The Balkans: Foreign Direct Investment and EU Accession

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The Balkans: Foreign Direct Investment and EU Accession

Aristidis Bitzenis

THE BALKANS: FOREIGN DIRECt INVEStMENt ANd EU ACCESSION

Transition and Development Series Editor: Professor Ken Morita Faculty of Economics, Hiroshima University, Japan The Transition and Development series aims to provide high quality research books that examine transitional and developing societies in a broad sense – including countries that have made a decisive break with central planning as well as those in which governments are introducing elements of a market approach to promote development. Books examining countries moving in the opposite direction will also be included. Titles in the series will encompass a range of social science disciplines. As a whole the series will add up to a truly global academic endeavour to grapple with the questions transitional and developing economies pose. Also in the series: Transition and Development in China Towards Shared Growth Yun Chen ISBN 978 0 7546 4834 5 Globalization and the Transformation of Foreign Economic Policy Pawel Bozyk ISBN 978 0 7546 4638 9 The Political Economy of Asian Transition from Communism Sujian Guo ISBN 978 7546 4735 5 The Periphery of the Euro Monetary and Exchange Rate Policy in CIS Countries Edited by Lúcio Vinhas de Souza and Philippe De Lombaerde ISBN 978 0 7546 4517 7 Transition, Taxation and the State Gerard Turley ISBN 978 0 7546 4368 5 The Institutional Economics of Russia’s Transformation Edited by Anton N. Oleinik ISBN 978 0 7546 4402 6

The Balkans: Foreign Direct Investment and EU Accession

ARIStIdIS BItZENIS University of Macedonia, Greece

© Aristidis Bitzenis 2009 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the publisher. Aristidis Bitzenis has asserted his right under the Copyright, Designs and Patents Act, 1988, to be identi.ed as the author of this work. Published by Ashgate Publishing Limited Ashgate Publishing Company Wey Court East Suite 420 Union Road 101 Cherry Street Farnham Burlington Surrey, GU9 7PT VT 05401-4405 England USA www.ashgate.com British Library Cataloguing in Publication Data Bitzenis, Aristidis.   The Balkans : foreign direct investment and EU accession.   -- (Transition and development)   1. European Union--Balkan Peninsula. 2. Balkan Peninsula- Economic conditions--21st century. 3. Investments, European   --Balkan Peninsula. 4. Balkan Peninsula--Foreign economic   relations--European Union countries. 5. European Union   countries--Foreign economic relations--Balkan Peninsula.   6. Balkan Peninsula--Economic integration.  I. Title II. Series   337.1'42'09496-dc22 Library of Congress Cataloging-in-Publication Data Bitzenis, Aristidis.   The Balkans : foreign direct investment and EU accession / by Aristidis Bitzenis.    p. cm. -- (Transition and development)  Includes bibliographical references and index.  ISBN 978-0-7546-4566-5 -- ISBN 978-0-7546-9082-5 (ebook) 1. European Union-Balkan Peninsula. 2. Investments, Foreign--Balkan Peninsula. 3. Balkan Peninsula-Politics and government--1989- I. Title. HC240.25.B28B58 2009 332.67'309496--dc22 2009007624 ISBN EISBN

978-0-7546-4566-5 (hbk) 978-0-7546-9082-5 (ebk.V)

Contents

List of Figures List of Tables Acknowledgements   List of Abbreviations  

vii ix xi xiii



Introduction  

1

1

Transition Economies vs. Market Economies: Increased FDI Inflows in Transition Economies  

3

2

Privatization Theory: Privatization Deals as a Reason for Increased FDI Outflows  

57

3

Foreign Direct Investment Theory  

75

4

Determinants of Foreign Direct Investment: Empirical Evidence  

103

5

Trends of FDI under Globalization: The Case of Regionalization of FDI Inflows  

127

6

The European Union (EU) and the Economic and Monetary Union (EMU): Prospects of the Balkan Countries Integrating into the EU  155

7 Case Studies  

253

8 Conclusion  

375

References   Index  

381 403

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List of Figures

3.1

Foreign involvement using entry modes  

6.1 6.2

Forms of integration   Inflation rate and long-term interest rate of some EU members  

76 156 231

7.1 Frequency of general ratings as ‘important’ and ‘very important’   278 7.2 Frequency of obstacles rating as ‘very important’ and ‘important’  279 7.3 Groups of motivations (hunters)   314 7.4 Ways (entry modes) used by MNEs to invest in Bulgaria   315 7.5 The key motivations for FDI in Bulgaria (research from 64 MNEs)  316 7.6 The most important obstacles for Bulgarian FDI inflows (research from 64 MNEs)   317 7.7 Groups of motives (hunters): Foreign vs. Greek MNEs in Bulgaria  353 7.8 Ways (entry modes) used by MNEs (foreign vs. Greek) in order to invest in Bulgaria   354 7.9 The most important FDI motives for MNEs (foreign vs. Greek) that invested in Bulgaria (research from 64 MNEs)   355 7.10 The most important FDI obstacles for MNEs (foreign vs. Greek) that invested in Bulgaria (research from 64 MNEs)   357

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List of Tables

1.1 Planned economies vs. market economies   1.2 Market economy characteristics   1.3 Nine reform models   1.4 Four steps for the transition to market economy  

5 6 9 34

3.1

FDI inflows in Poland  

82

4.1

Determination of FDI inflows according to the literature review: Survey based approach  

FDI inflows by host country, economy or region in million US$ (1991–2002)   5.2 Cross-border M&As with values of over US$1 billion (1989–2002)   5.3 Distribution of world FDI inflows, 1986–2001   5.4 FDI inward stock (cumulated FDI inflows) by host country, economy or region in million US$ (1980–2002)   5.5 FDI outflows by home country, economy or region in million US$ (1991–2002)   5.6 FDI outward stock (cumulated FDI outflows) by home country, economy or region in million US$ (1980–2002)   5.7 Structure of West European trade, 1928–1998   5.8 West European foreign direct investment outflows, 1980–1997

105

5.1

141 144 145 146 147 149 152 153

Box 6.1 The main reasons behind the ERM crisis in 1992/93  

170

6.1 List of European treaties   6.2 National currency weights to the ECU value   6.3 Conversion rates of EMU currencies   6.4 ERM II bands, central rates (conversion rates of future EMU members – not finalized rates), and dates of entrance   6.5 Stages of the Maastricht Treaty   6.6 Greek exchange rate during 2000 (Drachma against Euro)   6.7 Greek GDP and Greek deficit in 2002–2006   6.8 Revised Greek GDP and revised Greek deficit in 2002–2006   6.9 Greece: Long-term interest rates   6.10 Greece: Exchange rate stability  

160 167 172 172 174 177 179 180 186 187



The Balkans: Foreign Direct Investment and EU Accession

6.11 Greece: General government financial position   6.12 Greece: HICP inflation   6.13 Sweden: Long-term interest rates   6.14 Sweden: HICP inflation   6.15 Sweden: General government financial position   6.16 Sweden: Exchange rate stability   6.17 Advantages from being an EMU member and from the introduction of a common currency (EURO)   6.18 Costs of participation in the EMU   6.19 Debt over GDP   6.20 Surplus/deficit over GDP   6.21 Progress towards Maastricht – an overview of economic indicators of convergence   6.22 Membership referendum results   6.23 The enlargement of the European parliament   6.24 Chapters of acquis correspondence   6.25 Advantages and disadvantages from being an EU member   6.26 Economic indicators and the Maastricht Treaty convergence criteria 6.27 Economic indicators of convergence 6.28 GDP in European Union   6.29 GDP growth rate   6.30 Minimum wages in euros per month in EU member states, candidate countries, January 2003, 2004, 2005, 2006   6.31 Minimum wages in PPS per month in some EU member states, candidate countries, 2004, 2005, 2006   6.32 Human development index   6.33 Standardized unemployment rates in Europe   7.1 Mobile operators in associate candidate countries (ACC) and Western Balkan countries (WBC)   7.2 FDI inward stock in millions of US$   7.3 FDI inward stock per capita in US$   7.4 Active banks in Serbia as of 21 June 2006   7.5 Corruption perceptions index 2003   7.6 External debt/GDP per cent in EEC countries (1991–1993)   7.7 Current account balances of Central and Eastern Europe, 1990–2002 7.8 Current account in per cent of GDP in EEC (1991–1993)   7.9 Bulgarian inflation rate, 1990–2000   7.10 Direction of Bulgarian trade (1945–1998)   7.11 Merchandise exports of Eastern Europe, 1980, 1989–2002 7.12 Merchandise imports of Eastern Europe, 1980, 1989–2002 7.13 Inflows of foreign direct investment in Central and Eastern Europe, 1990–2002  

188 188 189 189 189 190 192 194 198 201 214 218 219 220 222 228 229 232 234 235 237 238 239

269 276 276 303 319 335 336 337 339 342 345 346 348

Acknowledgements Εγώ ειμί το φως του κόσμου. Ο ακολουθών εμοί ου μη περιπατήση εν τη σκοτία αλλ’ έξει το φως της ζωής. ‘Ιησούς Χριστός’

This book would have never been completed without the valuable support of my wife. Also, the comments and suggestions from Dr. Marangos were of greatest importance for the finest preparation of this book. I would also like to thank some other people for the help they offered me during the preparation of this book such as Prof. Klaus Meyer, Prof. Gabor Hunya, Prof. Bruno Sergi, and Prof. Paul Hare. I am most grateful to all of them. Special mention needs to be made to the splendid Ms. Christou Angela, who has spent hundred of hours and a great amount of her precious time checking on my written English, proofreading and editing all the chapters in this book. Her suggestions, comments and corrections were invaluable. Also, I would like to thank Kafteranis Xarisios, who not only supported my efforts, but also encouraged and helped me in every difficulty I faced during the preparation of this book. I should not forget Dymphna Evans, Brendan George, Carolyn Court, Aimée Feenan and Adrian Shanks from Ashgate for their kindness and full support, as well as Ashgate Publishing for giving me the opportunity to publish this book. Last but not least, I am especially grateful to my wife Anna – Xenia Lyssikatou, and to my sister Bitzeni Yiouli, for their continuous emotional and economic support and for helping me bring this task to its completion. I dedicate this book with my deepest love and affection to my son Loukas, my daughter Eftychia and to my whole family.

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List of Abbreviations

BGN Bulgarian Lev BOP Balance of Payments CARDS Community Assistance for Reconstruction, Democratisation and Stabilization CEE Central and Eastern Europe CEECs Central and Eastern European Countries CEFTA Central European Free Trade Association CIS Commonwealth of Independent States CMEA Council for Mutual Economic Assistance COMECON Council for Mutual Economic Assistance CPI Consumer Price Index DEM Deutche Mark EAD Economic Analysis Division EBRD European Bank for Reconstruction and Development EC European Community ECB European Central Bank ECE Economic Commission for Europe ECSC European Coal and Steel Community ECU European Currency Unit EDP Excessive Deficit Procedure EEC European Economic Community EFTA European Free Trade Association EIB European Investment Bank EIU Economist Intelligence Unit EMS European Monetary System EMU Economic and Monetary Union EU European Union FDI or DFI Foreign Direct Investment FRY Federal Republic of Yugoslavia FYROM Former Yugoslav Republic of Macedonia GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product GDR German Democratic Republic GNP Gross National Product IBI International Banking Institute IBRD International Bank for Reconstruction and Development IFC International Finance Corporation

xiv

The Balkans: Foreign Direct Investment and EU Accession

IIB International Investment Bank IMF International Monetary Fund IPO Initial Public Offering M&As Mergers and Acquisitions MEBO Management and Employee Buyouts MNC Multinational Corporation MNE Multinational Enterprise NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organisation OECD Organisation for Economic Co-operation and Development PETs Planned Economies in Transition PHARE Poland/Hungary: Assistance for Reconstruction of the Economy [Pologne/Hongrie: Assistance a la restructuration economique] PPP Purchasing Power Parity SAAs Stabilization and Association Agreements SAP Stabilization and Association Process SEA Single European Act SEEs South East European Economies SEECs South East European countries SGP Stability and Growth Pact SMEs Small & Medium Enterprises SOEs State-Owned Enterprises UK United Kingdom UN United Nations UNCTAD United Nations on Trade and Development UNECE United Nations Economic Commission for Europe US United States USA United States of America USD United States Dollar USSR Union of Soviet Socialist Republics VAT Value Added Tax WB World Bank WIIW The Vienna Institute for International Economic Studies [Wiener Institut fur Internationale Wirtschaftsvergleiche] WTO World Trade Organisation

Introduction

The fall of communism and the subsequent developments have put a renewed spotlight on the potential of the Balkan economies. Bulgaria, Albania, Serbia & Montenegro, Romania and the Former Yugoslav Republic of Macedonia are countries that have attracted rather low levels of investment, with poor political leadership in the majority of these countries delaying the much needed and anticipated reforms. However, there are now signs of improvement and this timely book aims to fill a significant gap in the literature. This book demonstrates and supports the idea that these countries must engage as fully as possible with the world economy via EU accession and explores the implications of the specific characteristics of these countries which have made the transition process more difficult. It is well known that FDI plays a potential role in encouraging and supporting a successful transition. FDI in transition economies appears to be an effective tool for several reasons such as transfer of knowledge, increased productivity, upgrading of managerial and labour force skills, improving the state balance, balancing deficits, accelerating privatization of state-owned enterprises and quickly restructuring of them. Over the last 30 years economists and investors have dealt with countries mainly from Latin America, and Asia such as Argentina, Mexico, Chile, Korea, Malaysia, Hong Kong, Taiwan, Singapore, the Philippines, China, and a few others like the UK, the USA, Spain, Ireland, Portugal and Greece for their inward investment activities. After 1989 and the collapse of communism, Central and Eastern European countries along with the Baltic States and the CIS have been an ‘attractive area’ for business. The interest is always with countries that open their borders; their economies offer great opportunities, incentives and challenges for inward FDI. In the last two decades (1990s–2000s), the interest of foreign investors has focused mainly on the Central and Eastern European Economies and secondly on the South East European Economies. Therefore, the fall of communism in Central and Eastern European countries raised the interest of economists, entrepreneurs and multinational enterprises (MNEs) in analysing and exploiting the potentials of Central and East European markets and especially the Balkan market. Bulgaria, Albania, Serbia & Montenegro, Romania and FYROM are among the countries that have not been studied yet. In reality, what makes this book interesting is the fact that the Balkans is a relatively neglected region in studies of transition, as well as being one that presents some unusually difficult problems. The economic environment in the region has not proved especially attractive to business, and the poor political leadership in most



The Balkans: Foreign Direct Investment and EU Accession

of these countries has delayed much needed reforms for way too long. However, there are signs of improvement in most countries, and that might make this book quite timely. These countries must simply engage as fully as possible with the world economy (globalization, EU integration), otherwise there is no way they will ever escape their present poverty. At the same time, the Balkan region displays the following specific characteristics: geographical distance from the Western markets, cultural distance from the West, strong dependence on the former Soviet Union and its subsequent dissolution (Russia and CIS), strong dependence on the CMEA trade organization and its collapse, adverse initial conditions, and political instability and/or inability of the respective governments that hinders the success of the whole transition process. This book will therefore prove suitable for gaining a greater understanding of the South East Economies as special case studies as well as understanding their prospects to enter to the EU. The book can be used in modules relating to transition economies, those discussing international business in the Balkan region, and the European business environment as it relates to the South Eastern Europe region. The book includes more than 20 case studies (uniquely from the Balkan region) and topics such as FDI, privatization (entry modes), and prospects for an EU entrance have been presented and analysed. The book is designed to further understanding of the reasons behind the low accumulation of FDI flows in the Balkan region and provides detailed coverage of the difficulties of the Balkan’s business environment (mentality, entrepreneurship, banking reform, legal reform, etc.). The book will also assist in comprehending the macro environment of the SEE region.

Chapter 1

Transition Economies vs. Market Economies: Increased FDI Inflows in Transition Economies

1.1 Introduction: Planned vs. Market Economies; The Transition from a Planned to a Market Economy The breakdown of centralized socialism in the Union of Soviet Socialist Republics (USSR), Central and Eastern Europe and Asia resulted in the adoption of the market process as a means of organizing the economy. The movement from a centralized socialist economy to an economy based on market relations has been termed transition, and thus the economies that have adopted this process are named transitional economies. In particular, the transition process was associated with an explicit end-state. The transition economies associated this end-state with the establishment of a capitalist economic system. Hence, the transition involved, in essence, the introduction of private ownership as a result of privatization and/or restructuring of state-owned enterprises, and the establishment of market equilibrium as a result of abolishing centrally administered commands. The transition went further to involve liberalization of economic activity, an institutional reform, a change in economic behaviour as a result of economic actors adjusting their behaviour in line with self-interest, and the rules of the exchange market. It also involved the reduction of the state’s role as a legislator and facilitator of economic activity. The term transition has been criticized as being inadequate, as it does not capture all the complications involved during the process. The term implies a linear movement from A (centralized socialism and disequilibrium) to B (capitalism and equilibrium). Specifically, as the term transition implies an endstate, the achievement of the end-state completes the whole process. It can be argued that the process is already completed as transition economies have adopted a capitalist economic system and most countries of the Central and Eastern Europe have become members of the European Union (EU). Hence, the term transitional economy is obsolete. On the other hand, it can be argued that the ‘transition’ process is ongoing and equilibrium can never be achieved by using terms such as transformational economies or simply developing economies. In addition, since capitalism comes in many forms, the question arises as to what type of capitalism should be the goal. This further complicates the process (Sergi, 2003; Marangos, 2004a). Even the goal



The Balkans: Foreign Direct Investment and EU Accession

of achieving a capitalist economic system was questioned by some commentators who offered alternatives such as market socialism as the most appropriate economic system, pointing out China and Vietnam as examples (Marangos, 2006a; 2006b). The economic programme of transition involved the following four factors, but in no particular order. The first was macroeconomic stabilization, in order mainly to reduce inflation and to decrease the debt burden. The second was liberalization of economic activity such as prices, trade, currency convertibility, etc. The third was the reduction of the size of public sector by privatizing and restructuring state-owned enterprises. The last factor required introduction of new laws and regulations. For example, property rights, corporate law, accounting practices, tax regulation, etc. Hence, the decision to move to a market-based economy required a total transformation of the economy as a whole (see also Zloch-Christy, 1994). Meanwhile, as citizens had been protected for so long by the socialist state, they were ill prepared to face the economic adversity and uncertainty that came about as the result of the free market process. Although all countries in transition had more or less the same final goal, the results of their efforts diverged. This was due to the diverse and/or adverse internal as well as external conditions each country initially faced and to the different strategies, policies, and paths they undertook to ensure smooth and successful transitions (Bitzenis, 2006b; 2007). A market economy, or a free economy, or a free enterprise economy is an economic system which allocates scarce resources, based on the interaction of market forces of supply and demand. It is an economy that operates by voluntary exchange and it is not planned or controlled by a central authority. It is the conceptual opposite of a command, or central, or planned, or government controlled economy, where all goods and services are produced, priced and distributed under government control. Nowadays, a market economy is associated with a capitalistic economy (see Tables 1.1 and 1.2). The market is a process in which individuals interact with one another in pursuit of their separate economic objectives. The basic principle under which the market functions is: if you own something which you are entitled to and you wish to exchange it for something else which belongs to someone else and you execute the exchange without violence, theft or deception then you become entitled to what the other person was previously entitled to, and vice-versa. Both parties in an economic transaction in the market benefit from it, provided the transaction is bilaterally voluntary and the parties well-informed. Otherwise, the transaction will not take place. In this way, through the market process, everyone is able to escape coercion at the hands of any buyer or seller by turning to another buyer or seller.

Transition Economies vs. Market Economies



Table 1.1  Planned economies vs. market economies Planned (centralized or central planned) economy characteristics

Characteristics of an economy during its transition to a market economy

State owned enterprises (SOEs), no private sector Bribery, lack of transparency, bureaucracy, corruption No effective allocation of resources Governmental inability/unwillingness for adequate reforms (political cost) (natural + human + capital) No unemployment, no or limited inflation Black economy Limited quantity, variety and quality of products Nomenklatura, criminality, mafia Central plan Unclear property rights (the government set the prices, salaries) Central plan (what to produce, in which Unemployment and increased poverty quantity and quality → secured clients – secured trade partners) Subsidies → on products for the local/ Legacy of communist regime as an adverse initial condition foreign market → on enterprises (bad loans), soft budget constraints Manipulation of output, pricing and employment Economic crises and output decline Free education – health system (high levels) Small savings, low GDP per capita Production of certain products High inflation, exchange rate devaluations, monetary overhang Lack of competitiveness Trade with Eastern countries (CMEA – COMECON) Exchange of products in special (low) prices Lack of sound financial institutions, political instability Over-inflated macroeconomic data Adverse economic initial conditions Lack of commercial legislation and market Reductions of trade quotas and tariffs, oriented taxation systems, one-tier banking Elimination of subsidies system, no stock exchange State: the guiding force of the market Unstable legal framework Lack of experience (managerial skills, Geographical and cultural distance from the west, isolation of the country reformers, governance, mentality, entrepreneurship)

There is currently no country where all markets within its borders are absolutely free. Rather, a free market economy is one with limited government intervention (otherwise known as laissez-faire). Market based economies require appropriate laws and institutions which include defined property rights that are respected and enforced, as well as procedures to guarantee the execution of contracts. Many states which are said to have a capitalist system do not have the level of market freedom that some would prefer. Even the United States of America (USA), a worldwide representative of capitalism, has placed restrictions upon the freedom of individuals in the economy.



The Balkans: Foreign Direct Investment and EU Accession

Markets are also characterized by market failure, i.e. an allocation of resources which is not efficient. The market is able neither to produce public goods (defence, law and order, etc.) nor to ‘cover’ the social cost or benefits of externalities (environmental pollution, education, etc.). Thus, it creates monopolies and oligopolies. Then, the state takes on the responsibility of producing public goods and subsidising positive externalities funded through taxation, while it restricts negative externalities, monopolies and oligopolies.

