued. M oreover, although o utput prices will be increased for farmers, input prices will also rise, so the scope for increased explicit taxation on farmers needs to be balanced so as not to negate the potential supply response. Enterprises and Private Sector Development 76. A central element of the government's strategy has to be the creation of a business environment that would be conducive to the development of a vibrant private sector, especially SMEs. Entry of new enterprises has been a leading source of growth and employment generation in all successful transition economies, and would cushion the decline in unviable enterprises as well as absorb surplus labor from agriculture as agricultural productivity increases. A more friendly business environment would also encourage enterprises to move their transactions from the large shadow economy. 77. Some progress has been made in reducing the gap between the official and parallel market exchange rate, and simplifying procedures for access to foreign exchange over the past year. Full foreign exchange liberalization is nevertheless needed, as it would eliminate a key constraint to the development of the private sector. However, it will not be sufficient to provide a robust supply response unless other constraints to competition from imports and domestic sources are also eliminated. Eliminating barriers to foreign trade would enable enterprises to realize their export potential as well as force them to focus on costs, efficiency and marketing by introducing competition from imports and diluting monopoly power domestic enterprises might have had. For this, the various export restrictions and import controls on enterprises and individuals such as ex ante export and import contract registration, export bans, export prepayment requirements, advance import payment restrictions, import price verification and other bureaucratic hurdles should b e lifted in the first instance along with foreign exchange liberalization. Reducing import tariffs and unifying excise taxes on imports and domestically produced goods could be more gradual. 78. Removal of domestic price controls is also necessary for providing market relative price signals and fostering competition. Price controls should only be maintained temporarily, if at all, for key foodstuffs, like bread, and price regulation should only remain for natural monopolies. Foreign competition will prevent other enterprises currently designated as monopolists because of lack of competing imported goods, from misusing their market power. 28 79. Creation of a level playing field for enterprises of different types and forms of ownership, and reduction in state intervention in enterprise operation are also essential. The excessive state control over the enterprise sector through industry and trade associations, including such vestiges of state planning as state production, export and import plans, as well as state distribution of key inputs and outputs through the system of material balances, is a major constraint not only to enterprise efficiency but also to private sector development. The state distribution mechanisms supplant the market, and new entrants with limited access to state-distributed resources are from the start at a disadvantage compared to incumbents. The mandatory state planning of enterprise activities and state distribution of key commodities therefore need to be phased out. This, together with foreign exchange, trade and price liberalization, will remove the rationale for the existence of industry and trade associations, which consists primarily in distributing scarce resources on behalf of the state among member enterprises and enforcing the execution of state production, export, and import plans. The recent government d ecision o n r educing the role o f associations i n e nterprise management i s welcome. However, associations should eventually be completely eliminated, their own shareholdings in enterprises be divested, and the state stakes which are currently managed by a ssociations on trust be transferred back to the State Property Committee (GKI). In addition, the tax and tariff discrimination against trading companies (as opposed to "producers") and individual entrepreneurs need to be eliminated: development of the trade sector is essential for increased competition. 80. In the medium term, tax costs of doing business have to be reduced. The government has been reducing rates of some taxes in order to reduce tax burden. A comprehensive review of the tax regime needs to be undertaken followed by its simplification and reduction in the number of privileges. This would likely include elimination or unification of taxes levied on a similar base, expansion of costs deductibility, adjustment in tax bases of some taxes in line with international practice, and refunding of VAT for all exports. A reduction in social security and pension payroll taxes that add up to 39.7 percent34 and may discourage formal employment generation needs to be considered. The tax system with graduated benefits the smaller the category of enterprise is a tax on growth, scale economies and employment creation. It is important to have a more equal tax treatment for all types and size of enterprises, rather than provide selective subsidies or privileges. 81. The imposition of financial discipline on enterprises and enterprise restructuring should be pursued more vigorously. The experience of transition countries shows that hard budget constraints embody incentives vital for enterprise restructuring and economic growth while delaying enterprise restructuring is costly as fiscal costs rise with time and the banking sector comes under increasing pressure from mounting non-performing loans to unviable enterprises. Therefore, the main sources of soft budget constraints such as banking system credit at non-market interest rates, public guarantees to enterprises, and tolerance of energy and tax arrears should be firmly addressed. The recent government 34 Including 1.5% payable to the Employment Fund and 0.7 percent to the Council of Trade Union Federation. 29 decision to more vigorously apply bankruptcy procedures to loss-making state enterprises, including their sale, is a welcome move in this direction. 82. Although hard budgets and import competition can spur state firms to restructure, the transfer of assets from the state to the private sector and creation of a class of owners is an integral part of the overall transition strategy. As the macroeconomic and business environment improves, the government should be able to expedite its privatization program but to achieve this, the approach to privatization would have to change. First, the majority of enterprises, not just those in poor financial situation, should be privatized. Second, m ajority o r c ontrolling s takes s hould b e o ffered t o p rivate i nvestors. F inally, adequate corporate governance arrangements should be put in place. Experience of transition countries has shown the dangers of privatizing to diffuse owners and to enterprise workers and managers ("insiders") led to problems and poor enterprise performance, whereas concentrated "outsider" ownership35 benefited restructuring. Privatization should proceed with an effective legal framework (for private property and contract enforcement) and market institutions to monitor managers. To establish trust in the privatization process, unilateral increases in state stakes in privatized enterprises, re- nationalizations, vesting the state with management powers disproportionate to its stake and other violation of property rights by the government need to be avoided. Banking Reform 83. The financial sector is essential to the overall reform process for at least two reasons. First, current account convertibility should be accompanied by financial sector policies that provide strong incentives to keep funds in the country. In this context, it is important to avoid financial sector policies that contribute to capital flight such as negative real interest rates and restrictions on withdrawing deposits. Second, banks have a pivotal role in providing a mechanism for the efficient allocation of resources and financial discipline to promote enterprise restructuring and private sector growth. Indeed, reform of the banking sector should be closely linked to enterprise reform. As experience in some East European countries has shown, a "healthy banks/unhealthy enterprises" outcome results in a highly profitable banking system that is oriented to consumer lending and purchasing state debt but contributes little to the development of the enterprise sector. 84. Development of the financial system in Uzbekistan depends crucially on developing a trusted commercial banking system. Actions need to be taken to improve confidence in the banking system so that banks are able to effectively mobilize an increasing proportion of financial resources. First, the system of cash planning should be fully abolished36 and banks should be fully delegated the responsibility for their own liquidity management: so long as depositors cannot be certain of access to their deposits on demand (or according to contracted terms) they will not see banks as trustworthy 35 The definition of "outsiders" to enterprises here, of course, excludes "insiders" to the political system and the ruling elite which in some other transition economies have benefited from their political connections by getting enterprises assets on the cheap - to the debtiment of the rest of the country. 6 resolution to this extent was adopted in February 2003 (see para 39). 30 fiduciaries or as reliable payment mechanisms. Second, actions should be taken to curtail the role of banks in tax enforcement. Banks should only be required to breach customer confidentiality where there is evidence of misconduct (such as required in documenting possible tax evasion or money laundering activity). Placing an embargo on the use of customer funds should be a last resort measure and any embargoed funds should be released only in connection with settlement of claims of other creditors. Indeed, without actions to bolster confidence in the banking system, there is a risk that dismantling the cash/non-cash restrictions will lead to a significant drain on the liquidity of the banking system, as enterprise managers seek to withdraw non-cash balances from their enterprise bank accounts. Third, interest rates should be liberalized to provide a positive real return on savings. 85. An equally crucial plank of the strategy is that the government impose hard budget constraints on enterprises as part of the transition process. Action needs to be taken now in disassociating the banks from directed or government-guaranteed lending to the enterprise sector. Capital injections by state-owned enterprises and associations to support the banks should also be stopped as they reinforce poor govemance and lending practices common in banks whose major borrowers are also their major shareholders. There may be situations where the govermment is justified in providing explicit and transparent on-budget subsidies to certain very socially sensitive enterprises as part of the transition process. It is, however, important that any subsidies provided by the government do not interfere with or distort the pricing signals provided through the banking system. Compliance with this policy should be monitored both by the CBU and the banks' auditors. The govemment's expanded special funding of start-ups and soft loans to SMEs from the Business Fund, channeled through banks, is in effect a new form of directed credit and conflicts with the govemment's avowed intentions of supporting the development of a market-based financial system. 86. The governance of state banks needs to be drastically altered in the short-term if banks are not to continue to accumulate off-budget fiscal losses and distort the allocation of financial resources by continued state directed lending. One means of reforming the banks' governance would be to appoint a majority of truly independent (foreign) directors to each bank's board of directors. These directors would be charged with ensuring that each bank both ceases to engage in directed lending and undertakes its own self- restructuring program directed at reducing costs and developing prudent private commercial lending capacity. The implementation of such governance arrangements also sends a strong signal to potential strategic investors that the govermment is serious in its intent to restructure and privatize the banking system. Overall banking supervision, especially giving regulators the authority to follow through with their recommendations, should be also strengthened. 87. Privatization of banks to strong strategic investors would reduce the risks of moral hazard inherent in rehabilitating or re-capitalizing state-owned or controlled banks. The government's strategy encompasses privatization of five banks initially. However, in the largest bank targeted for privatization, NBU, a stake of only 40 percent is proposed to be offered for sale, without management control being transferred to the strategic 31 investor. In another bank, Asaka, the govermment does leave open a possibility of privatizing more than 50 percent. It is a precondition for the banks to be attractive candidates for strategic investment that the govermnent make a clear policy statement that investors will be offered both management and board-level control in the banks; that up to 100 percent of each bank's shares will be offered for sale; that the government's post-privatization approach to any minority stake will be that of a passive financial investor; and, set out in advance any specific veto rights - which should be extremely limited - that the government would like to retain so long as it remains an investor. 88. A number of well-tested models are available for use in bank privatization. In the Uzbek case, the concentration of the major state banks' assets in state guaranteed credit exposures to SOE's is likely to dictate use of a carve out approach to privatization. Strategic investors would likely demand this structure be used because: (a) the banks' risks are imprudently concentrated in exposure to the state; (b) private sector lending offers more opportunities for higher lending margins and additional fees, whereas state guaranteed lending has relatively low margins; (c) the cash flow impact of the state guaranteed exposures is negative and poses liquidity risks; and, (d) the administration of state guaranteed exposures can result in constant political pressures and interference in a bank's activities. Using the carve out approach, the banks would be given the opportunity to transfer those commitments - both on and off balance sheet - which are guaranteed by the government (either before or simultaneously with the privatization transaction) to an Asset Restructuring Agency (yet to be created) along with corresponding liabilities of the banks to foreign creditors, the state, and the CBU. Several models could be considered in determining the nature of this transfer - including allowing the banks to assume commercial responsibility for those government guaranteed loans (against an agreed payment to the government) which they regard as viable and subcontracting with the banks to assist in collection activities as related to delinquent loans guaranteed by the government. However, the final structure of pre-privatization transactions required to restructure the banks will first require the preparation of full credit diagnostics on their credit and other portfolios (both state and non-guaranteed) and identification of the exact size and nature of the government's commitments to the banks. Indeed, carrying out the credit diagnostics is an urgent issue and should be a priority in any case for the government to know the condition of the borrowers and the probable extent and timing of its liabilities. 89. The government has already prepared the legal basis for the institutional framework to govem the bank privatization process by creating the Bank Privatization Agency (BPA) and preparing for the creation of an Asset Restructuring Agency (ARA) to handle the management of the assets carved out of the banks during the course of privatization. The government needs to establish the mandate of the ARA. It can either be a "parking lot" for the (mostly non-performing) debts of state enterprises or it can be a catalyst for the restructuring and privatization of SOEs by actively enforcing creditor rights. T he l atter c ourse i s recommended: i n most s uccessful transition c ountries the restructuring and privatization of the banking system has been a trigger for the commencement of the restructuring and privatization of the enterprise sector. 32 Energy Sector Reform 90. The government faces some critical challenges in realizing the oil and gas export potential and in meeting its electricity demand in a sustainable way. The country's oil and gas reserves need to be replaced with identification of additional reserves, the deterioration in energy infrastructure should be arrested and energy should be used more efficiently. To achieve these objectives requires large investments - a sizeable part of which should come from foreign investors - as well as modern technology and commercial know-how. 91. The government has chosen the option of attracting private investments by means of a sale of portions - mainly minority stakes - of SOEs responsible for oil and gas production, transportation and refining, and electricity sector, to strategic foreign investors. In this regard, i nternational experience over the l ast ten years, i n transition economies as well as other developing countries, points to a few key lessons that should be considered. First, appropriate pricing of energy commodities and products is fundamental. Second, a strong demonstrated commitment to enforce financial discipline is necessary. Third, investors require majority stakes in strategic sales, but also are willing to consider other options for private sector participation. Fourth, for segments of the industry that have a monopolistic nature (e.g., transmission of gas and electricity) and a utility service function (e.g., gas and electricity distribution), an appropriate legal and regulatory framework should be in place. Fifth, completing the reform of the energy sector is a time consuming process, and could take up to ten years. Lastly, while the entire refonn process would take a long time, critical actions should be initiated immediately. The following discusses how Uzbek authorities can draw upon these lessons to devise their strategy aimed at developing the country's energy sector with the help of private investrnents. 92. Taking into account the existing price distortions in the energy sector (para 48), pricing adjustments need to take place without delay but be implemented in phases over the medium term. The first phase could involve liberalizing petroleum and coal prices, and implementing a program of gradual real increases in gas and electricity prices. Liberalizing petroleum and coal prices quickly, recognizing the opportunity value associated with export markets for oil and coal, would yield significant gains at low costs, since they are more readily exportable than gas, and their price increase would induce efficient domestic consumption and not affect the poor as much since they are consumed less by the poor both directly and indirectly,7. Price increases for electricity, gas and heat may be modest in the first phase, although real increases should continue, since time is needed to introduce a reliable social protection mechanism for the poor (see para 117). Finally, another e lement o f t he first s tage s hould b e t he d evelopment, p ublication a nd implementation of a medium-term tariffpolicy for all utility services, including gas and electricity. 37 Coal is only used for a small part of electricity production and domestic heating. 33 93. With regard to commitment to enforce financial discipline, steps to reduce commercial losses should be undertaken urgently by addressing key issues such as, cross- subsidies, non-payment of bills, inadequate metering, and utility privileges (see paras 48- 49, 111). Particular emphasis should be placed on improving payment performance by state owned enterprises and eliminating legal restrictions to cutting off energy supply to non-paying enterprises. Reducing future n on-payment b y state enterprises would also harden budget constraints and induce enterprises to restructure and become more competitive. The government has also recognized the importance of reducing commercial losses and has started an ambitious program of gas metering. Such program of meteiing (or re-metering with accurate and tamper-proof devices) should be carried out in the electricity and heat sectors as well. 94. The second phase of the energy reform, could then focus on more aggressive gas and electricity tariff increases, by which time metering should be more widespread; a tested, functioning social protection mechanism for energy would be in place; and also efficiency of service delivery would have improved due to better metering, billing and collection that would buttress the larger price increases. It is useful to note that the above two actions, on pricing and reduction of commercial losses, are pre-requisites for eliciting private sector interest, and will go a long way in reducing the huge quasifiscal deficit. 