Table 1.2  Market economy characteristics Market economy characteristics Market forces (supply and demand) State: A role of the legislator and facilitator of the economic activities Competitive environment Free prices, trade, interest rates, exchange rates Private sector Hard budget constraints, new corporate governance New laws and institutions Taxes on private companies (corporate and personal income taxes and VAT) Black economy, under-reported data Unemployment Effective governance, competition Advanced two-tier banking system (central bank + commercial banks) Stock market exchange Financial intermediaries (insurance companies, pension funds etc.) Limited or even absence of subsidies, trade quotas and tariffs Reforms at all levels (tax, financial, legal etc.) Privatization and restructuring, macroeconomic stabilization, liberalization, institutional or structural reform (new laws, new institutions, new mentality) Open country, FDI flows, open trade, open economy

Finally, Bitzenis and Marangos (2007) argued that the terms ‘integration and transition’ are more appropriate than just ‘transition’ of what essentially took place in the Central and east European region and generally in transition economies. They stated that in fact, it is an integration-assisted transition. These terms, integration, assistance and transition, are not substitutes but complements in demonstrating the transition process in the CEE economies. Integration means that a country becomes a part of the globalized world. Integration is the goal of globalization, and integration is achieved by inviting multinationals and entering the EU. Integration is further enhanced by membership of the EMU and the adoption of the single currency. Both the European Union (EU) and the Economic and Monetary Union (EMU) are the best examples of integration and globalization, as

Transition Economies vs. Market Economies



membership involves the abolishment of barriers to entry, liberalization policies, and the adoption of the 35 chapters of the acquis (6th EU enlargement policy). All of them determine the legal, political and economic convergence among member countries, and create the fundamentals for stability for the members and a sound business environment to attract FDI and trade flows (Sergi, 2004).

1.2 The Transition Reform Paths to Democracy and/or Market Economy A successful transition process may be treated as a tool for the economic development of a country. However, … (transition) is not only an intermediate goal contributing to economic development. It may also be regarded as an ultimate objective in itself. The market economy, in contrast to central planning, gives, in principle, the individual the right to basic choices over aspects of his or her life: occupation and place of work, where to live, what to consume, what risks to take or avoid, and so on. (EBRD, 1994, 3)

An important factor in studying the transition process is the way in which the initial dismissal of the communist regime occurred. Regimes ‘fall’ in many different ways. For example, the transition of power was smooth and peaceful in Poland and Hungary, which had a tradition of dialogue and negotiations; it was peaceful but painful in East Germany, Czechoslovakia and Bulgaria; and it was painful and violent in Romania which was on the verge of civil war by Christmas 1989. (Berglund et al., 1994, 241)

There is a distinct difference between transition from a planned to a market economy and transition from a communist regime to democracy. In other words, after the Central and East European countries faced the collapse of the communist regime and moved towards democracy, they adopted monetary, income, fiscal stabilization policies and institutional reforms in order to establish all the elements of a functioning market economy in their economic environment. Thus, it is important to present and analyse the transition reform paths and the need to have a ‘strict government’, which would not sacrifice the successful implementation of its reform policy for the sake of popularity. Meyer (1998, 209) characterizes the transition from communism to democracy as a: ‘… decisive precondition for the establishing of new democratic institutions and the restructuring of economic institutions moving away from the planned towards the market economy’. The political transition comprised political liberalization, free elections and general democratization and aimed at replacing the single-party political regime and establishing liberal democracy and a civil



The Balkans: Foreign Direct Investment and EU Accession

society (Sokol, 2001). The transition from communism to democracy in most of the countries was supported by the previous development of a civil society whose characteristics reflected the revolutions themselves: it was anticommunist, anti-ideological, and anti-political (Tismaneanu, 2001). However, certain barriers might arise in the development of the new political system such as the risk the old elite faced to transfer its political power into new forms in the new system, along with the lack of democratic traditions and experience (Mygind, 2000). Despite the fact that transition countries adopted rapidly multiparty democracy regimes, some reversals of political reforms and many tensions, controlled by the previous regimes arose (EBRD, 1995). There is also a common consensus that the implication of a market-oriented transition might be deemed as a political development because of the robust relationship existing between the political and economic reforms (EBRD, 1995). We agree with Kolman et al. (2003, 87) who found that in spite of the small geographical distance, there are cultural differences between countries from the Central and East European region and the Western European countries. It was also their belief that, from a managerial perspective, it would be dangerous to treat the Central East European countries as a homogeneous group or cluster. In an earlier article, Ronen and Shenkar (1985) had attempted to create clusters among different countries and to group them together basically according to their geographical area, their language and religion, their beliefs that arose from certain norms and values and their technological development. Ronen and Shenkar had also argued that geography casually precedes the other variables such as language and religion and that the geographical grouping may contain countries from all five continents as the spread of culture may be attributed to colonization and immigration. They included in the proposed clusters only one country from the Central and East European region, ex-Yugoslavia. By applying a political economy approach to the transition process, Marangos (2004a) develops alternative models of transition. The alternative models of transition can be distinguished on the basis of what the author defines as the primary elements of each transition model: (1) Economic Analysis; (2) What is a Good Society?; (3) Speed; (4) Political Structure; (5) Ideological Structure; and (6) Initial Conditions. On the basis of the primary elements, Marangos (2004a) distinguished five transition models: The Shock Therapy model of transition; the Neoclassical Gradualist model of transition; the Post-Keynesian model of transition; the Pluralistic Market Socialist model of transition; and the NonPluralistic Market Socialist transition model (Chinese model). In Kolman et al. (2003), Ronen and Shenkar (1985) and Marangos (2004a), the grouping of the countries into clusters is profound and is based on cultural, geographical and transition elements in order to provide a framework for theoreticians and practitioners to study the interaction between companies and a host country (destination country of an FDI project) and to understand the values and attitudes of employees in such a country. To this end, the nine reform models

Transition Economies vs. Market Economies



presented in this paper will be our contribution to the categorization of transition countries into clusters, based on their political and transition reform features.

Table 1.3  Nine reform models Reform models

Countries/Year

Diplomacy

East Germany Bosnia & (1989) Herzegovina (1995)

Russia (1991)

Serbia & Montenegro (1995)

Croatia (1995)

Quiet/peaceful/ colour or flower revolutions

Ukraine (Orange Revolution) (2004); Georgia (Rose Revolution) (2003); Kyrgyzstan (Tulip Revolution) (2005)

Czech Republic (Velvet Revolution) (1989)

Slovakia (Velvet Revolution) (1989)

FYROM (1991); Slovenia (1991); Serbia & Montenegro (Peaceful Revolution) (2000)

Estonia (Bloodless – Singing Revolution) (1991)

Disguised

Hungary (1994)

Bulgaria (1990)

FYROM (1992)

Russia (1991); Albania Lithuania (2002); Serbia (1992) & Montenegro (1990)

Compromised

Bulgaria (1997); Albania (2002)

Hungary (1990)

China (1989)

Poland (1995-)

Violent

Romania (1989); Albania (1997)

China (1989)

Serbia & Montenegro (2003)

Lithuania Latvia (1991) (1991); Russia (1993)

Rebellion

China (1987)

Poland (without revolution) (1989)

Albania (1991)

Belligerent

Serbia & Montenegro (1992)

Bosnia & Herzegovina (1992)

Croatia (1992)

Transparent

China (1978)

Vietnam (1979)

Mixed

Bosnia & Herzegovina; FYROM; Albania

Croatia; Serbia & Montenegro

Source: Bitzenis, 2007.

Lithuania; Latvia; Estonia; Russia

China

Estonia (1992); Latvia (2002)

Bulgaria (1990, 1997)

Poland; Hungary; Bulgaria

10

The Balkans: Foreign Direct Investment and EU Accession

Studying the transition models to a market economy and the economic development of transition countries, one recognizes similar and different characteristics among transition procedures of the various countries especially at the beginning of the transition period (1990s), during the collapse of the communist regime. Thus, our introduction of nine general transition reform paths with regard to the way that the reform from communism to democracy and to a market economy was achieved: (1) the Diplomacy Reform; (2) the Quiet Reform; (3) the Disguised Reform; (4) the Compromised Reform; (5) the Violent Reform; (6) the Rebellion Reform; (7) the Belligerent Reform; (8) the Transparent Reform; and finally (9) the Mixed Reform (see Table 1.3). The Diplomacy Reform model: In the Diplomacy Reform model transition is achieved through political intervention of an external power. This transition path is recognizable in the German Democratic Republic (GDR) where the collapse of the old regime and the subsequent reunion with West Germany was demanded by the East Germans. It is also recognizable in the countries that have been created from the dissolution of the Soviet Union and Yugoslavia (e.g. Russia, FYROM, Croatia, Bosnia & Herzegovina, Estonia, etc.). However, in most cases a Diplomacy Reform was an outcome of a Belligerent Reform (see below). The Quiet or Peaceful Reform (colour or .ower revolutions) model: In the Quiet or Peaceful Reform model the old regime is faced with a peaceful yet determined opposition and through a proclamation of national elections eventually hands over power to the democratic opposition without any resistance. The dissolution of Czechoslovakia (the Czech and the Slovak Republic) and its transition to democracy is such an example. This specific reform is also known as the velvet revolution. In November/December 1989, a peaceful student demonstration in Bratislava and in Prague along with other popular demonstrations and strikes led the communist party to announce at the end of that year the end of its monopoly on political power. This resulted in the first democratic elections since 1946 for Czechoslovakia. The Quiet Reform with the simultaneous establishment of independence of the country in a peaceful way can also be called the Quiet/Diplomacy Reform. It took place in Slovenia, FYROM, Ukraine, Georgia, Kyrgyzstan, Serbia & Montenegro and Estonia. Both Slovenia and FYROM broke away from Yugoslavia (FRY) in a peaceful manner. Under the same kind of reform we have the so-called colour revolutions, the rose, tulip and orange revolution. The first of such kind, the Rose Revolution started in Georgia in November 2003. In the parliamentary elections, Saakashvilli, the opposition leader who was supported by independent exit polls, claimed that he had won the elections. However, this result was unacceptable to the leading party and led to a non-violent and anti-governmental demonstration in Tbilisi and other cities of Georgia. The demonstrations of the supporters of Saakashvilli

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with roses in their hands along with the elite military units’ refusal to support the government, forced President Shevardnadze to resign. In the same direction, in the Ukrainian presidential election at the end of 2004, Yanukovych (President from the end of 2002 until the end of 2004) was declared the winner. However, this outcome was not accepted by the majority since the exit polls proclaimed Yushchenko (Prime Minister from the end of 1999 until the end of April 2001) the winner. Thus, mass demonstrations in Kiev and many other Ukrainian cities took place at the end of 2004. Over half a million protesters, wearing orange ribbons demonstrated and supported Yushchenko (orange was the official colour of the movement and the predominant colour in Yushchenko’s election campaign). They peacefully asked for new elections in which Yushchenko finally won in the third round (Orange Revolution). This revolution has sometimes also been called the Chestnut Revolution due to the abundance of chestnut trees in Kiev, the capital city of Ukraine and the centre of this revolution. In March 2005, there were demonstrations in Kyrgyzstan against President Akayev and his government who were increasingly corrupt and authoritarian. These demonstrations were known as the Tulip Revolution and ended with Akayev’s resignation. Another peaceful revolution of the same kind took place in Serbia, in October 2000 with mass demonstrations in Belgrade when Kostunica and his supporters doubted the results of the presidential elections and the demonstrations replaced Milošević’s autocratic regime. Last but not least, another similar revolution took place in Estonia. It was in 1991 when mass demonstrations blocked the Soviet tanks and proclaimed the restoration of the independence of Estonia with the Singing Revolution which lasted four years (1988–1991). The Singing Revolution started in 1988 with various protests, acts of defiance, yet without violence. It ended with demonstrations with thousands of Estonians singing forbidden national songs and finally, winning Estonia’s independence. The Disguised Reform model: In the Disguised Reform model the old regime anticipates the inevitable changes and in an attempt to stay in power, ‘disguises’ itself as a democratic socialist party. For example, Bulgaria’s regime was transformed by a ‘Disguised Reform’. The ruling elite in Bulgaria lacked pressure from a strong opposition and moved to the ‘political opening’ only when the Soviet Union politically intervened. Then the communist party renamed itself the Socialist party, ousted its president, scheduled and won the first elections. The Compromised Reform model: In the Compromised Reform model under no significant pressures, the communist regime gives in to the demand for change and democratization by joining or co-operating with the democratic party. Together, they proceed to the first free elections (after 50 years of communism) and make the transition reforms. The Compromised Reform can also take place when the communist regime ‘allows’ the democratic opposition to hold and win the elections in order to proceed to the necessary transition reforms. The Compromised Reform

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can also be seen as the result of a conscious political decision for a gradual reform to a market economy. The starting point of such reforms goes back to the 1980s or even to the 1970s, during the communist era (e.g. Hungary, China, and Vietnam). In 1989, the communist regime gave up power voluntarily, and Hungary became a parliamentary democratic Republic. The first free parliamentary elections were held in May 1990 and were won by the populist, centre–right and liberal parties. The Magyar Demokrata Fórum (the Hungarian Democratic Forum, MDF – conservative/Christian democrat party) became the dominant party and won 43% of the votes. Its leader, József Antall, was elected prime minister of the centre-right coalition government. This was a coalition with the Independent Smallholders’ Party (FKGP) and the Christian Democratic People’s Party (KDNP). They commanded a 60% majority in the Hungarian parliament (Compromised Reform). In October 1989, the communist party was reformed into the social-democratic Magyar Szocialista Párty (Hungarian Socialist Party, MSzP). The poor performance of the Hungarian Socialist Party in the first free elections (won 24% of the votes) raised the political need for compromise solutions. In May 1994, the socialists made a comeback by winning a plurality of votes and 54% of the seats in Parliament after an election campaign which had focused largely on economic issues and the substantial decline in living standards since 1990 (the Disguised Reform). However, dissatisfaction with the pace of economic recovery, the rising crime rate, and government corruption convinced people to vote centre-right parties in the Hungarian national elections of May 1998. The Violent Reform to Democracy model: In the Violent Reform to Democracy model the old regime is overthrown by a violent uprising (violent uprising or violent the way that it was countered – e.g. Romania). Reforms and changes could be proposed by the opposition, or by the reform communists who came into power. It was some days before Christmas in 1989 in Romania, when the Dictator Ceausescu was swept from power in a popular uprising. The Romanian people had begun to rebel in Timisoara on 17 December 1989, when demonstrators stormed the Communist Party headquarters. On 23 December 1989, Romania’s ‘Revolution’ or Romanian coup d’état came to an end with the summary execution of Ceausescu and his wife Elena at the hands of a secret tribunal. The square where Ceausescu faltered was officially renamed Piatza Revolutiei (Revolution Square). The Rebellion Reform model: The Rebellion Reform model is the result of pressure put upon the communist regime during the communist era (e.g. the worker’s union pressures in Poland). It appeared with strikes, demonstrations, social anarchy, and demands for liberty and workers’ rights, especially in periods of economic crises and political uncertainty and where corrupted governments existed. More specific, in Poland in 1978, Lech Walesa along with other activists began to organize free non-communist trade unions. In August 1980, Walesa led the Gdansk shipyard strike which gave rise to a wave of strikes over most of the country with Walesa seen as the leader. The primary demands were for workers’ rights.

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The authorities were forced to capitulate and to negotiate with Walesa the Gdansk Agreement of 31 August 1980, giving the workers the right to strike and to organize their own independent union. When the Polish communists made this concession, which had been without precedent in the history of the communist world since 1917, the new union was named Solidarnose [Solidarity]. The country’s brief enjoyment of relative freedom ended in December 1981, when General Jaruzelski, mainly in fear of a Soviet armed intervention, imposed martial law, suspended Solidarity, arrested many of its leaders, and interned Walesa in a country house in a remote spot in Poland. In November 1982, Walesa was released and reinstated at the Gdansk shipyards. Although kept under surveillance, he managed to maintain contact with Solidarity leaders in the underground. Even though martial law was lifted in July 1983, many of the restrictions in the civil code were kept in practice. In October 1983, the announcement of Walesa’s Nobel prize raised the spirits of the underground movement, but the award was attacked by the government press. It was in 1988 when there was another occupation strike in the Lenin Shipyard in Gdansk, which Walesa joined again. A few months later, in 1989, the Polish communists entered into negotiations with Solidarity at the first Round Table. The Jaruzelski regime became even more unpopular as economic conditions worsened, and it was finally forced to negotiate with Walesa and his Solidarity colleagues. In April 1990, at Solidarity’s second national congress, Walesa was elected chairman with 77.5% of the votes. Walesa and his colleagues secured semi-free elections in which Solidarity proceeded to triumph. In August 1990, Poland got its first noncommunist prime minister in a non-communist government in more than 50 years. In a general ballot in December, Walesa was elected President of the Republic of Poland. He served until defeated in the election of November 1995 (the Rebellion Reform – a genuine workers’ revolution). The next phase in Walesa’s political career is more controversial. Angered by the fact that his former intellectual advisers were running the country in cooperation with the former communists, he declared ‘war’ on the heads of Solidarity. Thus, it can be argued that in that time period in Poland there was a co-operation of the two oppositions and thus, Poland also followed a Compromised Reform (therefore a Mixed Reform). The Belligerent Transition Reform Path model (e.g. Serbia & Montenegro, Bosnia & Herzegovina and Croatia): Τhe old regime of Yugoslavia, being the most liberal compared to those of other ex-communist countries during the pre-transition period, remained in power and promised transition reforms. However, it failed to change the situation. Only after 1999, after many years of the totalitarian dictatorship of Milošević, when the country had suffered immensely from the NATO war and its embargo, a democratic regime finally was established in the country, starting from scratch the reforms and the actual transition to a market economy. In June 1991, Slovenia and Croatia seceded from the federation, followed by FYROM (September 1991) and Bosnia & Herzegovina (March 1992) (the Quiet

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Reform was followed by all these countries but only at the early transition years [except for Slovenia]). However, the presence of large Serb minorities in Croatia (580,000) and Bosnia (1.6 million) led to wars (Serbia, Bosnia and Croatia). Hundreds of people died and nearly 100,000 fled from their homes (the Belligerent Reform). More specifically, on 1 March 1992, 64% of the Bosnian electorate voted in response to a simple question: ‘Are you in favor of a sovereign and independent Bosnia-Herzegovina, a state of equal citizens and nations of Muslims, Serbs, Croats and others who live in it?’ The overwhelming answer to this question was ‘Yes’. In April 1992, an alliance was established between the Croatians and the Bosnians in order to combine their strengths against the Serbian forces. On 1 March 1994, an agreement was reached between Croatian and Bosnian ministers to create a Muslim (Bosniak)-Croat Federation. Presidents Izetbegovic and Tudjman signed this agreement in Washington DC, USA on 18 March 1994 and it was quickly ratified by the Bosnian parliament. On 21 November 1995, the Dayton Peace Accord was initiated in Dayton, Ohio by the presidents of Bosnia, Croatia, and Serbia, calling for the division of the republic into two ‘entities’ (the Diplomacy Reform). Thus, as both the quiet and belligerent together with the diplomacy reform models appeared in the cases of Bosnia & Herzegovina and Croatia, it can be argued that a Mixed Reform path again is the appropriate one for both countries. The Transparent Transition Reform path model relates to the move towards a market economy without the abolishment of communism (e.g. China, Vietnam). In this case, the previous communist regime remains in power while monitoring the changes taking place in the Eastern bloc and in the former communist countries. At the same time, it proceeds to transition reforms, liberalizing the economy, opening the borders and ‘asking’ for FDI inflows in order to become a market economy (e.g. China, Vietnam). As mentioned in Marangos (2004a), the Communist Party is still in power in China and Vietnam – unlike the situation in the other transition countries – and the development of a socialist society is still the official state goal. A quarter of a century ago, the Communist leadership under Deng Xiaoping initiated a marketization process in China’s centrally administered socialist economic system. The start of these reforms is usually identified with the Communist Party Plenum in December 1978. Thus, the period of reform has been at least double of that of other transition countries. China’s reforms differed markedly from those reforms implemented in the transition economies of Eastern Europe and the former Soviet Union. The reforms in China consisted of small step-by-step changes. Neither was the ultimate goal announced, nor was any timetable for the transition mentioned. Some of the changes were initiated spontaneously ‘at ground level’, and only after they were successful were they ratified by the government and implemented as official policy. The reforms proceeded by trial and error, with frequent mid-course corrections and reversals of policy. Marangos (2004a) concluded that the Chinese economic

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growth rate is among the highest on record and fairly stable. It has been achieved without sacrificing external equilibrium, and inflation has been kept under control. However, China also followed the Compromised Reform model when the communist regime adopted transition reforms just by following the pressures for changes that existed in other transition economies. Worthy of mention is the fact that the Transparent Reform in China was backed-up by a failed rebellion (1987) and the Violent Reform (1989). The latter took place with various demonstrations in 1989, and was supported by thousand of students and workers in many major cities. Both students and workers peacefully demanded democratic reforms, asking for equality and protested against government corruption. The Chinese government answered with forceful military action with troops and tanks in Tiananmen Square. Hundreds of civilian deaths resulted from this unsuccessful violent reform. Marangos (2004a) mentioned that Vietnam’s transition was greatly influenced by China’s successful experience. The beginning of market reforms dates back to the Sixth plenum of the Fourth Party Congress in September 1979. After a long period of unsuccessful partial and gradual reforms in 1989, the course of transition in Vietnam broke away from the Chinese model and a shock therapy approach was adopted. The pace of reform in Vietnam from 1989 to 1991 was anything but gradual, and the stabilization programme adopted in 1989 was certainly as ambitious as the shock therapy approach in other transition economies. The Mixed Reform model is evidenced in FYROM, where the transition to democracy was achieved through a combination of the following: the Quiet Reform and the Disguised Reform. The Federal Republic of Yugoslavia (FRY) was on the edge of disintegration. Many political, ethnic and economic problems that had been successfully hidden throughout the communist years had risen to the surface, sparking civil wars with Croatia and Bosnia & Herzegovina and the break down of the Federation. FYROM was the only country together with Slovenia, which had managed to achieve its independence peacefully in 1991 (the Quiet Reform). After the break-up in January 1990 when the last Congress of the League of Yugoslav Communists was held and the Slovenians and Croatians had left, many changes occurred, including the change of the political system. In November 1990, the first multi-party elections were held in FYROM. In January 1991, Kiro Gligorov was elected as the first president of the country and after a while the first government, ‘the experts government’, was formed. However, by 1992 three governments had succeeded one another and finally the SDSM (Social Democratic Alliance of Macedonia that originates from the former Communist Party) got the right to form a government by coalition with the PDP (PDP – Albanians Party of Prosperity and Integration). Actually, the SDSM is the successor to the League of Communists in FYROM which renamed itself after the 10th Congress in 1991 (the Disguised Reform).

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By analysing the above information we can conclude that the country has followed the Quiet Reform model, but as a result of the SDSM’s history in the government it can be said that a Disguised Reform also took place (the communists were again heads of the state). Thus, a Mixed Reform path is appropriate for the case of FYROM. The Mixed Reform path was taken by the Baltic countries. Estonia held free elections on 18 March 1990. The Popular Front coalition, composed of left and centrist parties and led by former Central Planning Committee official Edgar Savisaar, held a parliamentary majority. Parliament chose nationalist Lennart Meri of the Isamaaliit Party (Fatherland Union) as the president of Estonia in October 1992. Lennart Meri appointed Mart Laar, a free-market supporter, as prime minister, who referred to himself as ‘Thatcher’s grandson’ (the Compromised Reform for the case of Estonia). Through a strict, non-confrontational policy in pursuing independence, Estonia managed to avoid the violence which Latvia and Lithuania incurred in the bloody January 1991 crackdowns and in the border-customs post guard murders that summer (Violent Reform for the case of Latvia and Lithuania). The central government of the Soviet Union granted independence to Estonia on 20 August 1991 (Brown, 1993; Hoag et al., 1999) (the Quiet Reform for the case of Estonia). On 6 September 1991, the central government of the Soviet Union granted independence to Lithuania, although the USSR had used economic, political, and military pressure to keep it within the union. Lithuania’s independence was achieved through mass demonstrations, violence and bloodshed where a number of Lithuanian protesters died at the hands of Russian soldiers in Vilnius, the capital city of Lithuania at the beginning of 1991 (the Violent Reform). In reality in 1993, Lithuania became the first of the three Baltic countries to be free of Russian military presence. The last unit of Russian troops left the country on 31 August that year. As in several other former Soviet republics, former Communists in Lithuania staged a political comeback in the post-USSR period (the Disguised Reform for the case of Lithuania). Although the anti-Soviet, pro-independence coalition (the Lithuanian Movement for Reconstruction) won the country’s first open parliamentary elections in February 1990 and successfully led the struggle for Lithuanian independence, the coalition could not maintain political leadership. Its popularity dropped as a result of (a) political infighting in the coalition; (b) the severe economic crisis caused by the disruption of trade ties with the former Soviet Republics; and (c) the deterioration of international relations with neighbouring countries. Consequently, the Democratic Labor Party (DLP; the former Communist Party of Lithuania) won a majority of seats in the Seimas in February 1992. In November 1992, Algirdas Brazauskas, the DLP leader, was elected president with 60% of the vote (the Disguised Reform) (Reardon, 1996). Various governments rose to power throughout the years in Lithuania, which succeeded in bringing about economic

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recovery and Lithuanian’s full membership in the European Union (EU) and NATO. Nonetheless, some scandals or negative events came to the spotlight: • • •

•

the major banking scandal with two of Lithuania’s largest commercial banks, the Innovation Bank and the Litimpeks Bank in 1995; corruption problems in the public sector along with the resignation of Prime Minister Vagnorius in 1999; economic problems and inadequate reforms (the resignation of Prime Minister Rolandas Paksas in October 1999 due to a protest of the privatization sell-off of a Lithuanian petroleum refinery to a United States company); the financial crisis in Russia in 1998 which led to an economic recession in Lithuania in 1999.

In 1991, Latvia claimed de facto independence. The central government of the Soviet Union granted independence to Latvia on 21 August 1991. The process up to independence was marked by violence and Soviet aggression especially in January 1991 when some people from Latvia were killed in Riga by the Soviets and the subsequent soviet coup failed in Latvia on August 1991 (Violent Reform). Throughout the political situation in Latvia, it can be argued that several coalition governments came into power and the Compromised Reform path was always adopted. Thus, in the 1993 elections, eight political parties passed the 5% threshold to enter parliament, but the Latvian Popular front (LTF) was outvoted. The liberal Latvijas Celš (Latvia’s Way, LC) became the largest party, forming a centre-right coalition with the Latvijas Zemnieku Savienība (Latvian Farmers’ Union, LZS). The 1995 elections resulted in a deeply fragmented parliament represented by nine parties, with the largest party commanding only 18 of the 100 parliament seats. Attempts to form right-of-centre and leftist governments failed and a broad but fractious coalition government of six of the nine parties was formed under the non-partisan Prime Minister, Andris Skele. In 2000, as a compromised candidate, Andris Berzins became prime minister. His four-party coalition lasted until the elections of 2002 (the Compromised Reform path for the case of Latvia). The Mixed Transition Reform path to democracy (e.g. Albania): After the collapse of communism, the first liberal elections in Albania took place in March 1991. The results gave the Communists a decisive majority, but a general strike and street demonstrations soon forced the all-Communist cabinet to resign (the Rebellion Reform). In June 1991, the Communist Labor Party renamed itself as the Socialist Party and renounced its past ideology (the Disguised Reform). However, the opposition Democratic Party won a landslide victory in the 9 April 1992 elections, and Sali Berisha, a former cardiologist, became Albania’s first elected president of the transition years.

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The political career of Mr. Berisha started with the students’ movement of December 1990. He had become well known for his public criticism of the old system and his speeches about the need for the democratization of the country. Despite many reforms that took place, his administration was marked by widespread corruption and abuse. The following year, ex-Communists, including Ramiz Alia and former Prime Minister Fatos Nano, were imprisoned on corruption charges. Finally, in March 1997, Albania’s experiment with the democratic reform and a free-market economy went disastrously wrong when large numbers of its citizens invested in dubious get-rich-quick pyramid schemes. When five of these schemes collapsed in the beginning of the year, depriving Albanians of an estimated $1.2 billion in savings, the citizens’ rage turned against the government, which appeared to have sanctioned the nationwide fraud. The country’s fragile infrastructure collapsed and gangsters and rebels overran the country; people were killed, a civil war began, buildings were set on fire and half a million rifles and other weapons were stolen when arms depots across the country were raided – plunging the country into virtual anarchy. During this time, Albania’s already inadequate and antiquated infrastructure suffered tremendous damage, as people looted public works for building materials (the Violent Reform or Armed Rebellion Reform). The anarchy of early 1997 alarmed the world and prompted intensive international mediation. A multinational protection force eventually restored order and set up the elections that formally ousted President Sali Berisha. It also led to the victory of a socialist-led coalition of parties. In July of 1997, Berisha was replaced by the socialist Rexhep Meidani. Later, Ilir Meta was elected prime minister in 1999 and rapidly moved forward in his first years to modernize the economy, privatize business, fight crime, and reform the judiciary and tax systems. He resigned in January 2002, frustrated by political infighting. In June 2002, former general Alfred Moisiu (a non-partisan figure) was elected president, endorsed by both the Socialists (headed by Fatos Nano) and the Democrats (led by Sali Berisha) in an effort to end the unproductive political fractiousness that had stalemated the government (Compromised Reform). Between 1997 and 2002, a series of short-lived governments succeeded one another. Fatos Nano, Chairman of the Socialist Party became prime minister in July 2002. Having in mind the political history of Fatos Nano, it can be argued that in that time period a Disguised Reform model appeared in Albania. The peaceful transfer of power from Meidani to Moisiu was the result of an agreement between the parties. This ‘truce’ ushered in a new period of political stability in Albania, making significant progress in democratic and economic reforms and in the rule of law possible and leading to the development of Albania’s relations with its neighbours and the USA. Yet, a decade of friction in Albania between the Socialist Party and the Democratic Party has delayed Albania’s transition to a market economy and postponed its admission to key European institutions. Most of the Transition Reform paths appeared in the case of Albania. This can partially be a significant reason for the delay in reforms and economic development

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in Albania. As the Violent, Rebellion, Disguised and Compromised Reform paths are all valid for the case of Albania, we are led to conclude and argue that Albania together with Serbia & Montenegro are the most complex transition country case studies in the region (the Mixed Reform). The Mixed Transition Reform path for the case of Bulgaria: Except for the Disguised Reform model for the case of Bulgaria, it can be said that two Rebellion models occurred in Bulgaria. One (with the help of a general strike) took place in late 1990 and replaced the Bulgarian socialist party by a coalition government and the other in 1997 when the Bulgarian people demanded the resignation of the corrupt government which remained in power from December 1994 up to February 1997. In this period, three economic crises took place. After this, a caretaker cabinet was appointed by the Bulgarian president and in April 1997 the united democratic forces’ coalition won the elections. Together with the International Monetary Fund, they brought about quick and successful transition reforms (Compromised Reform). The Mixed Transition Reform path for the case of Russia: After the resignation of Gorbachev in 1991, the USSR was dissolved and Russia as the Russian Federation became its largest successor state, inheriting its permanent seat on the UN Security Council. The 12 June 1990 is celebrated in Russia as its Independence Day. In the first democratic presidential elections in Russia, held on 15 June 1991, Yeltsin captured more than 57% of the vote, defeating Nikolai Ryzhkov and Vladimir Zhirinovsky, amongst other candidates. Yeltsin was well-known for his harsh criticism of Mikhail Gorbachev and the communist hardliners. In Yeltsin’s opinion, Gorbachev should have increased the pace of reforms in the USSR but got tough on the conservatives. However, in July 1990, Yeltsin quit the Communist Party. Boris Yeltsin’s career in the Communist Party administrative apparatus began in 1969, when he became Chief of the Construction Department of the Sverdlovsk Region Committee of the CPSU (Communist Party of the Soviet Union). In 1976, Yeltsin was elected as the First Secretary of Sverdlovsk Region Committee of the CPSU. He was also elected President of Russia by popular vote in 1991 (the Disguised Reform). It was at the end of 1991 when Yeltsin and other presidents of all former Soviet Republics signed the treaty dissolving the USSR (the Diplomacy Reform). At the beginning of 1992, just after the breakdown of the USSR, Yeltsin and his government started a hard-lined monetary economic policy which became increasingly unpopular. This policy was called ‘a shock without therapy’, in contrast to the economic reform of ‘shock therapy’ which took place for example in Poland. However, Schlack (1996) suggests that Russia’s parliamentary elections proved that the reformers of the shock therapy received far less support than they had enjoyed three years previous and that this happened after a ‘successful’

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transition. Schlack (1996) added that those who offered advice should have been more sensitive to the question of how ‘success’ might be defined. In September 1993, President Yeltsin issued a special decree on presidential rule and the use of a referendum to gain approval for his transition and economic reform policies. Publicly opposed by Vice-President Alexander Rutskoi, when Rutskoi refused to submit his resignation at Yeltsin’s request; Yeltsin stripped him of all of his vice-presidential powers. Yeltsin removed Rutskoi as Vice-President on charges of corruption, an action opposed by the parliament. Subsequently, Yeltsin issued a decree dissolving parliament. Although, many deputies obeyed Yeltsin’s order to disband, around 100 deputies and several hundred armed supporters led by Rutskoi occupied the parliament building. On 4 October, several elite divisions of Russian military forces decided to support Yeltsin. Tanks rolled up to the ‘White House’ (the Russian Parliament building) and firing began. Large crowds of Moscovites ‘attracted’ by the unusual events encircled the parliament building. Many were injured or even killed by stray bullets. A tense stalemate ensued between government and rebel forces that lasted for several days, ending when rebel supporters staged an attack on the city hall in Moscow and Moscow’s main television complex. The government responded by shelling the ‘White House’ and suppressing the rebels. A few days later, under Yeltsin’s pressure, the Head of the Russian Constitutional Court was fired, because he opposed the military and violent solution of the conflict between the presidential and parliamentary side (the Violent Reform). Thus, Russia followed a Mixed Reform, a Disguised Reform when an excommunist leader (Yeltsin) was elected president of Russia and remained in power for many years, a Diplomacy Reform after the breakdown of the USSR and finally, a Violent Reform in 1993. The Mixed Transition Reform path (e.g. the Federal Republic of Yugoslavia (FRY) and Serbia & Montenegro): The historical analysis starts with Milošević who began his professional life as a banker, working for the Beogradska Banka (the Belgrade Bank), at times residing in New York as the bank’s official representative abroad. However, he emerged in April 1987 as a leading figure in Serbian politics. His political views have sometimes been termed as nationalistic, despite the fact that his ideology was strongly marked by socialist and leftist viewpoints. However, after he was elected president of the Belgrade City Committee of the League of Communists, Milošević publicly opposed nationalism. His mentor and godfather, Ivan Stambolić, was the party leader in the Serbian section of the ruling League of Communists of Yugoslavia. In September 1987, Stambolić became president of Serbia and supported Milošević in the elections for a new leader, to the dismay of the other leaders in the party. Stambolić spent three days advocating Milošević’s election and finally managed to secure him a narrow victory, the tightest ever in the history of the Serbian Communist Party’s internal elections (the Disguised Reform).

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In February 1988, Stambolić was officially voted out of power, leaving the path clear for Milošević. Milošević would later be charged with ordering the murder of Stambolić, something that has never been proved. Milošević presided over the transformation of the League of Communists of Serbia into the Socialist Party of Serbia (July 1990) and the adoption of the new Serbian constitution (September 1990) which provided for the direct election of a president with increased powers (the Disguised Reform). Milošević was subsequently re-elected president of the Serbian Republic in the direct elections of December 1990 and December 1992. Milošević’s rejection of claims of a first-round opposition victory in the elections for the Federal presidency in September 2000 led to mass demonstrations in Belgrade on 5 October and the collapse of the regime’s authority (the Peaceful Revolution). Opposition-list leader Vojislav Koštunica took office as Yugoslav President on 6 October 2000. Ironically, Milošević lost his grip on power by losing the elections which he had scheduled prematurely (before the end of his mandate). On 25 January 2001, Zoran Djindjic took over the leading position in the Serbian government. However, the assassination of Djindjic in March 2003 created political instability in the country and a significant delay to the required reforms for Serbia & Montenegro (the Violent Reform). As previously mentioned, Serbia & Montenegro became involved in a war with the Croats and Bosnians due to the presence of large Serb minorities in Croatia and Bosnia & Herzegovina, and together with the Kosovo war, as well as the war and sanctions with the UN, it can be argued that for a long time period the Serbians followed a Belligerent Reform path. However, at the end of 1995, the Dayton Peace Accord was signed by the presidents of Bosnia, Croatia, and Serbia, calling for the division of the republic into ‘entities’ (Diplomacy Reform). Serbia & Montenegro suffered greatly during its transition, following a disguised reform path for many years (more than any other transition country) under the Milošević regime, a rebellion reform path when the Serbians ousted this regime together with belligerent and diplomacy reform paths during its war with the Croats and Bosnians, and another war with the Albanians and the United Nations army forces in Kosovo. Lastly, a violent reform model took place with the assassination of Zoran Djindjic in March 2003. Consequently, the Mixed Reform is the appropriate model for Serbia & Montenegro. It is the author’s conviction that there is a close connection between the transition from a planned economy to a market economy with the transition from communism to democracy. Countries which faced a mixed reform and especially the belligerent, violent and disguised reform models, are less advanced countries and weak reformers with limited institutional and transition (macro) reforms. To this end, nine reform paths were explored and analysed in order to describe the chosen democratic and reform paths of the transition countries. It is therefore concluded that the least advanced transition countries followed, or were forced by conditions to follow, problematic reform paths such as the violent, belligerent or disguised models.

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These countries have limited economic growth and not only lag behind other transition countries in the region, but are far behind the levels of industrial output they had attained in 1989. To be more specific, according to UNECE (2005), the figures show that Russia’s level in 2004/5 was -28.7% of its level in 1989, Bulgaria being -35.6%, Romania -45.6%, FYROM -55.5%, Bosnia & Herzegovina’s 84.7%, Albania’s -74.2%, and Serbia & Montenegro’s at -58.3%. Moreover, the same source claims that these countries are far behind the real GDP levels they had in 1989 (e.g. Bulgaria -8%, FYROM -16.5%, Russia -17.5% and Serbia & Montenegro -46.3%). We can thus infer that these countries have high unemployment rates, and high corruption rates. Moreover, they lag behind the other transition countries in institutional and transition reforms. Furthermore, they are proved to be countries with low living standards, low GDP per capita even in PPP prices, and low wages. They also rank low in the human development index; have a weak infrastructure, an unfavourable, bureaucratic business environment and an unstable legal framework. Finally, they are the least attractive destinations for FDI inflows in the region. To conclude, we strongly believe that such drawbacks are linked to the above mentioned unfavourable reform models existing in these countries.

1.3 The Transition from a Planned to a Market Economy: The Four Steps Needed for Transition Reform Given the common goal of the transition countries to move to a market economy and therefore to promote enhanced economic efficiency and high growth rates, there is a widespread agreement that the crucial elements (steps) of the transition process are macroeconomic stabilization, price and trade liberalization, restructuring and privatization and institutional reform (Lipton and Sachs, 1990; Fischer et al., 1996; Fischer et al., 2000; Gomulka, 2000; World Economic Outlook, 2000). The four dimensions (steps) of the transition reform are interrelated and progress should be made in all of them (sequence and speed of reforms). Otherwise, distortions, negative effects and the risk of a breakdown of the pursued market economy might appear. When the transition reforms were launched, the inherited imbalances were expected to bring about severe inflation. Therefore, an essential element of the transition towards the market economy was macroeconomic stabilization, which is comprised mainly of money, finance and exchange rate policies (Meyer, 1998). A macroeconomic stabilization programme reduces the inflation and money-overhang followed by severe efforts to decrease the huge debt burden. Kiguel et al., 1991, 85, 90) have argued that: ‘The effectiveness of alternative stabilization strategies largely depends on a country’s inflationary history … hyperinflation cannot be stopped always and everywhere in the same way’. Macroeconomic stabilization implies implementation of measures and policies related to key macroeconomic

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variables such as policies for low inflation, higher output performance, improved balance of payments, lower debt, and lower unemployment (EBRD, 1994). In most countries of the CEE, macroeconomic stabilization was based on the standard IMF heterodox approach, applying an income anchor simultaneously to a tight fiscal and monetary policy, and a fixed exchange rate when feasible. Yet, by considering the credit to government and enterprises, it might be inferred that money was the key nominal anchor, while the exchange rate and income policy had a supportive role (Gomulka, 2000). After the initial years of transition, there was a tendency in the transition countries to move to more flexible exchange rate regimes, as although inflation declined, it did not fall enough to stop a significant real appreciation. This created balance of payment problems (Jonas and Mishkin, 2003). However, during the transition course it became clear that the choice of the exchange rate regime did not seem to be a critical factor influencing the stabilization results in the transition economies, because a successful anti-inflation policy is primarily determined by pursuing a consistent monetary and fiscal policy (World Economic Outlook, 2000). The macroeconomic stabilization programme should be initially adopted in order to reduce inflation and money-overhang, and severe efforts to decrease the huge debt burden should follow. There are two determinants for the stabilization process, each of which includes two different stabilization strategies; the orthodox and heterodox approaches combined with money based and exchange rate based stabilization strategies. The orthodox approach is based on elimination of the budget deficit by using strict fiscal policy (fiscal anchor), simultaneously using a monetary policy (monetary anchor). In the heterodox stabilization approach, income policy is used together with monetary and fiscal policy, as an extra tool for rapid and synchronized cut of inflation. Thus, there is direct intervention in wages and prices (income anchor). [The] heterodox approach argues that budget adjustments and tight monetary policy alone are insufficient to stop high inflation … in [the] … contrary … wage and price controls may be superfluous … [The] … price controls may be difficult to enforce beyond a very small group of commodities … controls might be anticipated, controls may be addictive, giving policymakers the idea that inflation can be stopped without any other pain … [Those] … controls can introduce a great deal of rigidity in the relative price structure of the economy … controls may prove hard to phase out. (Jeffrey Sachs, 1993, 754)

In the money based stabilization policy, the central bank chooses the money stock or the net domestic assets as its main policy target. Alternatively, in the exchange rate based stabilization strategy, the exchange rate serves as the main nominal anchor. Therefore, a country has to choose between heterodox and orthodox stabilization policy, setting the option of having the exchange rate as an extra nominal anchor or using the money based stabilization programme. However, if a country chooses

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the heterodox exchange rate based stabilization programme, but after a short or long time removes the wage and price measures, then the programme becomes an orthodox exchange rate stabilization programme. Miguel A. Kiguel et al. (1991, 85, 90), argued that ‘The effectiveness of alternative stabilization strategies largely depends on a country’s inflationary history … hyperinflation cannot be stopped always and everywhere in the same way’. It should be pointed out that money based stabilization applies an inadequate solution in the wrong way: because of the unstable demand of monetary targeting is inadequate, applied in the wrong way, designed as a medium-term concept and not as a strategy for short-term macroeconomic fine-tuning (Bofinger, 1996, 665–7). Most Central and Eastern countries followed the heterodox stabilization programme (Bulgaria, Romania, Czechoslovakia, Poland and Hungary). Only Russia, Ukraine and Kazakhstan, followed the orthodox programme (Bofinger, 1996). Bulgaria and Romania, having limited foreign reserves, chose a money-based approach. However, the other countries mentioned have selected the exchange rate based stabilization programme. The Bulgarian economy suffered from economic and political instability from 1989 until 1997, when on July 1997 the introduction of the currency board finally brought ‘peace’ (see also Zloch-Christy, 2000). The excuse of lack of currency reserves, the inability of each government to draw loans from the western countries or institutions, or the foreign countries’ or institutions’ unwillingness to help, brought about three major economic crises in Bulgaria in the first eight years of the transition period. Those crises weakened the economic position of the Bulgarian people. As a result of which per capita consumption fell drastically, discouraging any significant FDI inflows. Reaching the main transition goal, sustained economic growth implies that inflation should be kept at a low level, as Fisher et al. (1996) suggests the positive growth in transition economies could be observed within two years of inflation decreasing below 50%. Ghosh (1997) infers that if the inflation level is above 10%, a GDP growth above 2% cannot be attained. Given the negative impact of inflation on the output level, fighting inflation was a major goal of the macroeconomic stabilization programme at the onset of transition and as stated by Fisher and Sahay (2000, 7): ‘Several checks were introduced in the stabilization programs to contain inflation: tight monetary and credit policies, wage control policies, monetary reforms, and non-inflationary sources of financing the budget deficits’. By applying either the orthodox or heterodox approach combined with the money- based or exchange rate based stabilization strategy, policy-makers of transition countries can pursue the desired macroeconomic stabilization. The orthodox approach aims to elimine the budget deficit by conducting stringent fiscal policy and by employing a monetary anchor through monetary policy at the same time. The heterodox approach not only implements monetary and fiscal policy, but it also uses income policy, as well as wages and prices controls for fighting inflation.