95. Regarding private sector participation, it is important that the government recognizes the difficult internal environment (see the discussion on Enterprises and Private Sector Development) as well as the dwindling interests of western investors in developing country energy assets globally, and therefore be realistic in its expectations about private investments. The government should offer majority stakes in strategic sales to investors. In addition, the government should consider alternative approaches to private sector participation, such as: (a) concessions, where the assets are turned over to a private concessionaire, who will have responsibility for investments; (b) joint ventures with the state where the private investor has the majority and management control; (c) franchise models38, where a foreign operator/manager takes over the operation of an asset with a small equity stake; and (d) performance-oriented management contracts. 96. Efforts to attract private sector in energy should also follow a phased approach. In the first phase, they could be focused on (a) upstream oil and the oil services sector, because investor interest is highest in development of existing oil reserves and further exploration; and (b) refined product and LPG distribution and marketing, since this segment of the sector is easiest to privatize including to local SMEs. Private sector participation in refineries, parts of the upstream gas sector, gas distribution, and electricity distribution and generation should all be part of second and third phases, since private sector participation in such assets and businesses requires significantly more preparation in terms of legal, regulatory, and organizational changes. 97. Preparation of the more complex segments, such as electricity and gas transmission and distribution, for private sector participation requires establishing an 38 Widely used, among others, in the hotel industry, where e.g. a Sheraton hotel may only be owned 5% by Sheraton but bears the full Sheraton identity and is operated by Sheraton to its international standards. 34 appropriate industry structure for both gas and electricity, as well as an acceptable legal and regulatory regime. Work is already underway for the oil and gas sector (except gas distribution) and is being planned for the electricity sector. The government should enact key I egislation i n the energy s ector together with s upporting regulations. T his should include a Petroleum Law during the first phase and an Electricity Law during the second phase. In addition, a single strong and independent regulatory body for the entire energy sector should be established. In the first phase, the two existing technical regulatory bodies (one each for oil and gas and for electricity) should be merged into a single regulatory agency for the whole energy sector and this agency should be given sole authority to regulate prices (which is currently with the Ministry of Finance). Work should also be initiated to build regulatory capacity to strengthen this new agency, to develop its technical capacity to regulate the sector when it begins to operate competitively and according to market principles, and to provide the legal basis to make it independent. The implementation of the strengthening and independence measures would take place during the second and third phases. 98. Finally, the government should realize that reform of the energy sector is a time consuming process. The first phase would comprise actions such as complete liberalization of petroleum and coal prices, initiation of modest but real tariff increases for gas and electricity, implementing social protection mechanism(s) for the poor, implementing measures to enhance financial discipline, privatization of upstream oil, oil services, and retail operations of petroleum and LPG, initiation of the industry structure for oil and gas, passage of a petroleum law, and initiation of the creation of an independent regulatory body. The second phase would comprise more aggressive tariff adjustments for gas and electricity, completion of the revision of the industry structure, passage of an electricity law, and private sector participation in the remaining parts of the oil and gas sector, and implementation of the regulatory framework. This phase would also include initiation of private sector participation in the electricity and gas distribution sectors. 99. Experience elsewhere shows that, as soon as there is demonstrated commitment to address the pricing issues and financial discipline issues, i.e., say at the end of the first phase, private investors would start showing interest in the sector. Therefore, the government should be in a position to realize some private investments during the second phase, if necessary using contract based regulations (such as concessions) while the regulatory capacity is still being developed. However, the bulk of the private investments would come in a third phase, assuming of course the reform momentum is sustained during the first five years (i.e., the first and second phase). During this third phase, the regulatory capacity would also be strengthened. Data, Public Disclosure and Transparenscy 100. Improving public access to information is a prerequisite for strengthening government accountability at all levels and thus reducing the scope for corruption. In Uzbekistan r eforms i n t his a rea s hould b e d esigned t o i nitiate a s hift in t he c ulture o f public service from a presumption of secrecy to a presumption of openness. This will 35 require substantial efforts to extricate the remaining legacies of the Soviet approach to information flows. It entails more than just augmenting existing statistical publications with some additional data categories. Rather, these legacies are embedded in the legal framework and the institutional network regulating access to information in Uzbekistan. 101. The legalframework governing government information management should be revised to reduce the discretion of bureaucrats to classify information as secret, to end the practice of declaring legally binding resolutions or portions thereof as secret, to ensure proper legal guarantees and appropriate legal recourse for public access to official information, and to commit the government to a dissemination schedule of economic and financial data on a regular basis. The aim should be to narrow down and explicitly provide the criteria for what constitutes a state secret, to specify and limit who has the authority to classify information as secret, and to strengthen the procedures of appeal and oversight over the classification of such information. This requires amendments to the Law on State Secrets, the Law on Freedom of A ccess to Information and the Law on Normative-Legal Acts, as well as the publication of COM Resolutions identifying specific categories of information subject to state secrecy. 102. The time for such revisions is opportune now given that some of the basic laws determining access to inforrnation are currently being considered by the Oliy Majlis. The current draft Law on Principles and Guarantees of Freedom of Information actually represents a step backwards in this agenda by further increasing the state's discretion to restrict access to information in the interests of "information security" - a concept designed to counter the potential impact of religious and political extremism. As a minimum, clear guidelines should be incorporated in the draft law to ensure that the umbrella.of information security is not used to restrict access to economic, financial and social data unrelated to such threats. The current draft Law on State Statistics should also be revised to strengthen the government's obligations to disseminate economic, financial and socio-demographic data as well as to provide for independence and enhanced public oversight mechanisms for the State Statistics Agency. 103. One clear and relatively low-cost measure that would immediately signal the government's commitment to greater transparency would be the high-profile publication of a broad range of economic and socio-demographic data in line with international standards that have been withheld to date from the Uzbek public expanded. The government should adopt the IMF's General Data Dissemination System (GDDS), and begin publishing output, monetary, fiscal, external debt, foreign trade, balance of payments and social data with standard detailed breakdown, appropriate periodicity and in a form widely accessible to the Uzbek public, including the development of data websites. Existing publications should be printed in higher circulation runs and be made commercially available. New high-frequency statistical handbooks for reporting data by the Ministry of Finance and Central Bank should be launched with the annual report of the Central Bank made public as well. 104. These recommended changes to the relevant laws and existing practices will not be effective as long as the institutional network of "first departments" and other 36 information regulators continues to exist in its current form. This should be the subject of a comprehensive review and appropriate reforms to eliminate such structures where feasible and to clarify and restrict their powers where their presence is still required. To enhance the credibility of official statistics, the State Statistical Agency must be established as an independent institution with a Consultative Council that would include independently selected representatives of information users. 