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There were some controversies with regard to the type of stabilization programme to use. Calvo and Vegh (1999) assert that choosing between the exchange rate and money supply as nominal anchors presupposes a trade-off between ‘recession now’ (related to money-based stabilization) and ‘recession later’ (indicative of exchange rate based stabilization). It has been pointed out that the exchange-rate anchor is a more easily observable target and if monetary and fiscal policies exhibit discrepancies from the defined exchange rate target, doubt will be cast on the ability of policy makers to conduct the reforms efficiently. Drabek and Brada (1998) argue that if fiscal policy or other stabilization policies are improper, the decision of choosing exchange rate as a nominal anchor may result in a significant pressure to conduct protectionist trade policies. Christoffersen and Doyle (1998) imply that output losses could be observed due to the employed undervalued pegs, when a rapid disinflation policy involving pegged exchange rate is pursued. On the other hand, money-based stabilization involves reduction in the growth rate of the money supply. This means a lower level of liquidity. Subsequently interest rates will rise and the economy will be driven into a recession (Calvo and Vegh, 1999). Jonas and Mishkin (2003) contend that in the transition countries the use of monetary aggregates as a nominal anchor is not appropriate because of the instability of money demand and the unstable relationship between the growth of money supply and inflation. Rusek (2001) investigates the effectiveness of the monetary policy in the transition countries by focusing on the stability of the relationship between the money stock and macroeconomic variables such as output, price level, interest rates, and exchange rates. He infers that active use of monetary policy is difficult in the transition economies because of their significant rigidities, which in turn lead to an unstable relationship between monetary aggregates and macroeconomic variables. The best outcome a monetary policy can provide is to discourage inflation in the long run, by being excessively loose and not impeding growth by being too tight, while the short run application of monetary policy is limited only to maintaining a stable real exchange rate and to providing necessary liquidity. Klyuev (2002) supports the advantages of the exchange rate anchor in fighting inflation but questions the effectiveness of the exchange rate stabilization in the long run. He argues that the inflation rate does not decline instantly to tradingpartner levels that yield a real appreciation of the domestic currency and negative effects on the trade balance and current account balance. The basic inference is that there is a non-linear relationship between the inflation rate and the exchange rate flexibility; an increase in inflation from a low level requires a flexible exchange rate, while the fixed exchange rate regime would be a necessity when a rise in already high inflation appeared. At the start of transition it was recognized that a crucial part of the macroeconomic stabilization is the change that both state’s revenues and expenditures should undergo. However, the need for major fiscal reforms was overlooked and the reforms of state structures and public administration received

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little attention until a number of fiscal crises appeared in late 1991 and 1992 in transition economies (UNECE, 2000). Regarding the revenues, the taxation policy should be modified as a new tax system based on general tax rates, value-added tax, income taxes, profit taxes etc., should be adopted. As to expenses, the subsidies to goods and to state enterprises should be eliminated or replaced by credit subsidies. At the same time, many of the government expenditures related to social issues should remain unchanged. Tight wage policy should also be implemented in order to avoid an increase in monetary overhang and to improve the government budget (Meyer, 1998). Another element (step) of transition is liberalization of economic activity aimed at abolishing the centrally planned system and central regulations by establishing market determined prices, foreign trade liberalization and currency convertibility. Price liberalization is one of the most significant factors for the creation of a market economy because market determined prices are the essence of the market mechanism, reflecting both the consumers’ demand and the producers’ costs and supply. An additional decisive condition for the establishment of a market economic system is that trade liberalization should provide for enhanced competition, elimination of trade monopolies and the opening of the economy to foreign investors (Meyer, 1998). Thus, the second step of transition, is liberalization of economic activity (prices, trade, currency convertibility etc.), which should be supported by institutional restructuring. This structural reform provides an efficient system of laws regulating the economic activity and redefining the role of the state. This also includes the restructuring and privatization of the bulk of the state assets, which constitute a large percentage of the total assets of the country. The sudden exposure to market forces is likely to cause instability in the economy. This, complemented by the trivial experience of people and the mediocre economic legacy of the past, may lead to severe economic crises. In order to avoid these crises, the state needs to establish macroeconomic stabilization policies. The typical symptoms of the ‘transition shock’ are a drastic increase in inflation, reduction of total output levels, increase in the unemployment rate, increase in prices, a severe social impact, and citizens’ negative reactions due to their bad economic condition. Liberalization of prices is of vital importance for the transition towards a market economy. Prices should be undistorted so as to facilitate enterprise decisionmaking, as they should be changed significantly and liberalized in order to reflect the required reduction of subsidies needed for the successful macroeconomic stabilization (EBRD, 1995). In the beginning of transition, it was recognized that the expected considerable increase in the prices of basic goods, such as food and energy products should be avoided and either a price ceiling should be placed on them, or the desired price level of the basic goods should be maintained through subsidies (Meyer, 1998). Since the beginning of transition the relative price adjustments were more divergent among the transition economies. This was because of their greater

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susceptibility to external shocks such as significant changes in world market prices for commodities, large devaluations of some of the domestic currencies and the various degrees of price control. Although most other product prices were liberalized during the early phases of the reform process, the prices of most formerly state-provided services remained under control, as an element of the social safety net, and their prices increased only gradually. It might be inferred that one of the crucial trade-offs in the transition countries is between achieving macroeconomic stability, and at the same time gradually moving towards market determined prices or instant liberalization of most prices. However, the decision to keep inflation low through price ceilings proved to be counter-productive in the long-run. To this end stable relative price structure is vital for macroeconomic stability and sustained growth (UNECE, 2000). The more intense the price liberalization in the transition countries is, the sharper the initial fall in the level of output will be and the more rapid the contraction of the old enterprise sector will become. On the other hand the creation of new, more profitable enterprises will be encouraged and a favourable environment for higher levels of income in the medium term will also be in place (Herdandez-Cata, 1997). Herdandez-Cata (1999) analyses the main determinants of the intensity of liberalization reform in the transition countries and concludes that political freedom, proximity to the West, and the level of underground economy are all associated with low resistance to price decontrol. Therefore, they affect positively the intensity of liberalization, while the membership in rouble area and the longer period under central-planning impede liberalization reforms. However, integration of the transition countries into the world economy requires opening up the domestic economies through an orthodox commercial policy: elimination of the CMEA’s regimes, removal of tariffs, establishment of an effective exchange rate reflecting price-based international competition, and entrance into global economic regimes and organizations (Van Brabant, 1994). Many discussions took place regarding the way under which trade liberalization would be conducted. Many studies support the application of a more gradual approach in liberalization of the international trade and the opening of the economies of the transition countries. Van Brabant (1994) maintains that the effectiveness of trade liberalization heavily depends on the credibility of the government policies pursued, pointing out that if liberalization coincides with macroeconomic instability or with an unstable political climate, as in Eastern Europe, there may be a trend toward a lower level of investment. The author suggests that in this case rapid trade liberalization might destroy much of the transition countries’ productive capacity. He further argues that the trade regime must be tailored to longer terms, because of the time required for building up production and exporting capacities and capabilities and well functioning capital markets. These findings are supported by Hare (2001) who asserts that a sudden liberalization may cause a significant adverse shock to domestic enterprises, because they lack the necessary time to adjust to the new environment and external competition will drive them out of the country.

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Marangos (2001) offers a set of international trade policies for transition economies, comprised of a fixed exchange rate and protection policies from imports that are expected to result in substantially reducing the transition cost and corruption, thus stimulating a civilized society. He argues that as international trade is an important ingredient of the transition process, it should be introduced gradually, in an organized fashion and by using social benefits as a measure of its effectiveness. He reasons that the total liberalization of foreign trade would damage those industries which were technologically advanced but uncompetitive in the international market. Designing the proper path for trade and exchange rate liberalization for transition economies means that the initial conditions, political processes and the incomplete nature of domestic markets should be considered. Furthermore, CMEA ties should be maintained at least in the short run, given the substantial volume of idle resources in the transition countries and their considerable absorption capacity (Van Brabant, 1993). Gowan (1995) asserts that after trade liberalization takes place, only a small number of the transition countries (Central European countries) will be able to uphold the considerable market pressures resulting from liberalization and thus be ready to compete in Western markets. Effective trade liberalization requires re-integration of the formerly centrally planned economies into the global trading system. Almost all countries in transition from central planning have accepted the WTO rules in principle, despite the variations in trade policies and performance. WTO membership is a key factor underpinning the reform process. It provides some protection against imposition of non-tariff barriers and offers dispute mechanisms in case of disagreements between the members. Moreover, in respect of European transition economies aiming at EU membership, WTO membership shows their sincere ambition to create a market economy and to observe international trade law (Pomfret, 2001; Hare, 2001). Foreign trade liberalization policy is closely linked to the liberalization of the foreign exchange market, particularly with the exchange rate regime, current account convertibility, and capital account liberalization (Hare, 2001). A third step to transition is the privatization and restructuring of the economy. Privatization and restructuring have a crucial importance for the creation of a market economy, as they are essential determinants for the transition of the decision and motivation structures (EBRD, 1994). Thus, a decisive step in the transformation process is the size reduction of the public sector through quick privatization and restructuring of state-owned enterprises. It is essential that this be supported by the introduction of new corporate governance and property rights. The expected positive outcomes of privatization imply that it should lead to a new private and institutional ownership structure, replacing the old state administered system and together with deregulation and demonopolization, privatization should reform and overcome the inherited industrial structure. It is also anticipated that privatization encompassing all economic areas, including the banking sector, will

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eliminate the inefficient capital and labour allocation inherited from a centrally planned economy (Schusselbauer, 1999). With regard to the privatization of state-owned banks, Fries and Taci (2002) contend that in real terms privatized banks developed more rapidly not only than state banks, but also more rapidly than the newly established banks as well. This implies that there is inadequate regulatory control of entry into, and exit from, the banking sector. No evidence has been found that foreign banks have a higher real growth than privatized and newly established private banks, a fact that might reflect an informational disadvantage concerning local markets or the existence of obstacles to their expansion. Although privatization, restructuring, imposition of hard budget constraints and elimination of subsidies may create high unemployment rates and decrease living standards, they are all necessary for the successful transition to a market economy. The relationship between privatization and restructuring appears to be rather complex as EBRD (1995, 128) defines restructuring as a: … multidimensional, encompassing: reactive policies brought about by the hardening of firms’ budget constraints (e.g. labour-shedding, wage reductions, plant closure); strategic aspects, including export reorientation, changes in the mix of products and changes in management structures; and deeper restructuring, generally involving substantial new investment, that can deliver large improvements in enterprise performance and growth over the long run.

The restructuring process in the majority of the transition countries took place in response to privatization and consisted of the introduction of hard budget constraints; a result of product market competition and elimination of direct and indirect state subsidies (EBRD, 1994). The progress in market-oriented restructuring depends on the effectiveness of price and trade liberalization, privatization and macroeconomic stabilization, as well as on the development of the financial sector (EBRD, 1995). In the first decade of the transition procedure (1990s), the privatization programmes in the countries comprised diverse methods and reflected the transformation of the political environment, as during that time, the focus and the intensity of the privatization strategies, as well as the role of the foreign investors in the different stages of privatization altered (Schollmann, 2001). There were many obstacles to achieving the privatization objectives in transition economies; political constraints, unwillingness to accept foreigners in the privatization process in the early years of transition, lack of funds for the government to implement privatization procedures and for the population to buy privatized assets, absence of market-based financial and business skills, existence of undeveloped financial markets and legal systems (Kaufmann and Siegelbaum, 1997). Privatization was not successful enough in some transition countries to lead to efficient enterprise restructuring and it could be inferred that the change of

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ownership is not sufficient for an effective reform. The transfer of ownership should be accompanied by the implementation of procedures and measures such as the imposition of hard budget constraints on enterprises, the development of a competitive environment, and the establishment of an effective legal framework, an effective property rights system and effective standards of corporate governance (World Economic Outlook, 2000). A considerable obstacle exists at government level which blocks privatization reform and makes privatization slow and inefficient. The governments in transition economies on the one hand should conduct fiscal policy aimed at keeping public deficits at certain limits in order to fight inflation, while on the other hand the restructuring process increases government budget expenditures, because of the cost reallocation in the restructured firms. Therefore, policy-makers might not be able to implement effective restructuring, because of the subsequent negative impact on the budget deficit (Schroder, 2000). The methods through which privatization of state-owned enterprises can be implemented might be divided into direct and indirect methods (Schusselbauer, 1999). Direct methods include forms such as public auctions, tenders, public invitations, capital privatization and employee or management buyouts, while indirect methods include different distribution schemes developed to privatize a major part of state-owned enterprises in one mass privatization programme. Given the limited capital and savings in transition economies, the direct methods of privatization have limited application. Mass privatization was widely implemented as it was considered to be the second best solution, meeting both efficiency and distribution goals (Schusselbauer, 1999). The aim of mass privatization promotes a rapid privatization programme by minimizing the role of the state and maximizing the role of the market in the privatization process. Mass privatization functions by offering privatization vouchers to the population, in most cases for free, as proxies for shares in state-owned companies, as these vouchers, often through investment funds, are invested in a particular company (Spicer, 2000). Ferreira (1999) suggests that although mass privatization is meant to be a fair process, as the assets are uniformly distributed through vouchers, it may influence the level of the public sector wages and consequently lead to an increase in the income inequality. Mramor (1996) criticizes the way voucher privatization was designed in the transition countries, pointing out that instead of the increase in economic efficiency; the redistribution of wealth appeared to be the primary goal of this type of privatization. The method of privatization has been a major factor determining the speed and fairness of privatization, but a clear relation between the privatization methods and the post-privatization ownership and restructuring cannot be found (World Economic Outlook, 2000). A study by Frydman et al. (1999) asserted that privatization is effective if the ownership is transferred to outsiders, but produces no considerable effect in employee-owned firms. If outsiders control the firms, an increase in revenue will be observed and productivity performance will be enhanced. Moreover, there

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will be an insignificant negative effect on employment, while the performance of insider-controlled firms will not be significantly different from the performance of state firms. Privatization that concentrates ownership in the hands of workers and managers might lead to a slower speed of the restructuring process. However, the dispersed outsider ownership is likely to cause corporate governance problems and to create obstacles for the owners to control managers. Therefore, it may be inferred that the change of ownership is not a sufficient condition for effective restructuring (EBRD, 1995). The above mentioned steps/reforms in the transition process should be accompanied by an Institutional Reform in order to facilitate the transition process. Namely, the creation, consolidation and strengthening of the institutions, policies and behaviours that underpin the market economy (Stern, 1998). In the fourth step, new laws must be issued in order to establish market institutions (corporate law, an accounting system, a tax system, a pension fund system, etc.). Unlimited and unrestricted private ownership/property must be legally established. New laws should also be issued regarding the banking system structure, bank rehabilitation, privatization of banks, foreign banks participation and the payment system. Methods for dealing with bad loans as well as bankruptcy and liquidation laws must also be enforced. New social policy is needed and social expenditures such as unemployment benefits (e.g. unemployment allowances, lessons/means for finding new jobs, and increasing employee’s skills, etc.) must be introduced. Hard budget constraints must also be introduced, together with a generous elimination of subsidies from the government to the state-owned enterprises in order for the governmental expenditures to be lowered. The tax system should be reformed in order to encourage individuals and companies to acknowledge profits. A financial reform is also necessary to support any other activity. The creation of a stock exchange will facilitate the privatization process, and it should be met by currency reforms, including the introduction of unlimited currency convertibility. Moreover, all deficits must be balanced; the overvalued domestic currency must be devalued and generally there is a need for introduction of adequate institutional reforms. The transition from socialist to market economies requires the development of many institutions including the market itself (Koslowski, 1992). World Economic Outlook (2000, 141) states that: There are two dimensions to the massive changes in the structure of the transition economies since the start of transition: the wide range of structural and institutional reforms implemented by governments and the resulting changes in economic behaviour and institutions.

The establishment of relevant market institutions facilitating macroeconomic stability, entrepreneurship and competition is a basic precondition for a successful

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transition process. The fundamental institutional reform of the economic system comprises a wide range of significant changes in institutions, types of ownership, corporate governance, laws, norms and modes of attitudes and interpersonal behaviour (Gomulka, 2000). Menshikov (1994) emphasizes the importance of the appropriate institutional reform, pointing out that the divergent institutional settings as well as the varying levels of political stability are the main causes of the variations in the macroeconomic performance of the transition countries. It might be inferred that the institutional structure, improved state corporate governance prior to privatization, as well as the redefining of the role of the state are vital elements required for systemic renovation, growth and stabilization (Kolodko, 1999). Behrman and Rondinelli (2000) suggest that six basic institutions (patterns of behaviour and guiding structure) provide for efficient transition: development of new forms of economic motivation, protection of private property rights, guarantees of freedom of enterprise, decisions based on market signals, development of competitive environment and employment of government regulations for the private sector. These reforms may be accomplished slowly and their development depends on the dedication of the policy makers to the reforms as well as on their effectiveness in employing and pursuing the transition goals and policies (Gomulka, 2000). The massive transformation of the structure of the transition economies resulted in market-determined prices, in a reduction of the level of industrialization and a rise in the service sector share. It also resulted in the replacement of public sector dominance by increasing private sector activity and the development of financial sector (World Economic Outlook, 2000; Hare, 1993). While the pursued structural reforms have led to rapid liberalization and expansion of private sector activity in goods and non-financial services, the reforms regarding financial markets have been more gradual, starting with the break-up of the monobank system into two tiers: a central bank conducting monetary affairs; and state-owned commercial and specialized banks responsible for deposit mobilization, lending and other commercial banking activities (Borish et al., 1997). Fries and Taci (2002) emphasize that the state plays an essential role in the banking sector’s reform and should provide prudential regulation and supervision of banks by enforcing new banking laws and regulations. They infer that the progress in the reforms of the banking sector and in complementary enterprise reforms, particularly in areas such as corporate governance and bankruptcy are a vital requirement for the development of a market-oriented banking system. Although the primary elements of a legal and regulatory framework regarding financial sector were set up in most transition countries, there were problems in enactment and implementation of new laws, due to the absence of independent regulatory authorities (World Economic Outlook, 2000). At the same time, issues concerning the failures of banks were politicized and biased (Fries and Taci, 2002).

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Maliszewski (2000) investigates the central bank’s independence in the transition countries and concludes that an independent central bank plays an influential role in protecting price stability. However, if there are acute macroeconomic imbalances, such as an institutional change, it might not influence economic stabilization. He also maintains that central bank independence is an effective device for fighting inflation, only when a significant progress in liberalization reforms is made. He further observes that in most countries the new central bank laws were adopted after the stabilization programs commenced. The speed of the progress in the establishment of non-bank financial institutions such as security markets and insurance companies is even slower than that in the banking sector (World Economic Outlook, 2000). That slow progress could be attributed to the incomplete enforcement of regulatory rules and institutions providing independent share registers, secure settlement procedures, protection of minority shareholders and supervision (EBRD, 1995). Despite the efforts of the policy makers in the transition countries to enforce new laws and regulations facilitating the market economy, the progress varied across countries (EBRD, 1999). Raiser et al. (2000) investigated the factors that cause divergent results in respect of institutional reform and analysed the obstacles to institutional change in the transition countries. The main set of factors affecting the institutional performance outlined are comprised of initial conditions and path dependencies, implemented policies that generate a demand for new institutional framework, and the state capability to enforce new rules and regulations. Rosenbaum (2001) asserts that the variances in the success of the institutional reforms in the economies in transition might come as a result of a specific historical, cultural and social background and places emphasis on the importance of informal institutions. The author suggests that institutional reforms cannot be limited to the implementation of formal institutions, but should comprise a wider range of social practices combined with relevant ideas and concepts. Stahl-Rolf (2000) investigates the divergence in the institutional reform in the transition countries and contends that the main determinant of the degree of success in creating new efficient institutions is the historic experience of forming models and social learning. In his opinion, the change in behaviour models particularly in the underlying mental models and individual behaviour, defines the success of the institutional reform. The effectiveness of the institutions rests on the ethical system that comes from religious or philosophical beliefs and encourages individuals to contribute to the common wealth as well as to their own well-being sharing at the same time common societal values (Behrman and Rondinelli, 2000). The most important element of a transition process in CEE is the institutional change required to satisfy the criteria for EU membership, as the institutions of regional integration are specific, focused on macroeconomic measures and comprise high levels of government involvement (Tihanyi and Roath, 2002). It is assumed that the institutional system in the transition economies will be strongly

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influenced by west institutional models, and that external assistance is of crucial significance for institutional development (Meyer, 1998). Thus, an efficient transition takes place in four steps (Table 1.4), each contributing, independently and inter-dependently, in transforming the country in question.