105. The government has already made some important steps forward in this area with the elimination of the State Secrets Inspectorate and the State Press Committee and the dismantling of UzPAK's monopoly on intemet access. There is an opportunity now to increase the momentum of reform in this area and, by doing so, to build a stronger foundation for the market economy and to enhance the credibility of Uzbekistan's refomn program both at home and abroad. IV. lfmpact of lReforms and Mitigadonm Options Social Effects of Exchange IRate Unification 106. As Uzbekistan proceeds with market-oriented reforms, the short-run costs and benefits of these reforms are very likely, as experience from other transition countries shows, to be unevenly distributed. There are two channels through which unification of exchange rates will have an impact on people's welfare. The first is through changes in prices, and the second is through enterprise restructuring and employment. In addition, as part of general price realignment and further structural reform, there would be increases in utility prices and reduction in household subsidies ("privileges"). Estimated household income gains and losses as a result of these reforms are shown in Table 3. Table 3: Estimated Household Income Gains annd Losses due to Exchange Regime Liberalization in 2003 (In millino USS, at the market exchange rate)* Urban Rural Total RntonaletAssumptions Loss of purchasing power due to pnce increase -16 -12 -28 Pnce increases range from 900/% for bread to 0% for of 7 key foodstuffs tea. Loss of gross inconme due to higher -55 0 -55 Baseline elasticity of employment to implicit unemployment r c t 0 -55 subsidies is 0.5. Unemployed are assumed to be paid their sector's average wage. Loss of purchasing power due to higher utility -2 -3 -5 Prices of natural gas and electricity are assumed to pnces increase by 50%0. Assuming quantity purchased under state order does Gain due to higher grain prices (net of input not change compared to 2001 (2,462 thousand tons) Gaun due to higher gramn prices (net of input 0 56 56 and pnce per kilogram increases from 48 to 92 cost increases) soums. Increase in grain input costs to economic levels is estimated at 43% Assuming quantity purchased under state order does Gain due to higher cotton pnces (net of iriput not change compared to 2001 (3 27 million tons) and Gai due to higher cotton prces (net of iput 0 171 171 price per kilogram increases from 98 to 177 soums. Increase in cotton input costs to economic levels Is estimated at 24%. Total gain: -72 212 140 X Assumnmg exchange regime liberalization is accompanied by incrases in state procurement prnces of grin and cotton to world market levels 37 107. The exchange rate unification may not affect the real welfare of the poorer segments of the population through price increases of essential commodities as much as feared by the government. The reason for this is that domestic prices of many of the seven essential goods that the government has identified (bread, meat, vegetable oil, sugar, tea, butter, and rice) seem to have already adjusted to the parallel market exchange rate. This is not unusual. In other countries that have had multiple or highly overvalued exchange rates, surveys have shown that the domestic prices of many tradable goods reflect the parallel market exchange rate and the poor generally end up buying goods at those prices. In Uzbekistan, only the prices of buhanka (the subsidized kind of bread) and gasoline are significantly cheaper than neighboring countries and even for other goods that are under price controls in Uzbekistan (cooking oil, rice and sugar), the retail prices are close to Kyrgyz levels at the parallel market exchange rate. As a result, with exchange rate unification and the lifting of price controls it is estimated that the increase in prices of the seven essential commodities would raise the cost of current food consumption by 12 percent. 108. Urban households, however, are likely to be more adversely affected since they rely much more on purchasing food whereas rural households rely more on consumption of home-produced food. Thus, the average food cost for urban households is estimated to increase by 16 percent versus less than 10 percent for rural households. In addition, rural households would gain from increases in prices of their output - not only cotton and grain - but also other food items if the government removes price controls and export bans. In terms of a distributional impact, agricultural workers earniirig a fixed wage would stand to benefit less than private farmers. Overall, however, there is little doubt that on average the effect of exchange rate unification and price liberalization would be beneficial for the rural population. 109. The exchange rate unification will affect employment mainly through the elimination of net foreign exchange subsidies currently received by certain enterprises or sectors with access to foreign exchange at the below-market exchange rate. It is estimated that this could result in a total net job loss of 3.5 to 4.5 percent of those currently employed in the formal sector. However, some heavily subsidized sectors (for example, chemical and petrochemicals, machine building, construction, and wood processing) could be affected much more and even experience double-digit percentage job losses. On the positive side, there would be some increase in labor demand in sectors that become more profitable under the liberalized exchange rate and prices. The elimination of various structural constraints discussed in previous sections would also promote economic growth and generate new job opportunities, especially in small and medium enterprises. However, there may be a need for a retraining and labor redeployment program because skills of people who have lost jobs may not match the demand of the expanding or new sectors. 110. Experience of the CIS countries shows, though, that an exchange rate liberalization per se has rarely been translated into immediate mass redundancies, in part due to insufficient tightening of budget constraints on enterprises. Instead, the adjustment took place though real wage cuts, some shedding of non-core or older 38 workforce, such as administrative staff or workers at retirement age. Some workers were sent on administrative leave until the market stabilizes, or more part-time jobs were introduced. After the price and exchange rate liberalization in Belarus in 2000, for example, no shocks were observed in the labor market. However, as budget constraints are hardened in accordance with this Report's recommendations, the government should be prepared to mitigate the impact of mass redundancies, and these are discussed in the next section. 111. Increases in utility prices and reduction in "privileges " (discounts on the energy prices to certain categories of population) would cause an additional impact on the welfare of some segments of the population. Although privileges may in fact be regressive (as shown by the household survey analysis), their elimination as well as utility price increases have the potential to hurt the poor significantly. Nevertheless, inefficiencies associated with using subsidized utility rates as part of a remuneration package for budget employees are large and the cost significant (equivalent to 0.8 percent of GDP in 2001), and need to be reduced. Recognizing this, in March 2003 the President issued a decree eliminating privileges as of April 1, 2003 while instituting compensatory cash payments. A number of utility price increases have also been implemented since the beginning of 2002. The options for social protection against utility price increases are provided below. 112. The total fiscal cost to mitigate the impact ofthe exchange rate unification on household incomes of the poorest and most affected is estimated at about $30-40 million for the first year. This assumes that compensation for price increases of essential foodstuffs and energy is only paid to the bottom three deciles (identified as the poor in the Living Standards Assessment), while the unemployed are compensated for 50 percent of their income loss. Almost all of the compensation would go to urban households (since unemployment benefits account for most of the compensation). Compensation Mechanisms and Mitigaioon Options 113. The key to minimizing the temporary negative impact of the exchange regime liberalization on low-income households and employment is the decisive implementation of reforms which will create a favorable investment climate and foster accelerated economic growth and job creation, especially in the SME sector. In the short-term, if the government wants to cushion the cost-of-living increase, prices of bread and flour could be temporarily maintained under state control. Additional budget financing to compensate the costs of the exchange rate unification to the low income households and unemployed will also help. Such compensation does not require major institutional changes. The currently existing mechanism for the delivery of social assistance, namely the mahalla system, could be used, with some readjustments and appropriate controls to avoid abuse, to handle the new demands for social assistance to the poor. Uzbekistan also already has the basic institutional infrastructure to deal with unemployment, including (i) an unemployment benefit (passive) program, providing temporary cash assistance to the unemployed; and (ii) active labor market programs (ALMPs) including inter alia job counseling, job creation programs, training and public works. However, 39 public employment services need to be re-oriented towards more cost-effective programs. In order to increase the efficiency of the existing social protection mechanisms and improve their ability to cushion the specific costs of the exchange rate unification, several following policy measures can be proposed. 114. The mahalla system should be strengthened and better financed to be able to provide increased targeted compensation of the cost of living increases to the vulnerable groups following the exchange regime liberalization. Social assistance channeled through mahallas has been limited in recent years. In 2001 the state budget spent only 3 billion sums, or less than 0.1 percent of GDP, on means-tested and targeted benefits through mahallas39. Increased funding of social assistance through mahallas should be accompanied by higher transparency, accountability and tighter financial control over their operations to ensure that resources are not misused. 115. A shift away from job creation programs to counseling, job search assistance and training programs needs to be considered since, based on international experience, these programs appear to be more cost effective than the job creation program. According to current statistics, for example, training programs buy at least 10 times as many job placements per unit of funds spent as job creation programs, but currently almost half of the expenditures of the Employment Fund go towards job creation programs (credit schemes, etc.), through which only a relatively small number of unemployed are placed in jobs. Training, on the other hand, is effective in addressing structural unemployment due to a skills mismatch. Eventually, the development of public-private partnerships in the design and monitoring of training programs would help ensure their relevance to the emerging needs of the job market. 116. However, because of great regional disparities in welfare, there may be regions in Uzbekistan with little economic prospect for which training or other active programs simply will not be sufficient, in particular in problem areas with high poverty and in mono-enterprise communities where many workers are laid off. The more expensive public works programs and active job creation programs should be specifically targeted at these depressed areas, but be limited and carefully targeted to the vulnerable because of high unit costs and some evidence of limited success at improving post-program employment prospects. Easing barriers to labor mobility (e.g., residency registration) to allow workers to migrate to more labor scarce areas would be desirable. Mass redundancies can be mitigated by developing labor redeployment programs (LRP) which provide income support to displaced workers, as well as help them reintegrate into the labor market. 117. The utility price increases should be accompanied by the introduction of an effective, targeted social protection scheme. In transition countries, different mitigating mechanisms have been introduced to compensate for utility tariff increases, be it life-line tariffs in which the price subsidy is restricted to the initial block of consumption (called the basic need level); notional burden approach in which the burden placed by utility 39Budget spending on child benefits, which also involve some targeting, accounted for 1.5 percent of GDP in 2001. 40 expenditures on household budgets is limited to a certain percentage of household total incomes; or earmarked cash transfers to provide cash to selected households to pay part of their utility bills. The life-line tariff has the advantages of low administrative costs and small errors of exclusion. However, it requires metering of energy consumption, which is currently in Uzbekistan universal only for electricity, and the targeting of the subsidy is poor since everyone receives it. While the government is rightly placing emphasis on extending metering of gas as well, other options would have to be considered in the short- term. The main alternatives practical for Uzbekistan are thus means-tested programs, and the notional burden approach. Under the latter, delivering of targeted housing allowances through the mahalla system seems to be the most promising option, which is another reason for strengthening the capacity of the mahalla system, including reallocating through it funds released from the elimination of social privileges to compensate the vulnerable groups for utility tariff increases. Fiscal and Output Impact of Foreign Exchange ]Regime Liberalization 118. Dismantling the extensive system of implicit subsidies currently in place will have a profound impact on the established economic system. The liberalization of the foreign e xchange regime a nd o ther m easures t o r educe i mplicit r esource t ransfers w ill have a fiscal impact. The direct effect will come through the increase in the cost of the foreign exchange component of budget expenditures and enterprise-related contingent liabilities falling on the budget. Fiscalization (i.e., taking explicitly into the budget) of a limited amount of implicit subsidies may also be necessary for a transition period. This could include compensation to the vulnerable for eliminating the price subsidies on essential goods identified by the government and the unemployment impact of enterprises that are unviable post-liberalization, as well as possible temporary support to some enterprises during the adjustment period. 119. Overall, assuming that around a third of debt service on "non-budgetary" public debt falls onto the state budget, support to strategic enterprises is limited to 0.5 percent of GDP and social cost is around $30-40 million as discussed above, the liberalization of the foreign exchange regime is estimated to result in an increase in annual government expenditures of around $0.4 billion in the first year (see Table 4). However, it should be noted that this estimate is very sensitive to the financial situation of enterprises and the extent to which the government will have to assume their foreign debt servicing. If enterprises start defaulting on publicly guaranteed debt en masse as happened in some other transition economies, the annual government expenditures could increase in the first year by as much as $0.7 billion4o. As fiscal policies would need to remain tight during and after the liberalization to maintain exchange rate stability, a fiscal adjustment would need to be undertaken to align the expenditure levels with the new revenue generation capacity. 120. Even with the phased elimination of implicit subsidies and fiscalization of a portion of them to support strategic enterprises, a short-term negative impact on output is 40 It should be stressed that these estimates of the costs of liberalization are only indicative and demonstrate that the cost of reforms is less than the longer-term cost of maintaining the status quo. 41 Table 4: Fiscal Cost of Foreign Exchange Regime Liberalization in 2003 Revenue/Expenditure Category I bn. USS % ofGDP [ Rationale/Assurmptions l Foreign exchange expenditures, 001 0.1 The liberalized official exchange rate is expected to devalue b excl extemal debt service around 50 percent in 2003 The cost is estimated as the devaluation 'Budgetary" public and publicly- 0.08 1 0 rte times foreign exchange expenditures of the budget. guaranteed external debt service "Non-budgetary' public and 30 percent of "non-budgetary" debt service of enterpnses comm publicly-guaranteed external debt 0 19 2.4 due in 2003 is expected to fall on the state budget due to enterpnse service of enterpnses irsability to pay following the liberalization. 30 percent of domestic public guarantees coming due in 2003 Publicly-guaranteed domestic debt 0.01 0 1 (estimrated based on end-2001 guarantee stock of 161 bn soums an service ofenterpnses assuming 5 years average matunty) is estimated to become fiscal losses due to enterpnse inability to pay following the liberalization. Temporary support of strategic 0 04 0.5 Enterpnse support is assuned to be limited to 0 5% of GDP as unde enterpnses Resolution 423 of October 2001 Targeted support of vulnerable 0O1 0.1 Compensation of the estimated 11-12% increase in the foo strata of population consumption cost to the lowest the income decilcs Compensation based on half the average wage to the estimiated 250 Employment Fund 0.03 0 3 thousand newly unemployed as a result of enterpnse resitctunn minduced by foreign exchange regime liberalization Total Consolidated Budget 0 4.5 Expenditures: _ 035 4.5 Source Bank staff estimates unavoidable given the current large distortions from such subsidies. In some sectors and industries, which have large external debt obligations or net imports, such as chemicals and petrochemicals, food processing, wood processing, and construction, the implicit subsidies provided through the foreign exchange regime alone account for over one fifth of value added, and in machine building they even exceed value added. On the other hand, two sectors - agriculture and mining, especially gold mining, - which have been net providers of foreign exchange subsidies, would be among the major beneficiaries of foreign exchange liberalization. Agricultural value added is projected to grow around 5 percent as a result of removal of the implicit tax on the sector complemented by other reforms that provide appropriate incentives to farms. 121. Since agriculture and services account for close to 70 percent of total value added, the net negative impact of foreign exchange regime liberalization in the short term is expected to be relatively moderate even though industry as a whole is projected to contract by over 10 percent. Overall, real GDP growth is estimated to decline cumulatively by between 1 and 2 percentage points below the trend growth, and lead to a net increase in unemployment as discussed above. The overall impact of reforms on output is more difficult to quantify. For example, the recessionary impact of energy price increases to cost-recovery levels as well as effects of enterprise restructuring and other structural reforns would be additional to the elimination of implicit subsidies through the foreign exchange regime and would likely, in the short-term, reduce GDP growth further and contribute to unemploymnent. On the other hand, enterprises that did not have access to foreign exchange or found it unprofitable to export at an overvalued exchange rate will benefit from liberalization and their output will expand. The net total short-term output loss, however, would be more than compensated in the medium-term (within 2-4 years) as improved, market-based incentives and more efficient resource allocation will bring about pay-offs in terms of higher investment and accelerated growth allowing Uzbekistan 42 to break out from its current pattern of costly state interventions and low employment generation. Conclusion 122. The authorities have been taking steps in recent years to reduce distortions and implicit taxes and subsidies created through the foreign exchange regime and (agriculture and energy) pricing systems. These are politically difficult decisions and, as discussed above, may have short-term negative consequences - socially, fiscally, and in terms of output growth. However, unless the continued reduction of implicit resource transfers is accompanied by measures to decentralize economic decision-making and eliminate state controls over production and marketing, economic agents will not be able to respond to improving price incentives and the economy may end up bearing costs without the benefit of a positive supply response. The government needs to take bold, resolute action that credibly demonstrates its reform commitment. This Report has laid out an agenda of reforms in key areas which could be the foundation of a 3-5 year structural reform program that, suitably phased, would merit strong support by the international development community and break the economy decisively out of its centrally planned govermment controlled mould. APPENDIX I REPUBLIC OF UZBEKISTAN: Reform Program Matrix41'42 Policy Objective Status I Phase I Phase ii Phase III OVERALL STRATEGY AND SEQUENCING OF REFORM Reform actions during Phase I aim at (i) achieving foreign exchange, trade and price liberalization, (ii) imposing hard budget constraints, and (iii) increasing transparency. The initial liberalization will be followed, during Phase II and