Table 1.4  Four steps for the transition to market economy Macroeconomic stabilization

Liberalization

Monetary policy, decrease in monetary overhang, control of money supply

Increased competition, increased product prices, ending of subsidies

Exchange rate policy, fixed exchange rate as an anchor for stabilization Wage policy, social safety net, unemployment benefits, increased wages, decrease in unemployment rate

Liberal interest rates

Credit policy, interest rate policy, low interest rates needed, increased competition, competitive environment, growth

Financial policy, decreased foreign debt, decrease all deficits, balance the state budget, increased revenues from privatization deals

Institutional or structural reform Legislation, extensive introduction of new laws and rules for a new market environment, rules to support a free market economy Commercialization of state-owned enterprises (SOEs)

Privatization and restructuring Clear (well defined) property rights, demonopolization

Restitution and settlement of claims

Open trade rules, new trade partners, new trade agreements, ending of subsidies, new competitive products, increased competition, differentiation of products, increased quality products, no trade barriers, elimination of quotas and tariffs Currency convertibility, free move of currency, easier foreign transactions, attraction of foreign investments, capital mobility

New worker’s environment, workers’ councils, new accounting rules, consumer protection, infrastructure improvement, environmental protection

Introduction of privatization and liquidation laws

Adoption of new commercial code, privatization rules and competition rules

Open economy, easy entry access for foreign investors, worker mobility, establishment of relations with foreign organizations

Two-tier banking system, bankruptcy laws, clearing bad debts, end of subsidies, hard budget constraints, new banking rules

End of monopolies, large scale privatization, financing state budgets, decrease in deficits, increase of competition, increased quality and variety of products Small scale privatization, incentives for creation of new firms, increasing private sector, increasing services’ sector

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Table 1.4  continued Macroeconomic stabilization Income policy, strict income policy as a nominal anchor for stabilization, elimination of subsidies Taxation policy, revenues from VAT, taxation of revenues of profits in the new private sector (or in privatized state-owned firms) Fiscal policy, decreased governmental expenditures, increase revenues Inflation policy, decreased/low inflation rates

Liberalization Establishment of new foreign companies, liberal market rules, competitive environment

Institutional or structural reform

Privatization and restructuring

New market rules and introduction of FDI laws and incentives for foreign participation

Elimination of governmental intervention, giving power and ‘space’ to private ownership, elimination of state bureaucracy Introducing hard Introduction of rules for financial budget constraints, new intermediaries and corporate governance, stock market exchange, new bankruptcy laws creation of commercial banks, establishment of foreign branches and foreign banks New tax system, new Settlement of bad loans social security system

Source: Bitzenis, 2007.

1.3.1 Assistance and External Help for Transition Economies A successful transition comes about not merely from within the country. Outside assistance is essential, either in the form of guidance or directly in the form of financial or other support. The countries in transition obtain assistance on technical aspects from international institutions, mainly the IMF and the World Bank, which guide the way into the set up of a functional market economy. They receive assistance in organizing legislation, in deciding on monetary policies and tools, in issuing new tax and treasury systems and in improving the management of administration and public expenditure. The help of international institutions is also reflected in the financial sector, in the restructuring of the banking system and in the creation of financial markets. Finally, with help from the IMF, inaccurate statistical systems used in the past are upgraded, so that dependability of the data can be trusted for evaluation of the country’s progress (World Economic Outlook, 2000, 185). International organizations provide the country in transition with financial help in order for the country to meet certain stabilization goals, and to be able to repay the old and new debts. The steps required from the IMF assistance plans and shared among the transition countries are large-scale liberalization of trade, prices and

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exchange rates regimes, demonopolization of large state owned enterprises, rapid privatization, development of the Small and Medium Enterprises (SMEs), a social safety-net provision in the state budget, and adjustment of the taxation systems. Each plan provides additional steps, appropriate for each individual country. International organizations are willing to embrace reformed countries. Some of the countries that took the path of transition to a market economy, have already joined the OECD, WTO and NATO and a number of Central and Eastern European (CEE) countries are likely to enter the European Union (actually eight countries from the CEE region became EU members in May 2004) (EBRD, 1997). Although all countries in transition have the same final goal, that is the creation of a market economy, the results of their efforts vary. The different reform paths, the different transition strategies and policies, the sequence and speed of reforms which are followed by each country, and the different adverse initial economic conditions along with other external facts each country has faced or started with, are decisive factors for the amount of success each country will achieve in the transition process (Bitzenis, 2007).

1.4 The Speed of Transition Reform Policies for Becoming a Market Economy; The Shock Therapy vs. Gradualism Debate The speed of adaptation of each policy is crucial in the transition process. The concepts of gradualism and gradual changes that lead to a market economy in the long-term, and the concept of shock-therapy or big-bang and rapid changes which were refined in time, are the two main approaches that can be used, either separately, or combined in the different steps of the transition. An alternative speed of reform is the ‘stop and go’ or ‘trial and error’ approach. According to this approach, the government proceeds in the announcement of a concrete plan of reform policies. However, during the implementation of the plan, endogenous and exogenous factors prevent its completion or a provisional freeze of reforms befalls. A provisional postponement of these reforms may also occur due to the political cost of changes that were proposed (e.g. various reactions of citizens, or a delay in the appearance of the positive factors that result from reforms, or an inability of the government to succeed in the reforms, etc.). Furthermore, divergence in the programme of reform, or a short delay in the achievement of reform (either through a gradual or shock therapy) does not alter the speed of reform, changing the speed of reform into the alternative of ‘stop and go’. Finally and sometimes on purpose, the ultimate goal of the reform is not announced. For example, for the case of China, some of the reform changes were initiated spontaneously at ‘a ground level’, and only after their success, were they ratified by the government and implemented as official policy. In this case, a trial and error speed of reform existed. The World Bank (2002), pointed out that some economists were in favour of promoting reform in all aspects of the economy and the transition as fast as

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possible, while others were critical of a strategy imposed at such a high cost on the country’s economy. World Bank (2002, 16) pointed out that: The relationship between the speed of reform and economic growth has been the subject of controversy. Some economists argued for advancing reforms in all areas as fast as possible; others criticized such a strategy as imposing un-necessarily high cost. The most interesting part of the debate focuses on the sequencing of policies-on the relative speed of different types of reform. Advocates of moving fast in areas amenable to rapid reform argue that the synergies among different components-for example, privatization together with liberalization of prices and trade-may generate enough gains and winners to maintain the reform momentum. The need to take advantage of windows of opportunity is also cited as important in that decision. By contrast, advocates of slower reform point out that going ahead with reforms that can be implemented quickly – ‘stroke of the pen’ reforms – without waiting for those that take more time, such as the creation of institutions that support markets, significantly reduces the benefits of these reforms. The loss could be so severe as to generate output losses and also lead to the creation of interest groups opposing those reforms requiring more time.

The government must focus on what is beneficial to its economy and not on what is urgent. It is impossible for the government to protect the entire population from the burden of the transition process and the imposition of strict measures. Dornbusch (1991) argued that radical change is the only realistic option, and gradualism opens the door to an unstructured free-for-all market: consumers will go to the black market and firms will produce for the black market. Temporary collapse may be inevitable one way or another, but in the context of radical reform it may at least be the seed for reconstruction. Transition needs to be accomplished extremely fast because the ice is melting, the distance to go is far, and the task is overwhelming. The belief that transition could be accomplished over many years is an illusory one. The gradualist solution is appropriate only when a market economy is already in place and the issue is how to improve the use of resources at the margin. Dornbusch concluded that this is not the case for Central and Eastern economies. Therefore, a radical and rapid reform is the correct remedy. Stanley Fischer et al. (2000, 1) suggests that the faster the speed of reforms, the quicker the recovery and the higher its growth. Although, rapid changes were favoured by most countries, they have sometimes been criticized by theorists. By observing countries in transition, some researchers concluded that the shocktherapy approach leads to drastic increases in the level of poverty and income inequality. Especially in the case of privatization of state owned firms, such rushed   The World Bank (2002), Transition The First Ten Years; Analysis and Lessons for Eastern Europe and the Former Soviet Union, Washington DC, The International Bank for Reconstruction and Development/The World Bank, USA.

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moves have often led to the disorganization of valuable operational enterprises, which subsequently assisted the drop of the output level. However, advocates of a rapid reform object to this view, pointing out the fact that the output would drop anyway and that output had already been manipulated before the transition. They also claim that the level of poverty and income inequality is higher in countries following the gradualist method, a method that provides more space for the satisfaction of personal interests and corruption (World Economic Outlook, 2000, 190). The supporters of the shock therapy approach (even in the case of sequencing) assert that the precondition for successful transformation and stabilization of the economy is the simultaneous and rapid development of reform. Lipton and Sachs stated: … a rapid transition to a market economy, with a heavy emphasis on economic integration with the Western Europe – through free trade, active participation of foreign firms in the domestic economy, and closer political ties – will permit the Eastern European economies to overcome some of the thorniest problems of transition, both economic and political. (1990, 77)

The advocates of the shock therapy method regarded the gradual approach to be both unnecessarily costly in respect of time and lost output, and also infeasible in some cases, given the unstable political situation (Hall and Elliot, 1999). The transition reforms, according to Lipton and Sachs (1990), should be performed as quickly as possible in order to prevent reverse political processes that might impede the whole transition strategy. Heavy criticism of the shock therapy’s propositions exist in a large amount of literature, which maintain that radical reforms produce more negative than positive effects in the transition economies, such as; economic decline, high unemployment, inflation, uncertain privatization outcomes, decline in standards of living and income inequality. The gradualists favour a prolonged period of state intervention in terms of price and wage controls, fixed exchange rates, postponed privatization, and the state establishment of market institutions (Van Brabant, 1993; Zajicek and Heisler, 1995; Kolodko, 1999; Marangos, 2001; Hall et al., 1999; Sergi, 2003). Basing his arguments on the Post-Keynesian propositions, Marangos (2001; 2006c; 2004c) maintains that the goal of transition should be the development of a civilized market society that could be achieved by a managed transition process with active government intervention. A transformation is an evolutionary process that necessarily takes place over a rather long period of time (Lichtenstein, 1996).

  World Economic Outlook (2000), A Survey by the Staff of the International, Chapter III, 190, ‘Transition: Experience and Policy Issues’, International Monetary Fund, Washington DC.

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Angresano (1994, 26) states that one of the main shortcomings of shock therapy is that economic change is perceived in a mechanical and simplified way. He also regards shock therapy as a social experiment, stressing the high social cost caused by that approach. More specifically, Angresano (1994, 26) states that one of the main shortcomings of shock therapy is that: … economic change was perceived in a mechanical and simplified way … the reformers believed that certain stimuli, consisting of such available tools as stringent monetary and fiscal policy and liberalized prices will induce desired changes throughout the economy. It was assumed that using the proposed stabilization measures as stimuli, the desired changes in economic behaviour were virtually guaranteed, as the chemist’s combining of particular is certain to produce specific reaction.

Kolodko (1999) contends that the main reason for the severe output contraction and social pressure lies on the set of radical reform policies adopted by the majority of transition countries. Those policies underestimated the role of the state and erroneously assumed that the emerging market forces will quickly replace the government as a facilitator of new institutional settings, in the development of infrastructure and the investment in human capital. Sokol (2001, 645) infers that shock therapy did not lead to quick and smooth ‘closure’ of the wealth gap with the West, but brought about a painful change from a planned to a market economy and lead to fragmentation and increasing disparity between the transition countries and the West, as well as considerable discrepancies within the transition countries themselves. Meyer (1998) insists that shock therapy recommendations for reforms did not consider the political and social consequences, while Kolodko (1999) insists that the set of radical policies performed in the beginning of the transition were induced by psychological and political rather than economic and financial decisive motives. Finally, Van Brabant (1993) maintains that in order to have a well-functioning market economy, there is a need for an almost simultaneous completion of all the reforms rather than a simultaneous start of the various policies of the transformation process. Moreover, he views ‘shock therapy’ rather as a mode designed to improve resource allocation. Zajicek and Heisler (1995) argued that the shock therapy reform strategies have disregarded some of the limitations that remained from the centrally planned economy, namely the concentrated and outmoded industrial structure, the absence of developed financial infrastructure, the specific social infrastructure in terms of behaviour modes and attitudes, and the existing net of costly social programs. They maintain that given these constraints, the employment of a comprehensive transition-period policy focusing on the effective and realistic removal of the barriers to a free market system rather than focusing on the application of quick

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market solutions, is a more appropriate approach. They estimated that the time required for the creation of basic market institutions, the adoption and enforcement of corporate laws and the antitrust legislation is at least 15–20 years and that the aims of the economic policy should be instant stabilization of the economy, promotion of economic growth, stimulation of investments, a new approach to privatization, and a clear economic role for the government. Goodhue et al. (1998) maintain that government policies supporting information provision and institution-structuring are important in the earliest phase of transition, when their benefits are most significant, especially in industries with more privatized production. It is argued that the big-bang approach leads to highly optimistic forecasts, because it does not consider the costs of rapid privatization in an uncertain environment and only when there is almost no uncertainty and learning is correspondingly unimportant, will the big bang predictions be realistic. To be more specific, the difference between shock therapists and gradualists can also be seen from the following: the shock therapists believe that you cannot jump over a gorge in two jumps. The gradualists, however, believe that the passage to market economy is the ascension of a mountain where the top cannot be reached in one jump.

1.5 The Sequencing of Reforms and the Importance of Institutional Reforms In the early stages of reformation, the majority of the reformers supported the idea that the initial focus should be on liberalization and privatization, because institutions will need a longer period to develop and the creation of markets will also make the institutional reform easier (Raiser et al., 2000a). However, there were considerable differences in the type of reforms to be implemented, especially in the pursued privatization strategies (Stern, 1998). In Van Brabant’s (1993) opinion, monetary stabilization must be done quickly and with great intensity, while price and foreign exchange liberalization are policies that could be introduced quickly but might be performed over a longer period of time as well. Transformations that cannot be accomplished rapidly are privatization and restructuring of state-owned enterprises, because a radical transformation in attitudes and behaviour of economic agents will appear over a longer period of time. Meyer (1998) argued that the reforms in the initial stage of the transition should focus on the critical elements of liberalization and stabilization. He claims that successful liberalization is a necessary precondition for privatization at a later stage. This rests on the foundations of the market mechanism, as market adjusted prices are required for a market valuation of the assets that should be privatized. It is assumed that the institutional system in the transition economies will be strongly influenced by western institutional models, and that external assistance is of crucial significance for the institutional development (Meyer, 1998).

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Castanheira and Roland (2000) argued that an optimal transition requires immediate price liberalization, openness of the economy and elimination of governmental intervention. A model created by Castanheira and Roland (2000) presents at the same time an ‘evolutionary’ as well as a ‘big bang’ view of transition, as optimal transition is characterized by coordinated development of the new private sector through capital accumulation and through the gradual phasing out of the state sector. At the same time, attaining this optimal transition requires immediate price liberalization, openness of the economy and elimination of governmental intervention. However, there is no optimal path (sequence) for a successful economic reform. Given the absence of an optimal model, each country must draw its policy approach in the first steps on the road to a market economy out of practical guidance rules and the past history of transition experiences. The major objectives of transition policies are to raise economic efficiency and promote growth. However, despite the fact that all transition countries had similar objectives and final goals, actual transition policies have differed both in measures and sequence implemented and results achieved to date. The sequence of adaptation of every policy is important in the transition process and refers to the order in which either macroeconomic policy action or specific reforms are introduced. Specifically, it involves the order in which reforms are undertaken across sectors and the order in which reforms are undertaken within sectors (IMF, 2002). The issue of sequence and the importance of the institutional reforms have also been mentioned among others by Marangos (2003, 963) who concluded that an optimal sequence of the transition process primarily requires a combination of state and market-produced institutions. Moreover, immediate government intervention is required in setting up the minimum institutional structure essential for the operation of the market. An institutional core was essential to ensure economic development in transition economies. Moreover, Marangos (2004a) added that it is important to allow the market to nourish and expand state-produced institutions through the development of both formal and informal market-produced institutions and trust. Finally, economic policy makers and advisors would normally require time to experiment and make mistakes to bring about an efficient institutional structure. To be more precise, the transition process sometimes requires gradualism. As mentioned above, the concepts of gradualism and gradual changes that in the long term lead to a market economy and the concept of shock-therapy and the rapid changes, which are refined in time, are the two approaches that can be used, either separately or mixed in different perspectives of transition. However, there is no optimal path for a successful economic reform. The main reasons for that are the differences in the country’s initial position, the external environment, and the particular policies pursued during the transition process. As mentioned above, the major steps of the transition process are macro stabilization, restructuring and privatizing state enterprises, price and market liberalization and redefining the role of state (Fischer and Gelb, 1991, 91–105).

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Roe (1992) suggests the following guiding principles for economies aspiring to liberal reforms: • •

•

•

•

Allowing of prices that are both flexible and reasonably reflective of international price movements. Elimination of impediments that could abort necessary producer responses to changing prices. In particular, insurance of a reasonably liberal basis for both new products and producers to enter markets and for failed products and producers to exist. Allowing of productive agents to emerge and agents who are motivated to change in response to changing conditions. Those who manage capital without ownership involvement may not have the proper incentives to build a sound capital base, resist unaffordable wage demands, and generally champion the needs of corporate profitability and capital. Establishment of macro (economic) stability; a difficult prospect in many of the reforming socialist economies because of the inherent tendencies toward instability caused by large monetary overhangs, as well as the perceived need to generate important changes in relative prices, an essential feature required by the reform process. Establishment of sound and flexible financial systems.

In price and market liberalization, trade rules are open and there are new trade agreements. Trade barriers are eliminated, and a competitive environment with differentiation of products established. According to Exeter and Fries (1998), the main benefit of liberalization is the adjustment of relative prices. As a result, prices begin to reflect production costs and market demand, and they are able to provide clear, market-based signals to producers. Many studies choose to spot the speed of transition process by examining measures of liberalization. These measures of liberalization were defined by De Melo Denized and Gelb (1996). Liberalization was measured in terms of internal markets, external markets and private sector entry. The measure of internal market liberalization reflects domestic price liberalization and progress in abolishing state trading monopolies. The external market measure assesses the liberalization of the foreign trade regime, including currency convertibility, elimination of export controls and taxes as well as substitution of low or moderate import duties for import quotas and high import tariffs. Finally, private sector entry depicts the openness of the economy to private sector development. Lipton and Sachs (1990), and Gerloff (2000) argue that tight macroeconomic stabilization policy has to be accompanied by price and trade liberalization, currency convertibility, promotion of private enterprises, free market competition, privatization restructuring and institutional reforms from the very beginning of the transition from a planned to a market economy. In restructuring and privatizing state enterprises, the property rights should be clear and monopolies should be stopped. Political commitment to transparent

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privatization outcomes should exist combined with the elimination of bureaucratic systems. More incentives should be given for new companies to be established in the country with no governmental interference (Bitzenis, 2002a; 2002b). According to Johnston and Sundararajan (1999), structural reforms should include the reform of the interest rate regime and of monetary operations, the development of the banking sector (reforming selective credit regulations), the development of money and interbank markets, fostering of competition in financial markets and the development of long term capital markets. Exeter and Fries (1998, 27) stated that: one of the most important lessons to be gleaned from the diverse approaches to privatization is the strong influence the method of privatization has on the creation of ownership structures. These structures have important implications for corporate governance in the post-privatization phase and, in turn, for the pace and extend of restructuring, enterprise performance, and growth of output.

One of the most widespread structural changes, as a consequence of privatization, was the foundation of millions of new family enterprises, improving the previously backward service sector throughout regions. Finally, while redefining the role of the state, it is essential to introduce new laws and rules in order to create a new market economy and provide incentives for foreign direct inflows. Gray (1997) suggests three factors that appear to be essential to a reform in both the content and processes of legal systems. The first one deals with the supply of market-friendly laws that clearly define individual rights and responsibilities and that embody market-friendly economic policies. The second one is the establishment of supportive institutions. Formal institutions include judges, arbitrators, prosecutors and court functionaries so that the laws are effective. The third factor is the creation of a set of incentives for individual market participants that can motivate them to take full advantage of both their legal rights and the information and enforcement capacity provided by institutions. Additionally, commercialization of state-owned enterprises is another major issue that could lead to a new working environment, providing power to work councils, new accounting rules and protection for consumers. Finally, changes in the subsidies system, bankruptcy rules and hard budget constraints of the banking sector need to be looked into (Matousek and Sergi, 2005). As mentioned above, there are four steps that should take place so that an economy can be deemed a market economy. Regarding the sequence or the speed of reforms, we can argue that the first step is to conduct a careful long-term plan of stability, which must be used in order to improve the economic condition of the country. This is the longest (in time duration) of all steps, but in order to successfully stabilize the whole there is a necessity for liberalization of the market, together with structural or institutional reforms and privatization and restructuring of state owned enterprises. In our opinion, the recommended approach here is one of gradualism because of the time taken for changes to occur (costly measures).