III by institutional reforms and restructuring in enterprise, banking, energy sectors A. MACROECONOMIC FRAMEWORK, FOREIGN EXCHANGE AND TRADE REGIMES I. Improve Macroeconomic Framework and Strengthen Fiscal Management Capacity Restore Internal and external macro imbalances as Ensure that interest rates are at Incorporate all externally- macroeconomic evidenced by consistently high inflation, positive levels in real terms financed public expenditure and stability by tightening continued, though reduced, capital outflows, (based on realistic inflation investment into the state budget. broadfiscal and and significant devaluation of the official levels). monetary policies exchange rate. Extensive quasifiscal and stabilizing activities take place through the multiple Discontinue the practice of external debt exchange rate regime. The government has extending public guarantees on large outstanding contingent liabilities. domestic and external borrowing. External debt rose rapidly before leveling off over the past two years. Public and Continue to limit annual publicly guaranteed debt service is close to external public borrowing to 25% of exports of goods and services. principal repayments coming due during the period. Improve the fiscal Existence of extrabudgetary funds and Incorporate all extrabudgetary Establish a Treasury and management and accounts of budget organizations under- operations and funds into the implement other Public streamline the tax mines consolidated budget management. consolidated state budget. Finance Management Reform regime Budget has large idle budget balances. Project recommendations. Tax burden is high and system is Conduct a thorough review of Implement recommendations of complicated (with duplicating taxes levied the tax system. tax review, including expanding on similar base, privileges and differential deductibility of costs, adjusting treatment for different enterprises), and tax base in line with interna- unstable (with most tax rates approved and tional practice, unifying taxes revised annually with the state budget). levied on similar base. 4' The precise duration of the different phases is difficult to gauge, and will depend on government capacity, technical and political economy factors, as well as the availability of intemational financial assistance. However, the phases need not be strictly sequential. 42 Reforms in bold denote priority measures that would need to be implemented early during Phase 1. 2 Policy Objective Status Phase I Phase 11 Phase LHI VAT on exported goods, including cotton Enforce VAT refunds on all Enhance stability and predicta- exports, is not refunded and effectively exports. Revenue loss from bility of tax system by de-linkmg results in an export tax. VAT on cotton exports could be budget and tax rate approval. replaced by less distorting tax. H. Liberalize Foreign Exchange and Trade Regimes Eliminate the implicit The over-the-counter (OTC) and cash Unify the exchange rates by Establish an interbank foreign resource bureau exchange rates are admimstratively liberalizing access to foreign exchange market. redistribution via maintained at an overvalued level. Access exchange. foreign exchange to foreign exchange is restricted and regime and introduce rationed for priority uses. a market exchange rate Export earnings are subject to a 50% man- Reduce currency surrender for Eliniinate the foreign exchange Further reduce foreign datory surrender requirement (cotton - to cotton to the decentralized surrender requirement for decen- exchange surrender require- 100% surrender) at the overvalued OTC ex- export level. tralized exports. ment for all cotton exports. change rate. SMEs exporting goods of their own production are exempt from the Remove the bias against micro, surrender. small and medium trading companies by abolishing foreign exchange surrender requirement for them. Reduce non-tariff Export bans on 11 categories of goods are Abolish all export bans (except Abolish export bans on grain and Jom the WTO barriers to foreign in place. Export contracts must be pre- grain and flour). flour. trade registered at conmmercial banks to ensure Take further rneasures to that export prepayment requirement is met. Abolish commercial bank regi- secure access to developed stration of fruit and vegetable countries' narkets for Uzbek All import contracts are subject to price export contracts. Abolish import price verification goods verification. Import contracts requiring requirement. purchase of foreign exchange are subject to Replace export prepayment an ex ante registration at the MFER. requirement with time limnits on repatriation of export earnings. Advance payments on import contracts are restricted. Eliminate ex-ante Import contract registration Additional restrictions on consumer goods requirement. Sirnplify certification imports and individual traders were requirements for imports. introduced in the second half of2002 and Abolish advance payment early 2003. restrictions on imports. _ 3 Policy Objective Status Phase I Phase II Phase m Reduce restrictions on consumer goods imports and trade by individual entrepreneurs. Reduce import tarif The basic import tanff regime for most Permit duty-free exemption of Reduce protection by lowenng Continue to reduce protection protection levels favored nations has 3 bands - 0, 10% and imported mputs for all exports. import tariffs. by lowenng import tanffs. 30% (for other countnes tanffs are double this level). To individual entrepreneurs, a Abolish a surcharge on re- unified customs payment (40% for food and exports to Uzbekistan 70% for non-food goods) apphes. A 20 Exclude tariffs and other percent surcharge is applied to consumer Elimninate excise taxes levied on customs payments from the goods re-exported to Uzbekistan via imported goods only. Unify tax base for VAT on imports. neighbonng countries. excise tax rates on imported and domestically produced goods. Excise taxes on imports serve as an addi- tional layer of protection. The VAT base includes inmport tanffs and excises. B. PRIVATE AND FINANCIAL SECTOR DEVELOPMENT I. Promote Private Sector Growth Create a favorable Enterprises are subordinated to industrial Dismantle associations' control Disband associations. environment for associations which assist in obtaming inputs over enterprises by inter alia: private sector growth and financial resources, and mi marketing * transferring the Prohibit cross shareholdmng by and competition outputs. The associations manage on trust management of state stakes in enterprises within one sector. state stakes in enterprises, and serve as an enterprises from associations instrument of implementing government to the State Property industrial policies and state planning. Committee President decreed a reduction in the role of * divesting other share- associations in enterpnse management in holdings of associations January 2003. Output, exports and inmports of enterprises Permit independent trading Elimmate mandatory state Eliminate other unwarranted in associations are effectively planned by companies to freely purchase plannng of enterprise activities. state mtervention in business the state. The state distnbutes around 60 and market output of enterprises activities of enterpnses. commodities by setting consumption quotas - members of associations. based on input/output tables ("material balances"). Reduce state rationing of key commodities through material Establish level-playing field for Adopt a simpler and more The tax/tanff regime discriminates against balances. all types of entities by elimi- transparent system of encoura- trading companies (as opposed to nating various forms of ging foreign investment. 4 Policy Objective Status Phase I Phase 1 Phase III "producers") and individual entrepreneurs. discrimination against traders Discretionary and biased system of and mdividual entrepreneurs. incentives for foreign investors is in place. Abolish the state control of wholesale trade network through The wholesale trade network is being Uzbeksavdo and Uzbekbirla- centralized under the Uzbeksavdo and shuv, and relax restrictions on Uzbekbirlashuv state associations. new entry by private trading _ _ _ _ _ _ _ _ _ ~~~~~~~~firm s. Accelerate the A large number of enterprises are Equalize the rights of the state Privatize remamning state shares transfer of state designated as strategic with controlling and other shareholders. in medium and large enterprises assets into private stakes not subject to privatization. If the where the state still holds a stake hands state has any shareholding in an enterprise, of less than 25%. the state, through state trustees, has the power to veto any strategic decision of the Expedite transparent case-by- Set up an mdependent Board. case sale of selected large com- Securities and Exchange panies offering majority stakes Commission and a database of Access to legal information and information and introducing internationally financial statements for public on ownership of "privatized" companies is accepted transparent bidding companies. difficult, and discretionary and discrimi- procedures. natory system of incentives to foreign investors. Enhance market Price controls are maintained on "socially Eliminate price controls except Eliminate barter and non-cash Audit stock of arrears among pricing mechanisms significant" or strategic goods and services for natural monopolies and transactions between budget and state enterprises, budget and and harden budget and their exports are banned or restricted. key foodstuffs (bread, flour). enterprises. private sector, and settle constraints Price regulation is also applied to about 440 arrears between state enter- enterprises, covering 270 products, which Limit price regulation to natural prises. are defined as monopolies. monopolies only. BI. Strengthen Financial Sector ._. ___________. Launch restructuring The government has identified two banks Appoint a majority of Allow the privatization of up to and privatization of (Asakabank and NBU) to be the first to be independent (foreign) board 100% stakes in the state banks. state-owned banks privatized. However, the privatization members to state-owned strategy should provide for the sale of banks' boards. Provide for the state to give up majority stakes and transfer of management management control to private control from the state if it is to be successful Adopt measures to ensure no investors. in attracting reputable strategic investors. distressed borrowing by enterprises. State owned banks are heavily involved in Perform diagnostic credit Establish an Asset Resolution Launch prnvatization of all directed lending, alnost all of which is audits of state banks. Agency (ARA) to receive assets other state banks. 