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The second step is to change the whole legal framework in order to be in position to protect the changes which will lead to a market economy. A shock therapy approach is important to be used, at least initially, so that the most important changes of the laws that will support the rest of the system finish quickly. Of course, a change in the legal system is not easy and for the rest of the process that will take a long period of time, gradualism should be used. Gradualism in this occasion does not mean that things will an inordinate amount of time to be completed or that the process will stop for a period and then continue (avoidance of stop and go sequence/speed of reforms). It means that things will change steadily until the desired result is reached. The third step relates to the liberalization of trade, prices, interest rates, exchange rates, etc. Those who support shock therapy suggest that this step should be achieved in that way in order to quickly obtain the benefits of the transformation, while the supporters of gradualism suggest that people are not ready for such a change and that, for example, a liberalization of prices at once will create high inflation. Finally, the fourth step relates to the reduction of the public sector and the restructuring of the publicly owned firms. The choice between shock therapy vs. gradualism used here, largely depends on what the government decides (among others) upon the issue: whether the state owned enterprises (SOEs) are firstly will undergo an initial restructuring and then become private or will be firstly privatized, allowing the private sector to restructure them. Of course, in order to have results from this step, the other steps should also show an important improvement. For example, clear laws, property rights, transparency, economic and political stability, monopoly abolishment and a well-defined competitive environment should exist in the country so that the government can expect successful privatization deals. The essential element of a transition process in CEE is the institutional change required to satisfy the criteria for EU membership as the institutions of regional integration are specific, focused on macroeconomic measures and comprise high levels of government involvement (Tihanyi and Roath, 2002). To sum up, transition is a massive and complex task and very few of the transition countries are close to the completion of the transformation process. The aims of transition were clear from the very beginning: the establishment of political pluralism similar to Western European models, the substitution of the administrative planning system with market-based decision making, the speedy integration into the world economy and participation in the European Union. In some transition countries without previous experience of economic decentralization, the dismantling of central planning proved painful. In others, overcoming the legacies of administrative planning created decisive problems. Despite that, the macroeconomic situation in all CEE countries in the early phases of the transition process had its main characteristics; a collapse of output and employment, accompanied by rising inflation. The diverging trends among the transition economies became noticeable during the course of the transition. Through close observation of the experiences of many countries, theorists have set

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up the guidelines for the transition economies. The results are valuable not only for countries in transition, but also for other countries, developed or not, in their application of any reform strategies (World Economic Outlook, 2000, 166). Technically, it is impossible to simultaneously implement all the reforms required to bring about a market economy. If a country prefers to a successful ‘big bang’ approach and a rapid sequence of reforms, the country should already have the basis for the restructure (political stability, a legal framework base and experience, a competent government, eagerness and support from the citizens, and sufficient per-capita income so that citizens are able to endure the changes). The changes must be induced in such sequence that will provide the framework for the changes to come. For example, how can a government liberalize the exchange rate regime, when the foreign currency reserves of the country do not exist? Or how can a government achieve a quick and successful privatization process when the country lacks a sound banking system, financial intermediaries, and a stock exchange market? How can a country attract significant FDI inflows, when state monopolies in basic goods (gas, electricity etc.) have not yet been abandoned? Hence, in the cases where a reform in one step is highly dependant on the success of a reform in another, the reform should take place gradually. However, this argument should not be confused with the policy of continuously and deliberately postponing changes such as the privatization and restructuring of state-owned enterprises and the introduction of a new legal system (‘stop and go’).

1.6 The Impact of Adverse Initial Conditions in the Transition Process of a Country 1.6.1 Adverse Initial Conditions and the Speed and/or Sequence of Reforms In studying the transition strategies and the outcomes of the reforms, it is of paramount importance to be aware of the initial conditions in the transition countries. In spite of the common purposes and guidelines of transition economies, there were considerable variations in the transition countries performance due to the initial conditions, external shocks and the conducted policies to facilitate transition (World Economic Outlook, 2000). Given the legacies of the centrallyplanned economy, the vital economic, political and social reforms, were to be implemented in a very complex environment characterized by severe economic crises, weak political institutions, lack of experience in operating in a market economy, influential communist presence, and often serious ethnic conflicts (Lipton and Sachs, 1990). When the transition process was launched, there were two distinct views in the literature regarding the initial conditions, the result of two distinct views regarding the speed of implementing the reforms: shock therapy vs. gradualism. The transition process for the shock therapy supporters was neither peculiar, complicated or enigmatic. While the problems associated with the transition process might be

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serious and complex, they were not unparalleled. ‘In fact in many ways it is a welltrodden path’ (Sachs, 1993, 2). These problems needed to be solved by ordinary means and the ‘uniqueness’ of the situation required unhesitating and determined action. ‘Everything in this setting pointed to the need for a hard and (of necessity) rough stabilization policy’ (Aslund, 1997, 186). Many elements of the transition programme did have general application across economies with immensely different initial economic and political environments (Woo, Parker and Sachs, 1997, xi). Initial social factors do not substantially influence economic growth in transition economies; rather openness and investment do (Thomas and Wang, 1997, 230). Thus ‘in principle the tasks and instruments of macroeconomic stabilization are the same in Russia as elsewhere’ (Aslund, 1995, 181). The Chinese model of gradualism was not irrelevant as a guide to transition economies for the shock therapy supporters. Three quarters of China’s population lived in rural areas at the time of the reforms and agriculture was the main source of income. Economic growth was initiated outside the state sector. In contrast, Lipton and Sachs (1992, 277) argued that in Russia and Eastern Europe a majority of the labour force was employed in urban industry. Thus, the main source of growth, in the short run, would come as a result of privatization of the public sector. As already said, there is no universally optimal speed. The Chinese gradualist process was a succession from easy to hard, addressing the easy problems first and leaving the difficult ones for later (Cao, Fan and Woo 1997, 38). However, once the honeymoon period was over, the Chinese authorities had to deal with more difficult problems. In direct contrast to gradualism, the shock therapy approach addresses all problems simultaneously from the start. The shock therapy supporters argued that it would not be a surprise if China abandoned gradualism in favour of more rapid economic reforms. The different strategies implemented in China, and in Russia and Eastern Europe were mainly due to the varying economic problems confronted. The Chinese reform strategy was a traditional development issue – reallocation of surplus agricultural labour to manufacturing – while Russia and Eastern Europe were faced with the common adjustment problem of reallocating labour from uncompetitive industries to efficient existing or new industries. It was thus much easier to establish family agriculture in China than in Russia, especially when the bureaucratic obstructions are taken into account (Aslund, 1993, 96). ‘The fact is that economic development is easier than economic adjustment both practically and politically’ (Woo, 1994, 305). It was a priori plausible, for the shock therapy supporters, that a gradualist strategy was more likely to succeed in an under-industrialized country, like China, where there was a vast amount of surplus labour, rather than in Russia and Eastern Europe which were over-industrialized and dominated by state property (Cao, Fan and Woo, 1997, 28). However, this does not mean that it would have succeeded in Russia. Thus, ‘the recommendation that Russia should take the same path as China amounts to telling apples to be pears. The actual preconditions must be taken into account’ (Aslund, 1993, 99).

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Consequently, for the shock therapy supporters, a successful transition could only take place via the shock therapy approach, and a gradualist one would only fail. The Chinese experience demonstrated that a gradualist approach could only be realized where special initial circumstances existed. Here lies a contradiction. The shock therapy process was supposedly based on simple truths and applicable to any transition economy, independent of the initial conditions. ‘An economic program can be easily adopted from the Polish experience’ (Aslund, 1992, 178). By arguing that the success of the gradualist Chinese approach was due to the specific characteristics of the economy, the universality of the shock therapy approach was undermined. The experience of China weakened the arguments of shock therapy approach. This anomaly was explained by Parker, Tritt and Woo (1997, 15) who argued that in ‘Hungary, Poland and Russia, the transition process involved structural adjustment, while in China and Vietnam it involved ‘normal economic development’. Nevertheless this argument reinforces the position that initial conditions play an important role in determining the speed of the reform process, which shock therapy ignored. At the same time, it undermines the catholicity of the shock therapy approach. In contrast to the shock therapy approach, the gradualist process was inconsistent with rigid thinking and the implementation of the reform programme independent of the initial conditions. ‘Sensible economics’ required the incorporation of the initial conditions in the transition process (Murrell, 1995, 165). Policy instruments and goals had to reflect the specific economic conditions of the time and change accordingly. This required constant reassessment of the specific economic situation and active government participation in economic affairs. The government had to be flexible and responsive to economic changes. In terms of economic development, the socialist experiment was a temporary aberration in the course of historical events (Kornai, 2000, 27). However, the initial conditions of each ex-socialist country determined both the output response during marketization and the speed and sequence of transition policies. The different initial conditions made the situation quite unique and there was ‘no ready-make recipe’ (Kornai, 1995, 34), ‘no single detailed road map’ (Fischer and Gelb, 1991, 91). Incorporating the initial conditions in the transition process justified a gradual approach (Kornai, 1992a, 17). This was because the level of a society’s civilization, history, culture, size, efficiency and the degree of social satisfaction were correlated with what actually occurred in the economy. As a result, the dynamics and the speed of reform differed among transition economies because the starting points were different (Kornai, 1992b, 168). The starting point required clarification; there could not be a uniform line, and thus governments could not undertake liberalizing measures simultaneously. Instead, there was an ‘optimal’ order of economic liberalization, depending on the initial conditions (McKinnon, 1993, 4). While history and culture are important, for the gradualist supporters of the neoclassical persuasion, they were not such a binding

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constraint that a fatalistic approach had to be adopted. Based on the gradualist neoclassical approach, cultural values can mutate and history can change. Nonetheless, the transition process took place in a specific dynamic cultural context, characterized by instability and unpredictability. There was no single strategy. Ultimate success depended on whether or not sufficient non-economic conditions prevailed, including political, ideological and cultural dimensions, as the Post-Keynesians argued. Russia and former republics of the Soviet Union and Eastern Europe were characterized by widely different civilizations, history, religion and different levels of economic and political development. This strongly influenced the way transition problems were solved, since capitalism comes in many forms (Arestis, Dunn and Sawyer, 1999, 541; Minsky and Whalen, 1996–7, 161). The assumption of the shock therapy transition model was that cultural differences were not an obstacle to the introduction of market relations. The shock therapy model could be implemented independent of any specific economic, political and ideological conditions. However, Post-Keynesians and gradualists disagreed because they believed that culture, ideology and, the initial conditions in general, were extremely important. Institutions and social practices function and are founded on customs, traditions, and habits which are deeply ingrained and only slowly deserted and replaced by others (Argyrous, 1996, 113). For example, prices are determined in a social market, not just an economic market, by customs, power and competition (Whalen, 1996c, 9). In particular, in an oligopolistic and monopolistic market environment, prices are based on a mark-up pricing scheme. As normal cost is quite constant, mark-ups are established in the short run by customs, convention and reasonableness and in the long run by competitive pressures and market power (Lee, 1996, 93). In this environment, firms may maintain prices by reducing profits in the face of a threat of entry (Norman, 1996, 525). In this way, prices are not a means of resource allocation but rather a way of generating funds for expansion of the firm (Shapiro, 1977, 549). The transition process was a heterogeneous phenomenon. It was not possible to copy existing market models, contrary to what the supporters of shock therapy argued. Even though the transition process was dominated by shock therapy, ‘one sees in Eastern Europe several different transformations and transitions, not one transformation and transition. From country to country throughout the entire region, there are variations’ (Share, 1995, 572). Post-Keynesians argue that economic development is a path-dependent process. Economic processes, most importantly the transition process, ‘are generally to be seen as path-dependent, and as such, any outcome whether equilibrium or not, depends on the route followed … in other words, current developments depend on past events as reflected in expectations, beliefs, institutions, etc.’ (Arestis and Sawyer, 1993, 9). Consequently, the transition process was a path-dependent process that relied on the initial conditions, the policies initiated and the external environment. While the initial conditions may exhibit some commonalties there were definite differences as well. The economy, history, politics and government

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intervention were inextricably linked in the development of a market system (Reardon, 1996, 634). Thus, as the transition process depended on historical, political cultural and ideological conditions prevailing in the country, PostKeynesians argued that reform strategists should not ignore these factors. However, if the problems associated with the transition process involved the specific socio-economic conditions of the country in question; introducing private property and market forces could not in any way deliver success. The neoclassical transition models, ‘ignore[d] the real environment in which the economy is located’ (Rider, 1994, 595). The shock therapy approach did not incorporate the differences between countries, even though they were recognized: Instead economic, political and social differences across countries are treated as aberrations on the model’s assumptions which will be ironed out over time with further market liberalization. (Smyth, 1998, 386–7)

For the neoclassical transition model, any endeavour to embody the noneconomic factors would only result in undermining the operation of the free market process. Although the characteristics of each transition economy differed, the neoclassical transition model did not consider it important enough to justify a change in strategy. This was due to the fact that transition programs were devised by technical experts who were ignorant of the economic, political cultural and history of the country in question (Share, 1996, 580). However, it is not accidental that Central Eastern Europe and the Baltics are performing much better than the former Soviet Union, since centrally administered socialism was established much later in Central Eastern Europe and the Baltics (Smyth, 1998, 368). There is currently an attempt to explain the economic outcomes of the transition process and the differences in magnitude of these outcomes due to the speed and sequence of the transition policies. In addition, there is also currently an attempt to explore the various characteristics of transition economies, which existed at the beginning of transition process, which naturally influenced the speed and sequence of reforms. This is in contrast to the shock therapy approach to the transition process, which involved the immediate establishment of a market economy with no consideration of the initial conditions. The initial conditions of transition economies incorporate among others the external and internal shocks derived from the breakdown of the central planning system, the dissolution of the Soviet Union, the wars and civil strives, all of which had an impact, one way or another, on the transition process. As a result, there was a variation of policies, which the countries of the Central and Eastern Europe (CEE) region adopted in order to achieve a transition to a market economy. A question that has been derived from the above analysis and requires an answer is: How did initial conditions influence the overall economic performance of transition countries and the consequent policies adopted in order to become a fully-functioning market economy?

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Gradualists argue that economic development is a path-dependent process. The transition process depends on historical, political, cultural and ideological conditions prevailing in the country. Post-Keynesians argued that reform strategists should not ignore these factors. In summary, literature and empirical evidence reveal that the initial conditions have a major influence not only in the speed and sequence of reforms, but also in determining the outcomes of the transition process. 1.6.2 The Importance/Influence of Adverse Initial Conditions on the Performance of a Successful Transition Process of a Country The argument developed in this chapter is that there are several characteristics that affect a country’s economic performance, not only at the start of the transition to a market economy but also at any stage of adaptation of a specific programme or measure, which encouraged or discouraged the country’s transition to a market economy. For example, countries with little experience as independent nation states had, on the one hand, more difficulties in creating efficient political institutions and on the other hand, the legacy of the communist regime and the external economic shocks delayed the economic recovery. In general, transition economies had to restructure in numerous ways, notably from heavy to light industry, from industry and agriculture to finance and services, and from CMEA to world trade. … Within existing firms, new products lines and production methods had to be developed, while simultaneously reducing input waste, notably in terms of energy, labor and the environment. (Estrin et al., 1997, 9)

While the goal of all transition economies was the same, the performance of these countries was uneven and disheartening. Bulgaria’s macroeconomic development is lagging behind, compared to other countries in Central and Eastern European region. We argue that the reason for this is due to the adverse economic initial conditions and exogenous shocks that were extremely problematical. Balcerowicz (1994, 49) stated that ‘initial conditions greatly affect the sequence of economic transformation’. He emphasized the importance of the initial elements of the economic system – the initial economic structure, macroeconomic condition, the size of the public sector – maintaining that these elements are the factors that determine the response of the economy to the introduction of stabilization and liberalization policies. According to Stern (1998), the differences in initial conditions are related to the length of the period under central planning, the previous adoption of some of the principles of the market economy, the economic structure, debt level, geographical location, natural resource endowments, and history and culture. Fischer and Sahay (2000) surveyed to what extent initial conditions influence the transition performance, by including in their analysis seven variables

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representing the initial conditions: the share of agriculture in GDP, natural recourse endowment index, years under communism, secondary school enrolment ratio, trade dependency, an index of over-industrialization, and the distance of the country’s capital city from Düsseldorf. It was found that explanatory power for almost 50% of the growth performance was due to the secondary school enrolment ratio which represents the economic development at the time of transition, and the years under communism. Fischer and Sahay (2000) also suggest that anti-inflation policies and structural reforms have a positive influence on the growth level. Price liberalization and small-scale privatization have a more significant impact than the large-scale privatization, while the fiscal deficits have a positive effect on output, only if the inflation is controlled. A fundamental factor behind the path of output growth was the extent and quality of the reforms pursued by the transition countries. There is a rapidly growing literature of empirical studies that analyse the effect of reform policies on the transition path. Many studies maintain that there is a strong relationship between comprehensive reform and output performance during the course of transition and infer that the economic and political reforms in the transition countries have strong impact on the growth and inflation rates (De Melo et al., 1996; Stern, 1998; EBRD, 1997; Fischer and Sahay, 2000; Gungur and Yamak, 2002). As the reform process intensifies, the influence on inflation and growth becomes more significant and the inflation rate compared to growth rate is more sensitive to changes, in the degree of the economic and political reform. Fischer et al. (1996) argue that there is a positive influence of the liberalization and the structural reforms on the performance of a successful transition process and infer that a pegged exchange rate regime and a tight fiscal policy have a strong positive effect on reducing inflation and enhancing growth of the countries in transition. Herdandez-Cata (1999) analyses the effect of economic liberalization, including price decontrol and monetary growth, on inflation in the transition countries. He concludes that despite price liberalization causes a significant increase in the average price level, particularly in countries with heavily repressed inflation; however, there is no lasting negative effect on the inflation level as the main determinant of inflation is monetary expansion. Berg et al. (1999) maintained that the main determinants of the variations in output growth in the transition countries were the extent to which structural reforms are effectively performed and the tight macroeconomic policy that was pursued. Although tight macroeconomic policy is less significant than structural reforms, the higher the speed of the reforms is, the faster the growth will be. Berg et al. (1999) investigate which factors have the strongest impact on the initial output decline and infer that in the early stages of the transition, the influence of adverse initial conditions was more profound than that of inflation and fiscal deficits, and that the progress in structural reforms does not affect the output negatively. The positive relationship between successful macroeconomic stabilization and the following enhanced growth and adequate microeconomic adjustments is argued by Svejnar (1991).

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Christofferson and Doyle (1998) contend that there is a robust relationship between export market growth and output in the transition countries and that inflation could be linked to low level of growth just above a threshold inflation rate. They infer that the structural reforms might be connected to weaker output only at the very beginning of the transition, as thereafter structural reforms are associated with increased output. World Bank (2002) upholds that the influence of the policies becomes more significant as the transition process advances, though it is substantial in the initial phases too. However, in addition to the fact that the efficient reform policies enhance growth level in the medium-term, they reduce the negative outcomes of the transition in the short run. According to the findings of Falcetti et al. (2000), average growth is strongly determined by initial conditions, both directly and indirectly, through their influence on structural reforms. Stern (1998) concludes that the different outcomes of the reforms in the transition countries are influenced by policies and actions during the transition rather than the initial conditions, and if the countries fail to move ahead in reforms after the initial developments this may destabilize their economies. 1.6.3 Four Groups of Adverse ‘Initial’ Conditions The argument developed in this section is that there were several characteristics which we consider to have the most important influence on a transition economy’s performance, not only at the start of the transition to a market economy, but also at any stage of adaptation of a specific programme or measure, which encouraged or discouraged the transition. For example, countries with little experience as independent nation states had more difficulties in creating efficient political institutions, and at the same time, the legacy of the communist regime and the external economic shocks delayed the economic recovery. While the goal of all transition economies was more or less the same, the performance of these countries was uneven and disheartening. The adverse ‘initial’ conditions of a country may be divided into four groups. Before the discussion of these four groups we should clarify that with initial conditions we mean initial or primary conditions (economic, social, and political). In addition, when we refer to initial conditions we suggest that the countries may suffer from these conditions not only at the beginning of their transition but also during the whole transition period. For example, the embargo in FYROM, or the wars in Kosovo, and in Serbia can be considered as initial or primary conditions for these countries, or in other words as decisive problems in their transition way for becoming market economies. Economic conditions The country’s adverse economic conditions, which could be strong enough to underpin the delay in the whole transition process (For example large foreign debt/

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GDP, low foreign exchange reserves and rather large monetary overhang, large current account deficit/GDP, etc.). The legacy of the past The legacy of the communist regime provided the transition environment with negative characteristics and worsened the situation. Therefore, time, sacrifices and hard effort were required in order the subsequent negative outcomes could be overcome. Typically these include: the negative attitude against consumption, labor and entrepreneurship, non-profit oriented enterprises, the low level of productivity, non-efficiency oriented behaviour, along with the absence of the private sector pursuing profitability and efficiency. In particular, the adverse initial conditions due to the legacy of the past may be: • •

•

• • •

The lack of regulations, legal framework, financial intermediaries, stock market, which are essential elements that facilitate a market economy. Macroeconomic instability due to the fiscal deficits burden, low productivity, external and internal loans (bad loans), increasing shadow or black economy, heavily industrialized GDP, low quality of produced products together with the lack of the possibility of finding new trade partners, inability to balance the state budgets, monetary overhang and depressed inflation. The low per capita income and living standards and the growing poverty, which may lead governments to be sceptical and at times to postpone tightened policies, especially in the early years of transition. The insufficient quality and variety of products, and the limitation of natural resources. Illegal activity during the transition process, which made business environment unwelcoming. The magnitude of the restitution problem and the significant delay in reprivatization of property that created a subsequent delay in the privatization process.