5 Polic Objective Status Phase I Phase 11 Phase III guaranteed by the state. Any privatization carved out of banks with the of the banks will require a carve-out of the mandate to maximize collections publicly-guaranteed assets.. on those assets, and transfer title to carved out assets from state owned banks to the ARA. Privatize NBU and Asakabank by sale to strategic investors. Strengthen bank Commercial banks usually do not adhere to CBU to adopt and begin to Revise the legislation to supervision and smgle borrower and group exposure lits, implement a supervisory ensure independence of the regulation there is lack of arms length relationship development plan. CBU. regarding related party transactions. Roll- overs and evergreen loans are widely Implement an industry-wide applied. program of credit exanmua- tions. Disclosure of the banks' financial standing, Pass new laws/amendments accounting and auditing systems and implementing IAS for banks and Adopt an Anti-money standards are not fully consistent with requiring new auditing Launderng Law. international standards. - standards. CBU's reporting requirements are perceived CBU adoption of procedures as being overly burdensome and not to subject new reportng necessarily useful for supervisory purposes. requirements to a cost/benefit test. Improve the banking Banks have inadequate access to reliable Repeal requirements for banks to CBU to introduce a credit bureau environment information on the financial condition of make tax reports on their system, including allowing current and potential borrowers. Enierpnses customers, broad access and reporting to the suffer from similar problems in determiining credit bureau (allowing whether or not to provide credit to their businesses to provide and use customers. credit mformation). The level of retail deposits m the system is Implement the abolition of Repeal regulatory measures very low reflecting a lack of confidence in cash plans and restrictions on capping lending interest rates bank solvency and secrecy. Enterprises are cash withdrawals by and setting floor for deposit required to surrender daily their cash individuals and enterprises, rates. receipts to commercial banks and cash withdrawals from bank accounts are Increase mirnmum liquidity restricted. All bank transactions by requirements for banks and individuals and enterprises exceeding a few mnimmum levels of cash on hand _ 6 Policy Objective Status Phase I Phase II Phase HI thousand dollars are reported by banks must maintain to ensure commercial banks to the tax inspectorate depositors have access to their and CBU. The government resolved to funds. abolish cash plans for commercial banks in February 2003. Increase limits of transactions subject to due diligence by commercial banks. C. RURAL SECTOR REFORM I. Accelerate Development of Agricultural Markets Eliminate state Under the system of state orders for grain Remove mandatory cropping Discontinue other unwarranted intervention in and cotton, the government sets production pattem restrictions on interference in farm production decisions plans ("targets"), dictates cropping pattems, agricultural enterprises and management of agricultural and distributes financing and inputs down to private farms. producers the level of an individual farm. Improve price State order prices of cotton (at the parallel Increase cotton and grain incentives for cotton market rate) and grain are less than half of procurement prices to world and grain producers the world market price and domestic market market levels (adjusting for price, respectively. transportation costs) at the market exchange rate at the time of harvest. Price incentives are blunted by the Enforce the abolition of the joint application ofjomt responsibility for responsibility of farms and meeting obligatory state order targets for brigades (pudrats) for meeting cotton and wheat. obhgatory state procurement targets for both cotton and The land tax is the only explicit tax on wheat. Increase land tax rates by 34 agriculture. Land tax rates of around 7,000 times to capture part of the sums/ha are low and not paid by a large farmer's windfall from higher proportion of farrnland. prices and to compensate for fiscal costs of agricultural liberahzation. Develop competitive Virtually 90% of raw cotton and close to Implement the decision to Reduce further mandatory state Reduce further mandatory agricultural markets 55% of grain is purchased by the state at the reduce mandatory state procurement of gram. state procurement of cotton. low state order prices. Cotton export is procurement of cotton and grain 7 Policy Objective Status Phase I Phase II Phase m channeled through 3 state-owned trading to no more than 50% of the companues and is subject to 100% surrender actual production levels with any requirement at the overvalued OTC additional procurement. exchange rate and burdensome export licensing requirements Export of gram is Ensure that producers of raw Actively promote tollmg of banned. cotton unconditionally retain cotton for raw cotton sold over property rights over ginned state procurement levels. Formally in late 2002 the government cotton and other byproducts issued regulations allowmg private traders produced from raw cotton to procure cotton fiber and sell it supplied over the mandatory Lift the ban on exports of grain. domestically or for export through state procurement levels. Uzbekauctionsavdo auctions.431n practice, these regulations have not been Liberalize exports of cotton implemented yet. not subject to state order. Promote competitive Cotton ginneries and cotton/grain storage Adopt a restructunng program Pnvatize gins and cotton/gram agro-processing and facilities are majority state owned through for the cotton ginnery sector and storage facilities, thereby agro service the Uzbkhlopkoprom monopoly, and are gram/cotton storage facilities promoting greater competition industries with key instruments in government control over envisioning the privatization of m the provision of tollmg privateparticipation financing and marketing cotton/grain crops. majority stakes in most gins and services for cotton and storage storage facilities over two years, services for cotton and grain. and restructunng/closing Agricultural machinery is procured usmg economically unviable gms. the government's financing and managed by Initiate privatization of state machinery companmes under agricultural machmery government instructions. compames. H. Promote Farm Restructuring, Improve Rural Finance and Cost Recovery Accelerate farm The government has actively promoted the Give shirkat members greater Address inconsistencies between Continue the allocation of restructuring and expansion of private farming by disbanding financial autonomy by excluding the Land Code and other land remammg cooperative land reform transforrming cooperatives (shirkats). unprofitable pudrats from legislation to clarify the (shirkat) lands to farmers and However, the size of pnvate farms and sharing m the shirkat's overall procedures for mortgaging land provide secure transferable households is legally linmted. profits. use rights, for liquidating and land use rights. using rights pledged as collateral, and for transferring nghts among collective farm members and private farmers 43 With the exception of a few rayons where IBRD and ADB agncultural support projects are being implemented where cotton fiber procurement and exports by pnvate firms are supposed to be unfettered. 8 Policy Objective Status Phase I Phase II Phase III Encourage the increase m the privately-financed agncultural credit. Increase the legal size of household plots to 0.5 ha and rescind the limit on the size of private farms. Increase role of Working capital for cotton and graim Allow advances of working The system of creating, private sources in growers is provided by the state through the capital from the State Fund for registering, and enforcing financing State Fund for Agricultural Purchases. Agricultural Purchases to be pledges and other security agricultural sector Given low procurement pnces, export repaid in cash rather than in interests in movable collateral controls and (for cotton) currency surrender kind. should be inmproved to allow requirement, private financing, especially lenders to expand financing of from foreign sources, virtually non-existent. Increase the share of advances agricultural producers. Direct financing of private farms is initiated that can be used by agricultural in 2003 on a pilot basis m a few regions. producers at their discretion (from the current level of 10%). Stimulate more Reduce indirect subsidies to the agricultural Increase cost recovery in the economical use of sector and decrease pressure on the national supply of irrigation water to agricultural inputs, budget. Lay the foundation for the long- 15%, based on the cost especially irrigation term financial sustainability of the irrigation recovery electricity prices. water sector. D. ENERGY SEcCTOR REFORM Reduce quasifiscal Due to (i) energy pricing below LRMC (for Liberalize petroleum and coal Complete pricing adjustments deficit and achieve electricity and gas) and export parity pnces prices. through aggressive price financial viability of (for oil and coal), (ii) technical and increases for electricity gas and the sector in a commercial losses, and (iii) collection Continue to implement modest heat. socially sustainable problems, quasifiscal activities in the but real (i.e., above realistic way energy sector are estimated at about inflation) increases in electricity, Ensure the effectiveness of the $2.1 bn., most of them in the electricity and gas and heat tanffs. social protection mechanism. natural gas sub-sectors Initiate abolition in stages of Complete abolition of privileged Energy sector enterprises engage in privileged electncity tanffs for electricity tariffs for enterprises. offsetting and barter schemes, and are enterprises. prohibited from disconnecting certain Complete phased transition strategic enterprises for non-payments. Implement social protection program initiated by government 9 Policy Objective Status Phase I Phase n _ Phase m mechanism(s) for the poor. to full cost recovery of central heating and hot water supply and Implement measures to enhance introduce incentives for the financial discipline including creation of association of comnpletion of the household gas housing owners that would take metenng prograrn, re-metering responsibility for timely with tamper-proof