Political conditions Political instability together with political inability or unwillingness of various countries’ post-communist governments to adopt adequate and proper policies, leading to a successful transition. Furthermore, politicians and governments may be unable to adopt effective transition policies in order for a country to become a completely functioning market economy due to (a) inability of the governments to cope with economic crises and to overcome them; (b) a significant delay in the liberalization of prices in products that had remained and had been produced by state monopolies in sectors such as energy, gas, petroleum, telecommunications, railways, television, etc.; (c) a noticeably low progress in the development and increase of the private sector; (d) a slow privatization progress, along with a slow creation and establishment of new small enterprises due to the inadequate institutional framework (EBRD various reports; Economist Intelligence Unit,

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IMF Staff Country Report No. 99/26 April 1999); (e) a ‘favourable’ introduction of specific laws in the early years of transition for the ‘nomenklatura’ and the governmental financial support they received, which later created an unfavourable business environment with no significant economic development, low FDI inflows, soft budget constraints, slow and inadequate restructuring, inefficiency of the state-owned enterprises, accumulation of new debts and slow privatization process of the state owned enterprises (SOEs); (f) the governments borrowing in convertible currencies from private commercial banks; this only worsened the situation, as the national currency was devaluated; (g) The effort of governments to get the higher possible proceeds from the privatization of the larger and more significant state owned companies, led the governments to decide on restructuring before privatization, which led to a slower privatization process and to a lack of significant offers from foreign investors; (h) The lack of transparency in the privatization process, the inexperience in valuation of SOEs, the bureaucracy, the complex criteria of selecting the buyers, corruption, the late introduction of bankruptcy laws and hard budget constraints, the accumulation of bad loans, as well as the large debt accumulated in most of the SOEs that the governments did not restructure rapidly and effectively; (i) The inability to stop inflation, and lastly; (j) the inadequate legal framework and the constant changes of the legal framework itself. External shocks Various external shocks, may also obstruct the way to becoming a market economy (e.g. The Persian Gulf crisis, which caused higher oil prices, the USSR’s energy crisis, the interruption of trade between Iraq and Central and East European Countries, as well as the collapse of trade relations with the Soviet Union, East Germany, and CMEA members, the unification of East Germany with West Germany, the dissolution of the Soviet Union, and Yugoslavia, the wars in the Balkan region, the economic crisis in Russia, etc.). USSR’s energy crisis (after 1988) and the termination of the USSR subsidies and exports of energy resources and commodities in preferential prices, along with the subsequent political fragmentation that followed the USSR’s collapse was a decisive external shock. During the period 1956–1960, the East European trade had a larger growth rate than the total world exports rate and even that of the trade of Western industrialized countries (Bruno, 1992, 763). The growth rate decelerated from 1961 to 1965, to a rate below the Western one, only slightly above the world total. Most of the trade among the CMEA countries was conducted on a governmentto-government basis. It was based on five-year agreements, supplemented by annual protocols which fixed the quantities and prices of the products to be traded. The commodity composition of CMEA trade and the international trade of each country was planned from the government. That was one of the problems of a centrally planed international trade.

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Lastly, the economic crises of Mexico, East Asia and the former USSR, which discouraged investors from investing in Eastern Emerging Markets, can be considered as external shocks for they contributed to delaying or interrupting the recovery of output in transition economies. Furthermore, repressed inflation, high black market exchange rates, and the war and civil strife in Armenia, Azerbaijan and Tajikistan in 1992–94, in Georgia and Moldova in 1992, and in Croatia and FYROM in 1991–94, all took a major toll on the lives of the people in transition economies, on infrastructure and on the institutional development, undermining the political consensus on reforms required for successful transition (World Bank 2002, 11–15). Although all countries in transition had the same final goal to create a market economy, the results of their efforts are different. This is because of the different strategies, policies, paths followed, different adverse initial economic conditions and external shocks, which each country faced or started with. Some countries lagged behind others in the CEE region, mainly because of their adverse initial economic conditions, the geographical distance from the west, the legacy of the communist regime, the external shocks they suffered, and the political instability. Besides the political aspect, the adverse behaviour of people regarding privatization together with the inadequate legal framework with its constant changes, or even the total absence of appropriate laws at the beginning of transition strengthened the nomenklatura, and thus bribery and corruption appeared, and the situation discouraged the inflow of significant amounts of FDI. The increase of nomenklatura’s power further delayed the privatization process, created social problems and income inequality, caused discontent to the citizens and reduction of per capita income, decreased governmental revenues, increased illegal actions, and most importantly created an unstable economic environment, which also discouraged foreign investors. Finally, the restitution problem and the unclear property rights in the beginning of the transition as well as bureaucracy are only some of the reasons that did not assist the transition process.

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Chapter 2

Privatization Theory: Privatization Deals as a Reason for Increased FDI Outflows 2.1 Defining Privatization The word ‘privatisation’ … is used in two senses. In the narrower sense, it means the transfer of assets hitherto owned by the state into private hands. The broader interpretation covers the property relations in the economy as a whole, so that privatisation of the economy means that the share of the private sector grows until it ultimately becomes the dominant economic sector. (Kornai, 1995, 32)

An extension of the broad definition provides us with more insight. Besides the selling or leasing of public property, the term further implies the abandonment of any government control over all units of the economy, as well as the abandonment of the state monopoly in certain sectors. It also includes the return of property that had been illegally confiscated to its rightful owners, the promotion of private enterprise and the effort to attract foreign investors. The broad definition may also be expressed as ‘the restructuring of the independent and private sectors’ (Hare, 1994, 34–35). The creation of small private firms may, eventually, achieve the revival of the private sector, even without the help of the privatization of state firms (Koves, 1992, 40) or in other words, privatization represents the transfer of state-owned assets to private ownership, alongside the creation and fostering of de novo private businesses (Hare and Canning, 1994). Privatization is an alternative way of distributing and choosing the means of generating wealth. Consequently, it may also be considered as a distribution of political and economic power in the long run. This is particularly so in the context of former communist countries, Estrin (1996) views privatization as a ‘reversal of communism’, considering the restoration of private property rights essential to a free market economy. In the same sense, … the emergence of a de novo private sector using the fixed assets of former state owned firms purchased after bankruptcy or liquidation, can lead to industry-level supply responses to demand changes even in the absence of supply responses from current and state owned firms. (Estrin, 1996, 2)

In contrast with the Western economies, where privatization represents only a transfer of the ownership of a few state-owned enterprises functioning in a fundamentally

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market economy dominated by private property, where reorganization, new corporate governance, and better allocation of resources are not needed, along with an entire restructure of the national economy; in the planned economies of Central and Eastern Europe (CEE) privatization plays an invaluable role in the transition process to the free market economy (Hunya et al., 2000). Thus, it is aimed at improving productivity, efficiency and competitiveness, lessening the burden of the state budget, and raising funds for financing areas of the economy. The privatization process and the emergence of de novo private entities for example in Central and Eastern European economies require an institutional reform that relies on an effective property system, and assists the stabilization of the economy (at a macroeconomic level), prices, trade, exchange rate liberalization, etc. (Frydman et al., 1992). The broader meaning of privatization incorporates the restructuring of the economy as a whole, including the mentality of entrepreneurship and the profit seeking under private ownership. Besides the privatization of municipal and state firms that reflect the tangible privatization observed in the everyday life of citizens, the creation of new firms is also essential for the total development and expansion of the private sector.

2.2 Reasons/Incentives for Privatization: Costs and Benefits Derived from Privatization A justifiable question is why privatization is necessary for advanced western countries and concomitantly why it is so vital for countries to be transformed into market economies. The answers lie in the social, economic and political aspects of the country. An examination of all the reasons for privatization is essential in order to understand the concept, for the identification of the goals of privatization and for the choice of the appropriate method(s) for each country. The following is a summary of the reasons and the benefits, as seen by those who are in favour of privatization: •

•

•

Privatization assists the creation and promotion of a competitive environment through the termination of monopolies, the creation of new small private firms and the passing of state companies into private hands. The individual/private owner is a better producer than the state, because the individual’s goal is profit maximization, therefore the privately owned firm will aim for larger percentage of the market, adapting to consumer tastes and needs. ‘The government is not a good manager of economic resources or a good monitor for the assets it entrusts to others’ and fails to provide motivation for managers and employees to increase production (UN, 1992, 213). For example, in a centrally planned economy the central authorities lack the incentive for good governance of the state-companies, neither do managers

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• •

•

•

•

•

•

•

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aim to maximize profits, manage effectively, or encourage innovation etc. It is difficult for the state to monitor and control managers, as managers may pursue their own rather than state’s interests. Estrin (1994, 15) has pointed out that, ‘even if they had the appropriate skills and experience, such managers rarely have the incentive to restructure their organizations for competition on world markets’. The socialist economy has no rational criteria for the effective allocation of capital, something that can be efficiently achieved by privatization. Private ownership will impose stricter control on management and hard budget constraints for the creation of extra revenues. Private owners recognize the necessity to upgrade and update the technological and management capacities and lifestyle of the companies; introducing new corporate governance ‘incorporating’ new ranges of products to meet the increased needs and demands of citizens. The state will be relieved by the burden of financing the deficits of lossmaking state owned enterprises (SOEs). The development of the private sector will assist the development of financial markets, which in turn, will assist with the financing of new investments, through the creation of a stock exchange market. In this way companies may find cheap capital, formerly provided (in many cases) by the state. The effect of privatization, for example, in transition economies is crucial for employees’ motivation, since their abilities are judged according to their work contribution and not according to their connections with the government. Under these circumstances, entrepreneurship and innovation are encouraged and productivity is increased (Aslund, 1991, 19). The creation of a healthy market will provide solid ground for further advancement of trade that will create a substantial market and may even attract foreign investment. The revenues from the sale of state assets and the saving of financial capital formerly given as aid to loss-making state companies may be used to cover for the budget deficits or for other governmental priorities such as social policy. Another source of revenue that will assist the state financially is the taxation from the new or transformed private firms’ revenues (Estrin, 1994, 17). Privatization results in more and different owners; an increased number of producers, leading to increased competition, more consumer choice, more and better products, better quality, and possibly better/lower prices. Privatization along with the clearance of property rights, the liberalization of the market, the elimination of monopolies, and the increase of competition is a necessary step for planned economies to grow into successful market economies. There are expected taxes on profits for privatized SOEs.

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•

• • • • •

Civil servants are not entrepreneurs. Public sector organizations are bureaucratic and fail to function in a way that will make the level of profit necessary to run and expand a business. Private firms and private owners become accountable to their shareholders and their desire for profit. Private enterprises are run on commercial rather than political grounds. Losses incurred by enterprises will accrue to the company and not the taxpayer. Privatization breaks down monopolies into more competitive industries and thus competition is introduced into the markets. Private properties guarantee the efficient use of resources and eliminate shortages (Marangos, 2004b).

The following can be considered to be a summary of the costs and disadvantages as seen by those who are against privatization: • •

•

• •

• • • •

Privatization simply creates private sector monopolies with barriers for new firms entering the industry. Privatized firms make decisions based on commercial profit maximizing grounds. Nationalized firms make decisions in the interests of the public. The state runs companies for the benefit of consumers: private companies will run their companies for profit. Privatizing strategic and profitable industries means that government revenues will be diminished. Profits are directed to the shareholders, as in the case of multinationals abroad. Lower government revenues may mean lower government spending on education and health. Privatization may sell-off national assets which the public, through taxation or work, has yielded and developed. The production and distribution of certain goods and services (such as medical care, education, water and electricity) especially for those with the lowest incomes or least ability to provide for themselves, should remain in the hands of the state. The state should also intervene in the market in terms of offering social security and welfare benefits. People have a basic right to enjoy basic goods or services without the state considering the cost it will have to pay. Privatized enterprises are sold at very low prices. Privatized companies take less heed of social costs. Prices (after privatization) may be raised whereas in SOEs the government has full control over prices. In the short term, and during the restructuring process, the unemployment rate may increase.

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2.3 Methods of Privatization Generally speaking, there are two distinct ways of privatization. The first is commercialization; which refers to the transformation of state companies to joint stock companies that in due time offer their stocks for privatization through the methods detailed below. When commercialization involves changes in management structure and working rules, it is also called corporatization. This conversion is an intermediate stage before the enterprise ownership and control can be transferred into private hands. The other way to privatize a state company is liquidation, a method involving the sale of separate assets of a company to different investors, and one preferred for the privatization of small-scale enterprises. A distinction should be made between the ‘insiders’, who are the people inside a firm (such as managers and workers), and the ‘outsiders’, who comprise of every other citizen local or foreign outside a firm. This distinction is important during the privatization process since the insiders are well-informed and enjoy a privileged position. Another element with which we can distinguish the privatization methods is the control mechanism of the procedure; whether it is centrally controlled by the government, or de-centrally by an independent agency supervised by impartial experts such as well-known consultant companies who evaluate assets and set the rules. If the procedure is centrally controlled by central courts, then the procedure is slow and requires a long period to bear results. Still, there is more clarity in any transaction and avoidance of ‘wild privatization’. Decentralized control is a quicker, more efficient way, but more vulnerable to personal interests and corruption. The control mechanism may adopt features from both ways in order to assure better results. An example is the model that transfers the ownership to institutional investors, like privatization funds or banks and insurance companies, who in turn, start trading shares. This third way necessitates the existence of a stock market (Meyer, 2000, 268–269). Mentioned below are particular methods of privatization: a. Selling by the public offering of shares, by initial public offering (IPO), and by public auction; b. Selling through financial intermediaries; c. Leasing of assets of public firms (a method that is not real privatization since the state still holds ownership of the assets); d. Human resources buyout (managers, workers, MEBO); e. Free distribution of shares (mass vouchers) to the public, workers and managers, and social institutions; f. Liquidation or bankruptcy; g. Return of the property to the rightful owner (restitution) (Hare, 1994, 34–35).

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A discussion of the privatization methods is as follows: 1) Sale of state property through auction By this the transformation of state property into private property can take place by auctioning state enterprises and selling them to the highest bidder. In this way all individuals have the opportunity to become owners at real market prices. Non-nationals can also participate as long as guidelines are imposed to protect the country’s interests. This protection policy, however, should not be based on isolationism or xenophobia. A substantial obstacle to this is the fact that the financial assets of the people may not be adequate to purchase state enterprises. The state could solve this problem by providing loans to individuals to finance the purchase of state enterprises (Marangos, 2004b, 587). 2) Sale of state property through financial intermediaries This involves the transfer of ownership of enterprises to financial intermediaries whose ownership structure may consist of pension funds, worker and/or management funds, citizen funds, or private financial institutions such as banks and government agencies. The advantage of this method is that it is quick and can be viewed as equitable. However, a loss of government revenue is involved. Moreover, there is a shortage of experienced financial managers operating in a market environment who can administer these financial intermediaries efficiently (Marangos, 2004b, 587). 3) Sale of state property through mass (voucher) privatization This involves the distribution of an amount of capital to private hands, in enough quantity to enable the purchase of state assets. This capital is distributed in nontransferable equity such as vouchers, only valid for purchasing state owned assets. In most countries, the distribution is equal among all the population, but in some countries nationalistic criteria may be applied against ethnic minorities which prohibits the fair allocation of vouchers. Another determinant of this method are the ‘rules’ for the use of the vouchers. Some tactics observed in different countries are the direct trading of vouchers for company stocks (Czechoslovakia), the trading for shares in government funds for the joint ownership of the formerly state owned assets (Poland), or the option of exchanging the vouchers for housing and assets other than firms (Latvia, Slovenia). The mechanism of the exchange should be determined as well the timing, or rights to assets (manager-employee buyouts, free to everyone, etc.) (Estrin, 1995, 8–10). The mass privatization method became increasingly popular after its success in several countries. The advantages of such a method are the speed of privatization and the equity in the distribution, avoiding the accumulation of wealth and thus power to the nomenklatura. In this way, voucher schemes can give a popular legitimacy to privatisation itself, for example by returning assets to people from whom they had originally been

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confiscated or by giving the general population a stake in the assets accumulated through forced saving in the communist era. (Estrin, 1994, 23)

Other advantages are the elimination of the need to find local buyers, and the creation of instant ‘players’ for the stock market. Furthermore, it is a very low cost method for the state to administer. Mass privatization is also contingent with the common public dislike of nonnationals as the majority of the privatized companies remain under local control. Mass privatization accelerates the privatization process, correcting the potential delay in market privatization. It also accelerates the establishment of social securities funds, and meets with the desire of the state for the broader participation of the population. One of the main objections to mass privatization is that it requires the existence or creation of financial infrastructure, including financial intermediaries, pension funds, mutual investment funds, investment banks, a stock exchange market and securities commission, prior to the implementation of the plan. Other drawbacks are that it generates minimum income for the government and that the wide range of parties involved foster fraud and financial speculation. Moreover, it creates problems in the governance of the firm, failing to compensate the government or generate the money-capital required for restructuring. Although many argue that mass privatization does not require the evaluation of assets, it is essential that each citizen receives vouchers not only of equal number but also of approximately equal value. The effort to fairly evaluate the companies and other operational problems may cause delays or even postponement in the process (albeit it remains much quicker than other methods). The wide distribution of the shares may prevent the establishment of a firm ownership, thus perpetuating the company’s problems in terms of effectiveness and managerial monitoring. In the mass privatization model, citizens ‘acquire’ the vouchers free or for a trivial price. Thus, they may view the vouchers as ‘free lottery tickets’, believing that they actually have nothing to lose if the company they acquire faces failure. This notion makes most citizens behave rather indifferently towards their investment. The mass privatization method is sometimes perceived as a way for the government to indirectly admit the failure, or insufficient success of the market privatization. 4) Management and employee buyouts (MEBO) This method combines the employee buyout (EBO) method and the management buyout (MBO) method. A company can be acquired by the existing management of the company (MBO) or by the ‘combined forces’ of the employees of a company (EBO) who can have the control in the respective company when acting as a group of individuals. Usually EBO and MBO are supported by one or more financial institutions. MEBO was established mainly in the Central and Eastern European countries, either as the only means of privatization of a company or, combined with other privatization methods. MEBO is facilitated with preferential policies for employees

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and management such as the lower purchasing price of the shares, payment for shares in instalments, higher dividends or preferential credits, etc. MEBO is favoured not only by employees and managers, but also by the governments as it offers a simpler and faster route than standard privatization methods. MEBO may reduce the resistance to the privatization process often seen from managers and workers, who may otherwise view it as a threat to their job security. This method creates ‘less valuation problems’ since the interest in the price of the privatized company that it is ‘sold’ is minimal, and the objective is not the creation of the maximum possible privatization revenue. MEBO has some negative effects, specifically on a company’s efficiency. Initially, MEBO privatization rarely eliminates the lack of funds of the companies due to the favourable payment agreements (sale price) mentioned above, which are provided by most of the eastern European countries’ legislation. Moreover, if the price of the company is trivial, the workers or managers risk very little. Consequently, the danger arises that they will not put much effort into the efficient operation of the company, returning the company to a loss-making position. The state however can minimize the effect of loss-making companies by imposing hard budget constraints and clear bankruptcy laws. Another danger of the MEBO method is that employees will support the undervaluation of the company in order to purchase it at a price significantly lower than its real value. If this happens, the method turns into wild privatization. Still another drawback is that under the employees’ ownership, the process of reducing the number of human resources of the company either as a form of cutting expenses or restructuring, is a matter not easily decided. Lastly, reinvestment of earnings is expected to suffer, since a common policy is to allocate the revenues to the labour compensation. 5) Leasing For some state assets, where privatization is not desirable or possible due to the high risks involved, privatization can take the form of leasing state property to individuals. As long as the lease or rent is market-determined, this will result in the productive exploitation of resources, as well as the creation of the preconditions for transforming these assets into private property (Marangos, 2004b, 588). 6) Asset privatization through liquidation For unsuccessful enterprises that cannot be restructured, and shares of companies that cannot be sold, the government can initiate liquidation proceedings and sell the physical assets owned by the state enterprise. This process would facilitate the reallocation of resources to the most productive activities (Marangos, 2004b, 588). 7) Initial public offering (IPO) This is the process of offering the initial shares of a company, private or state owned, for public sale. Potential investors are invited, through advertisements in

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the national press, to subscribe to the company’s shares. This method is used either when one or more shareholders wishes to sell their stake(s) in the company or when the company wants to raise capital by issuing equity or debt. In this privatization process, the major shareholder (the state) wishes to sell its holdings in a particular company. Under the IPO–PLUS scheme, private interests are allowed to establish special investment funds called Privatization Investment Funds (PIFs) in order to buy the shares of enterprises being privatized. The PIFs issue their own Public Participation Shares (PPS’s) to the public. These participation shares are issued at a uniform low price to ensure broad public participation. To initiate the programme, private interests form management companies. 8) Return to ‘real owners’ (restitution or re-privatization) The concept of this privatization method is to return the assets to the parties that owned them prior to communism. This may seem legitimate but needs consideration. First, there is the procedural ‘who owns what’ matter. At least one generation has passed since the communist regime was established, and the initial ownership may have been distributed to various parties, or the property may have been enriched by value added by the state, or even yet no real evidence of the former ownership status exists. This method is slow and complicated. If, as was the case, during the period of communism all citizens contributed equally to the state assets, how can one claim to be the sole owner of an asset on which ‘value’ was added during communism? Another issue that arises is that since the distribution of wealth was unequal before communism, the restitution may also be unequal today. A better way of returning wealth to the real owners is to offer the approximate value of the formerly state owned assets in the form of government funds, as was the case in Hungary. In countries where there was an actual return of assets, including Bulgaria, the process was very slow and provided the economy with little help (Estrin, 1995). The success of the restitution process depends on the existence of the past owners and of the appropriate documentation and political judgement. 9) Spontaneous privatization Here the managers or the state are authorized to issue stocks, transform a SOE into joint-stock company/ies, and sell them to anyone interested. By allowing managers in place or self-management councils, enterprise or workers councils to turn existing firms into corporations, these ‘autonomous’ firms were to become fully responsible for their own financial health. (UN, 1992, 231)

Usually the state requires the auditing of the firms’ assets, and at least one major investor, holding at least 20% of the shares. In the end, the company and the state share the profits. This method of privatization is the one that brings the fastest

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results but also leaves many ‘doors’ open for suspicious or even illegal exploitation, such as biased deals, and under-evaluation of assets. [The] insiders are likely to have a far better idea of the true value of the firm than the authorities, and are therefore likely to be able to obtain a very good price. Problems of this short led to a public outcry against so-called spontaneous privatisation, even in highly pragmatic Hungary which therefore introduced fairly strict state supervision of the privatisation process. (Estrin, 1994, 25)

10) The creation of small, privately owned firms (privatization from below) This is also a ‘method’ of privatization in the broader sense. In many countries this practice helped the re-creation of the private sector, especially in sectors like construction, local retailing, trade, and services, preferring trade rather than production. These firms are created from scratch or through reinstitution and other privatization methods. The emergence of small firms shows a development in entrepreneurship. Most of them have been relatively successful despite their vulnerability to heavy taxation, corruption and crime, and to the lack of infrastructure (Brada, 1996, 75–76). 11) ‘Wild privatization’ (Quiet, underground, illegal, mafiasation, hidden, or nomenklatura) This is a model rather than a method of privatization. It is the informal mobility of information that favours the people who have inside connections in agencies and firms, and allows them to obtain assets in informal and illegal ways, usually assisted by external capital. The parties that are favoured are state bureaucrats, managers, rulers of the former regime and, though very rarely, workers. In this way, the nomenklatura exchanges the political power they had during the regime with financial power, at the expense of both the state and the citizens, and continues the uneven distribution of wealth and the delay of social efficiency. Depending on the separate ‘informal’ situations, wild privatization has gathered many names through time: •

•

•

Spontaneous privatizations started as an effective indirect way of privatization in Hungary and Poland but, as mentioned above, its form nourished illegal actions from the part of the insiders (managers, workers, nomenklatura) in all the CEE countries and ended up as wild privatization. The corporatization procedure was very slow, and very modesty efficient. For example, in many cases in Bulgaria, it followed the path of spontaneous privatization and ended up as wild privatization. When the information about a public offering is restrained from the general public and becomes available only to potential investors selected by insiders (friends, relatives, investors willing to bribe government officials, etc.) with the criteria of personal profit, the privatization resulting from such a situation is characterized as ‘quiet’ or ‘underground’.