electricity payment of utility services by meters, introduction of modem their members. billing and receivables manage- ment systems, and abolishing SOEs' immunity from energy disconnections for non-pay- ments. Create an The current industry structure, in oil and gas Complete the restructurmg of the appropriate and in electncity is still quite monopolistic oil and gas sector environmentfor the and is not conducive to for private sector efficient operation participation. The monopohstic segments, Imtiate the work to establish the Complete restructurng of the and private sector such as gas and electricity transmussion, and appropriate industry structure for electricity sector participation of the the utility service segments, such as electricity energy sector electricity and gas distribution need to have appropriate legal and regulatory framework. Adopt Petroleum Law Adopt Electricity Law Merge the oil and gas and Build regulatory capacity and Strengthen regulatory capacity electricity regulatory (technical) implement measures to make it agencies and give them authority independent to regulate pricing Mobilize private Although privatization is the route chosen Adopt privatization policy to: (a) Initiate private sector Complete private sector investments for by the government to mobiltze investments, offer majority stakes in strategic participation m refineries, participation in energy sector hydrocarbon reserves the government is seeking private sales; and (b) consider electncity generation and replacement and investments: (a) without appropriate prior alternative approaches such as distribution, and gas arrest deterioration actions (on pncmg, industry structure, legal concessions, to realize private transmussion and distnbution. of infrastructure and regulatory framework); (b) in a difficult sector participation. internal and external mvestment environment; and (c) by offering only Initiate private sector Realize as much private minority stakes in selected enterprises. participation in: (a) hydrocarbon participation as possible using These efforts are highly unlikely to succeed. exploration and production; (b) contract-based regulation as oil field services; (c) retail necessary _petrleumoerahi_ns and LPG_ 10 Policy Objective Status Phase I Phase I1 Phase ll[ businesses. E. SOCIAL PROTECTRON Strengthen targeted Social assistance and child benefits are Develop measures to mitigate Assess effectwveness and social assistance to moderately well targeted to the poor the imnpact of exchange rate targeting of social assistance the poorest and those through the mahalla system. However, liberalization on vulnerable program to vulnerable groups of most vulnerable very limited resources are provided, groups of population, includmg population. especially for the low income mahalla an increase in funding for benefit. The cost of living is expected to targeted social assistance increase as a result of exchange rate programs and an expansion of liberalization and ongoing utility tariff the assistance to beneficiaries adjustments, and current budgetary who are in extreme poverty. allocations for social safety net may not be sufficient to offset the impact. As of April Enhance mechanisms of a social 1,2003, the Government abolished social mitigation to compensate the privileges to some professional groups of poorest for utility tariff population, replacmg them with cash increases. compensation. Enhance labor Exchange rate liberalization and enterprise Develop and implement Develop and implement labor Momtor the implementation mobility of workers restructuring and privatization would lead to measures aimed at: redeployment programs and assess impact of revised being made retrenchment of labor and an increased -enhancing the capacity of labor including pre-layoff and post- set of ALMPs. redundant and demand for employment assistance. agencies in providing job search layoff services and income improve efficiency of Moreover, due to ongoing demographic assistance and counseling support to displaced workers. active labor market pressure on the labor supply, and more services to address frictional programs (ALMPs) severe staff reductions resulting from unemployment; Assess efficiency of existing structural changes in the economy, the role -expanding retraining and re- ALMPs, mcluding job creation, of ALMPs will increase. skiling programs of workers training, and public works, and Assess effectiveness of the being made redundant and job initiate implementation of more programs. seekers to address structural effective employment programs unemployment; such as improved job search -expandmg programs of public assistance and job counseling works and self-employment, programs, as well as public and supporting family works programs. businesses, mcluding attracting additional resources for micro financing of relevant programs in areas of high unemployment and in mono-enterprise communities where many 11 Policy Objective Status Phase I Phase n Phase m worlers are laid off. Systematically Since April 2000, the government has been Develop and adopt indicators for Design and begin Design and implement a monitor living implementing an improved Family Budget momtoring income (e.g. poverty imnplementation of a poverty nationwide labor force survey. standards and labor Survey which permits poverty analysis. lIme) as well as non-income monitoring system which force Since January 2002, the Government has dimensions of poverty (e.g. child permits regular collection of data improved the system of regular monitoring mortality and malnutrition). on income/consumption and of labor force Strengthen the institutional non-income dimensions of capacity for monitoring of livmg poverty. standards and labor narkets. F. DATA DISSEMINATION, PUBLIC DISCLOSURE AND TRANSPARENCY Improve public An unusually wide range of economic, Start publishing in a widely Establish regular statistical Establish websites for the dissemination of financial, and socio-demographic data are accessible format detailed publications by the MOF and dissemination of official data economic, financial, not disseminated to the public. The current output, monetary, fiscal, CBU for wide circulation. by relevant govermnent and socio- level of constraints on information access external debt, foreign trade, Require annual report of the ministries and agencies, in demographic data are not compatible with the development of BOP and social data in CBU to be published. particular MMS, MOF and the a market economy and with the principles accordance with the General CBU. of good governance. Data Dissemination System Increase the circulation and standards (GDDS). commercial availability of all Increase transparency through statistical publications with the initiation of annual press Develop and publish annually a recommended Improvements in conferences and public Statistical Program specifying the quality and consistency of hearings to present and discuss data to be collected, the data presentation. the budget and annual periodicity and timeliness of progress reports on their public release, and the government economic means for dissemination. performance in selected areas. Select members of a Statistical Ensure public access to Council to mclude independent disclosure requirements for representatives of key data state enterpnses and publicly consumers to approve the annual listed companies. Statist_cal Program Strengthen the legal The existing legal framework govemig Amend and adopt the draft Amend the Law on State Secrets and institutional access to information leaves excessive Laws on State Statistics and on and related government framework governing discretion over mformation access to Principles and Guarantees of resolutions on state secrets to public access to individual government agencies and does Freedom of Access to sharply reduce the definition of information not have sufficient provisions to ensure Information in accordance what constitutes a state secret in public dissemnation of official data. The with the Bank's and Fund's non-military and security related defimtion of state secrets in non-military comments, areas and to linit the capacity of 12 Policy Objective Status Phase I Phase 1 Phase mI areas is excessively broad. Govermment mdividual ministries and resolutions classifying data categories as Make public which categories of agencies to restrct access to secret are themselves secret, justfying an information the CoM defines as mformation. organizational network of infomation state secrets. regulators with the power to withhold Review the existing structure of Implement reformns m the information. "first departments" in each structure and responsibilities ministry and agency that control of first departments. access to information to eliminate such structures where Establish procedures and feasible and to clarify and institutional capacity for Access to intemational sources of Make necessary amendments to restrict their powers where their cataloguing and responding to information is constrained by the state existing legislation on the presence is still required.. freedom of information control over internet access. decentralization of intemet requests withm each agency access as specified in CoM Verify access of private intemet under existing Uzbek Resolution No. 352 (October 10, service providers. legislation. 2002). Enhance the Policy decision making and legal Revise the Law on Normative- Ensure that all legally binding transparency of the environment for business are opaque Legal Acts to end the practice govemment decrees, resolutions, legal environment creating considerable uncertainty in the of allowing secret clauses in regulations and instructions be and policymaking investment climate. Numerous secret legally binding government registered with the Ministry of process resolutions are in place. resolutions, decrees, Justice and published. regulations and instructions. Strengthen Public procurement is regulated by a Adopt a Law on Procurement, legislative plethora of COM resolutions which have and enact a comprehensive set of framework and considerable gaps. Current disparate implementing regulations procedures for arrangements for the oversight of public establishing bid invitation, public procurement procurement are madequate. Public submission, opening, and procurement procedures limit competition evaluation procedures in line by mandating use of public design institutes with international practices. by procuring entities. The government practice of inviting bids from select industrial associations remains in place. Report No.: 25625 UZ Type: ER