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A privatization is characterized as ‘illegal’ if the working rules of any procedure, such as auctions, are violated. For example, many companies sold shares to insiders before the enactment of the Privatization Law, when the Law on Incorporating Single-Owner Firms with State Property, strictly forbade it. Also, long after some auction procedures were invalidated by the Law of Commerce, many state assets continued to be sold according to those past procedures (Frydman et al., 1993, 34–35). Especially in the case of MEBO, privatization employees and managers may have inside information about the real value of the company, but allow the under-valuation of the company in order to benefit from the marginal value. This type of privatization is characterized as ‘hidden’. In times when the phenomenon of wild privatization is widely spread and reaches a peak or the criticism about wild privatization is exaggerated and strong, then the phenomenon can be called ‘mafiasation’. Since the power to get involved in the different types of wild privatization is usually a privilege of the nomenklatura, wild privatization is also sometimes called ‘nomenklatura privatization’.

2.4 Sequence and Speed of Privatization: The Dilemma of Restructuring before or after Privatization The speed of introduction and completion of a privatization plan is crucial in the privatization process. The concepts of gradualism and gradual speed in the privatization programme and the restructuring process, and the concept of shocktherapy or big-bang and the rapid speed in the privatization, are the two main approaches that can be used, either separately, or combined in different stages of the privatization process. As mentioned in a previous section, an alternative speed of privatization is the ‘stop and go’ or ‘trial and error’ speed or sequence of privatization. Accordingly, the government proceeds in the announcement of a concrete plan of privatization process. However, during the achievement of this plan and the successful closure of a few privatization deals, endogenous and exogenous factors prevent its completion, a provisional freeze may befall it, or even a provisional postponement of the remaining deals may occur due to the political cost of the proposed privatization deals (e.g. various reactions of citizens, increased unemployment rates, a delay in the appearance of the positive outcomes that results from the finalized deals, government inability to succeed in privatization deals, etc.). Furthermore, divergence in the privatization programme, or a short delay in the achievement of the deals (either through gradual or shock therapy) does not alter the speed of the process, changing it into the alternative of ‘stop and go’. Sometimes, and on purpose, the ultimate goal of the privatization plan is not announced. Finally, the difference between shock therapists and gradualists can also be seen from the following: the shock therapists believe that you cannot jump over a gorge in two jumps. The gradualists, however, believe that the passage to

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market economy is the ascension of a mountain where the top cannot be reached in one jump. Rapid privatization is favoured by some countries, but it has been criticized by theorists. Fischer et al. (2000, 1) mentioned that, ‘the faster is the speed of reforms, the quicker is the recovery and the higher is growth’. Lipton and Sachs (1990, 77) argued that a rapid transition to a market economy with a heavy emphasis on economic integration with Western Europe is needed. Fischer (1992, 227) has concluded that: small firms should be privatised by sale almost immediately … larger industrial firms should be corporatized as soon as possible … plans envisage the corporatization phase being completed within a year or two … the key to the long-run transformation of the formerly socialist economies may lie less in the privatisation of the very large industrial firms … than in the development of new firms and the growth of existing smaller firms … for that reason, rapid progress in other areas, such as the creation of a suitable legal environment, price decontrol … is as important to the development of a vibrant private sector as privatisation of large firms.

The characteristics of the ‘big bang’ sequence favour fast privatization techniques – including mass privatization plans, leaving the task of restructuring to the owners of the privatized firms. On the other hand, others have suggested that, especially in the case of privatization of state owned firms that the rushed moves have often led to the disorganization of valuable operational enterprises, thus assisting the drop of the output level (Fischer, 1992). Lipton et al. (1991, 231) argued that: In Eastern Europe, privatisation is a very difficult task, involving nothing less than the complete redefinition of property rights for literally thousands of enterprises … Advocates of rapid privatisation are typically confident that even if quick Privatisation initially leads to an inappropriate distribution of ownership with, for example, too diffuse ownership, or firms in the wrong hands, then the capital markets will encourage a reshuffling of ownership through takeovers, mergers and buy-outs so that there is a proper matching of owners and firms …

Regarding the speed of privatization from an empirical point of view, we can safety infer that after the first decade of a transition process, privatization should be accomplished in a more gradual manner, and it should be preceded by enterprise restructuring along with the creation of an adequate institutional framework (World Economic Outlook, 2000). On the same line, Laban and Wolf (1993) argue that a more gradual strategy is beneficial, because a big-bang approach involves significant financial risks for the government. Threshold limits with regard to the level of transformation costs that should not exceed a certain threshold level (indicated by huge output decline and a high rate of unemployment) should also be

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considered. Spicer et al. (2000) argue that rapid mass privatization destroys the old system of central planning but does not build the institutional settings that facilitate the restructuring in the post-privatization environment. They advocate that by implementing a gradual reform process, new institutions will evolve gradually from the economic and social relations intrinsic to the initial post-communist economic environment. Rosser and Rosser (2001) maintain that gradual privatization is more appropriate, believing that an increase in the speed of privatization leads to a rise in the level of corruption, and therefore rapid privatization may have negative outcomes such as insider takeovers and corrupt asset stripping. Castanheira and Roland (2000) researched the optimal speed of transition from a state-owned to a private market economy, with respect to the closure or restructuring of state-owned enterprises (SOEs). By applying a benchmark general equilibrium model, the authors infer that if the closure of the SOEs is too slow relative to the optimal path, the resources left to new enterprises will be limited and the speed of transition will be reduced because of the smaller investments made. Only if SOEs are subject to hard budget constraints will the optimal speed of transition will be achieved. On the other hand, if there is an excessive rate of closure of inefficient SOEs (a case that happens early in the transition process), the speed of transition will be reduced. This means that policies aiming at accelerating the speed of sectoral reallocation might have negative outcomes. A more gradual approach is also upheld by Rider (1994), who asserts that an accelerated process will favour established interest groups (with their associated political links) and will encourage the establishment of monopolies. As mentioned previously, in the sequence of the restructuring and privatization process, first of all, property rights should be clear, and governments should tackle the restitution problem. Furthermore, clear and market-friendly laws that clearly define individual rights and responsibilities and that embody market-friendly economic policies should be introduced and enforced without discrimination. Constant changes in the legal framework should be avoided. Moreover, sound institutions have to be introduced and monopolistic markets should be abolished. Formal institutions that include judges, arbitrators, prosecutors and court functionaries should be established, so that laws become effective. Political commitment to transparent privatization outcomes should exist; combined with the elimination of bureaucratic systems and more incentives should be given for new companies to be established in the country without government interference. Finally, changes in the financial sector, such as the introduction of a stock exchange market, and investment and pension funds, along with the introduction of bankruptcy rules and hard budget constraints are also necessary. Goodhue et al. (1998) argue that during the transition process, market liberalization is accompanied by market uncertainty. There is a welfare trade-off related to the privatization policy in transition economies. Goodhue et al. highlight the role of the learning process and argue that the greater the degree of initial uncertainty about market conditions, the more gradual the privatization should

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be. It is suggested that if policy makers are more interested in short-run results, a policy of a less complete privatization will be optimal, because active privatization will result in a rise of short-run prices and production volatility. Overall welfare will decline. However, if the policy makers are concerned with strategic, longterm results, the policy of full privatization will be optimal, as the increase in private ownership will reduce the misallocation effect of the resources and welfare will rise. Moreover, the sequence and the path of a privatization plan also depends on speed. Thus, the shock therapists are in favour of the immediate privatization of state-owned enterprises through restitution, liquidation, auctions and free distribution of vouchers. Conversely, neoclassical gradualists favour a slower pace of privatization through liquidation and auctions (Marangos, 2004b, 589). However, when speed and sequence are considered, a decisive question that arises is whether a country should privatize before or after restructuring or should both proceed simultaneously. Another question is whether there is a need for sequencing in privatization and if there is, what principles should underline it. Since the question of whether privatization should preside over or follow restructuring emerges, the definition of restructuring is needed. Once again the definition of, restructuring is … a multidimensional, encompassing: ‘reactive’ policies brought about by the hardening of firms’ budget constrains (e.g. labour-shedding, wage reductions, plant closures); strategic aspects, including export reorientation, changes in the mix of products and changes in management structures; and ‘deeper restructuring’, generally involving substantial new investment, that can deliver large improvements in enterprise performance and growth over the long run. (EBRD Transition Report, 1995, 128)

Restructuring may also be viewed from a macroeconomic perspective. As companies restructure by adopting policies and strategies that increase their efficiency, governments restructure by adopting laws, regulations and policies in the same direction, in hope of increasing the efficiency of the state economy. In the macroeconomic sense, the adaptation of companies to new market standards is also restructuring (Hunya, 1997, 275). There are three kinds of restructuring, the physical, the organizational and the financial. They may be used separately or in combination, depending on the needs of each company. Physical restructuring involves the updating of the physical elements of a company, such as the introduction of new high technology equipment, and generally changes in the production facilities, like shifts to another production site. Organizational restructuring involves the improvement of the management in all functions of the company (such as marketing, human resources, etc.), but also the improvement in strategic decisions concerning the operation of the company, such as potential joint ventures or other forms of co-operations. Financial restructuring refers to the rearrangement of capital sources, in a way that

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best suits the needs of the firm. This kind of restructuring includes, in the case of state owned-firms in countries in transition, the termination of state subsidies, the restructuring of the internal and external debt, the exploration of other sources of capital, and generally the establishment of financial autonomy. If the state decides to undertake restructuring prior to the privatization of a firm, it needs to spend additional capital, time and effort on the company, in return for a more successful presentation of the privatization deal as well as higher revenue from the sale. On the other hand, if it avoids restructuring, the state achieves quick privatization and is relieved of the burden of financing the loss-making company. Restructuring before privatization holds another, hidden, drawback. The managers and employees of the company under restructuring procedures will be ill-motivated to participate in the restructuring given that, in the long run, they may lose their position in the company (because of restructuring). What governments may fail to consider is that the restructuring they are intent on applying on may be far from what the potential investors expect. A close inspection of the company should determine the path which is more profitable for the state. Sometimes the government uses restructuring as an excuse to delay privatization in order to avoid the political burden of mass dismissals of employees and generally to stall hard restructuring methods by the new owners. A long restructuring period leaves space for corruption and increases the possibilities that the nomenklatura will profit by wild privatization. All methods of privatization need different implementation periods and may be applied before or after the restructuring of a firm. Slow privatization: Most of the state companies will be restructured and sold, only after the domestic savings are adequate enough for purchasing the larger percentage of the state-owned assets, or when the host governments believe that the offers from foreigners are large and lucrative enough. Usually there is a delay for the sake of increased revenues from the sale or due to the search for a strong strategic investor, who will transfer know-how and other positive spillovers into the host economy. Rapid privatization: The country aims to privatize all companies either through inviting foreign direct investments (FDIs), or through vouchers, before they are restructured. This requires at least 2–4 years. Mixed privatization: Selected privatization methods for selected state assets that aim to quickly privatize 25–40% of the total state assets in three years, and 90% of the total state assets in seven to ten years. The choice of method depends upon the specific characteristics of each country. Most commonly, countries use combinations of different methods in order to achieve the highest possible efficiency in the privatization procedure. Kornai (1995, 34) commenting on the selection of the mass or voucher privatization method, and the manager’s or employee’s buyout, the return of

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property, compensations, solution of the restitution problem, etc., argued that all the above may be used for political reasons (to collect votes for the coming election by creating a favourable image for the party in power).

2.5 Problems during the Completion of a Privatization Deal: Reasons for the Delay of Privatization The obstacles for privatization are generated by the considerations each government has to make before and during the privatization process. The issues a government considers in order to efficiently start the privatization process are: • • • • •

The selection of the companies to be privatized in different time periods (the selection of sectors). The sequence and different paths (e.g. small enterprises first, or small and medium enterprises, or large companies at the end, etc.). The specific methods to be used for each company, the use (or not) of the mass privatization method. The speed of the whole privatization process (to restructure the companies before privatization or to pass on the task to the new owners). The selection of the percentage the state will maintain, and the time limit for the abolition of all monopolies.

Certain obstacles to the privatization process should be considered so that governments can take immediate action to resolve them and maximize their positive effects: •

• •

• •

The lack of legal distinction of property rights should be dissolved by the introduction of the appropriate legal framework. The clearance of the rights and obligations of the new owners of a formerly state-owned company, in terms of employ treatment, the debt of the company, and the environmental policies that will be imposed on them, should be considered and resolved. The lack of financial intermediaries and a stock exchange should also be addressed by institutional reforms. The claim of property rights by former owners (the restitution problem) must be fairly and equally resolved in order that such problems can be avoided. The uncertainty and economic instability that discourages foreign investors should be alleviated and show signs of improvement. The lack of information (lost documents, weak/inappropriate accounting standards) regarding the companies that are offered for privatization, which is due to misleading data from the former style of management and different accounting rules and techniques, need to be resolved by a proper evaluation of past performance together with the value of the assets.

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• • • • •

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The mentality of the citizens that may be against privatization should be dealt with, through informative campaigns by the state. The lack of private savings that prohibits citizens from directly participating in the privatization process, may force the government to introduce a specific privatization method (e.g. mass privatization) ‘to correct’ such a situation. The power of the nomenklatura needs to be decreased and the corruption during the privatization deals minimized. The lack of experience in the choice of appropriate privatization methods and processes in general has to be overcome by experts. Conflicts of interests among politically strong parties need to be avoided. Lack of transparency, corruption, briberies and bureaucracy must be overcome and abolished. The postponement of privatization in hopes of a higher return proved to be an illusion, because the debt that the government undertook during the time of the restructuring of SOEs was not covered by the alleged higher privatization price, not to mention that during the years of the ‘restructuring’, the country suffered great economic instability, accumulation of debt, and an enlarged deficit. It also lacked the revenues to cover its deficits. The complex criteria for selecting buyers created in many cases a process corrupted by the insiders and the nomenklatura and this should be avoided. The implementation of methods such as MEBO, imperfectly supervised, allowed insiders and the nomenklatura to acquire state property through informal ways and this should be avoided in the future. The constant changes of the laws and their inadequate enforcement fail to provide investors with any measure of safety. A feature that needs to be corrected. Some SOEs had large accumulated debts and the slow restructuring of them by the governments led to the delay in their privatization them. Isolation of the debt, bankruptcy or/and quick restructuring could be a solution.

2.6 Conclusions Private property is the foundation of market economies. Without private ownership the market cannot exist, and vice versa. The privatization of state property aims (a) to guarantee the efficient use of resources and eliminate shortages; (b) to provide revenues to the government; (c) to stimulate the restructuring process; and (d) to entice foreign investors to become active participants. At the same time, privatization has its drawbacks; the creation of private sector monopolies, and increased unemployment. Moreover, it takes less heed of social costs. The speed and sequence of the introduction and completion of a privatization plan are crucial in the privatization process. A decisive question that arises is

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whether a country should privatize before or after restructuring or should it proceed in both simultaneously (Bitzenis, 2003a). To this dilemma there is no clear answer. The choice of privatization method and privatization procedure depends upon the specific characteristics of the country (countries usually use combinations of different methods in order to achieve efficiency in the privatization process). The privatization methods are not a major concern in Western countries, since there has never been an urgent need for such actions. The typical method used was auctions, aiming for the highest possible return, either direct or through stock markets. The characteristic that differentiates the privatization in former communist countries from that in Western economies is the lack of significant private savings of the citizens in the former communist countries. Moreover, the trivial private savings that were heavily devaluated by inflation were not enough to purchase stocks in the sectors involving large enterprises. If the state held open, westernstyle auctions, the bulk of the assets would be purchased by non-nationals only. Central and Eastern European countries have used several methods in order to resolve these problems in the optimum way for both state and citizens. Needless to say, most of the methods did not bring about the expected results, and the privatization process has proven to be an extremely complicated and difficult task for the transition countries (Estrin, 1995, 8). Thus, the preferred method of privatization should depend on specific characteristics of the country in question, and on value judgments with regard to equity, sequence, and speed of privatization.

Chapter 3

Foreign Direct Investment Theory

3.1 Foreign Involvement and Foreign Direct Investment as an Entry Mode The topic of Foreign Direct Investment (FDI) has been thoroughly researched by academics and organizations alike. The literature originally sought to understand how organizations in developed countries made investment decisions in other developed markets. Gradually, however, as these opportunities dried up, the literature focus shifted towards opportunities provided in developing markets (e.g. South America, South-East Asia, Central and East Europe) as more and more companies seek greater returns on their investments due to expanded growth potentials in these markets. The commonly accepted goal of a multinational enterprise (MNE) or a multinational corporation (MNC) or a transnational corporation (TNC) is to maximise shareholder’s wealth. Thus, firms enact strategies in order to improve cash flow and enhance shareholder’s wealth. The company has a target which is to increase its market share and, therefore, it proceeds to various local or foreign investments: (a) if the foreign market ‘offers’ better opportunities (market size, liberalized economy, market prospects, etc.); (b) if the home market (local market, company’s market of origin) is over-saturated; or (c) due to globalization and competition pressures, in order to increase its sales and profits. Thus, the company and its management must decide when and which market(s) to enter and which entry modes to implement. All the possible obstacles that the enterprise will face in the foreign market must be considered and the various incentives offered by the host country (recipient country) must also be taken into account. The choice of a market entry strategy is a critical part of international business strategy. Companies employ special modes to cope with international markets that differ in the control that the entrant attains over the local operations and in the resources required for the entry. Firms entering a foreign market can choose between an array of possible organizational modes. Foreign involvement looks at different lucrative ways of expanding operations, or at different capital generating activities in a foreign country. There are five general entry modes in the economic activities of a foreign country. The first one is trading, either importing from or exporting to (directly or indirectly) a foreign country. Two other ways are foreign direct investment (FDI) and indirect (portfolio) investments. Portfolio investment is merely the transfer of money capital that allows the investor to participate in the earnings of a company.

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Foreign Involvement Using Entry Modes

A. Exporting

A1. Direct A2. Indirect A3. Intra-company transfers

C. Portfolio Investment

(indirect investment 10% of shares B1. Acquisition B1.1 Acquisition (minority stake, >10%, 50.01%) B1.3 Acquisition (wholly owned subsidiary, 100%) B2. Joint Venture B2.1 Joint Venture with foreign partners B2.2 Joint Venture with foreign and local partners B2.3 Contractual joint ventures B3. Greenfield FDI B3.1 Greenfield FDI (wholly owned subsidiary) B3.2 Greenfield FDI (joint venture) B4. Brownfield FDI B4.1 Brownfield FDI (acquisition + extensive incorporation of changes) B4.2 Brownfield FDI (wholly owned subsidiary) B4.3 Brownfield FDI (joint venture) B5. Privatization B5.1 Privatization (acquisition of a minority stake >10%, 50.01%) B5.3 Privatization (acquisition of a 100% stake, wholly owned subsidiary) B5.4 Privatization (joint venture acquisition) B6. Strategic alliance (Joint Venture) B7. Representative office B7.1 Representative office (limited invested funds) B7.2 Representative office (joint venture) B7.3 Representative office (wholly owned) B8. Subsidiary (Branch) B8.1 Subsidiary (Branch) (wholly owned) B8.2 Subsidiary (Branch) (joint venture) B9. Merger & Acquisition B9.1 Merger & Acquisition (wholly owned) B9.2 Merger & Acquisition (joint venture) B10. Fade out or planned divestment agreement

Figure 3.1  Foreign involvement using entry modes Source: Bitzenis, 2008, 198 (revised version).

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Foreign Direct Investment is differentiated due to the intent of the investor. In portfolio investment the goal is short-term, focused on the quick increase in the money capital of the investor with no intention of interfering in ownership rights, management and voting equity. In direct investment, the primary goal is the beneficial influence (enlargement of market share, elimination of competition, strategic alliance, etc.) of the investment to the investor-company, which should eventually lead to increased profits. Another difference between the two is the percentage of the financial capital involvement. What is considered as FDI is different throughout the world due to different regulations concerning the percentage of ownership in the operations in question. However, there is a commonly accepted definition of FDI as shown in Figure 3.1. The most common ways of undertaking an FDI project are: 1) Wholly owned subsidiary 100% ownership of the assets by a single company. This involves the internal transfer of capital, technology, know-how and rights to production from the parent firm to the subsidiary and full ownership of the subsidiary by the parent firm. 2) Joint ventures A commitment to a long period of capital funding, facilities and services, by two or more legally separate interests to an enterprise involving doing business together, the sharing of profits, the sharing of business risk and losses, and longevity of cooperation. A special kind of joint venture is the contractual joint ventures where a local and a foreign firm form a joint venture (but without creating a separate entity), of limited time (long term or short term), in order to conclude a certain project. 3) Greenfield investment The establishment of an entirely new entity; including the building of production facilities, the creation of an organizational structure, distribution channels, human resources, etc. 4) Brownfield investment The acquisition of an existing establishment; followed by the development of entirely new production facilities (Estrin et al., 1997, 23). 5) Acquisition of an existing company Direct acquisition or privatization of a state-owned company (SOE) or acquisitionmajority holding or even an acquisition-stake. 6) Merger and acquisition (M&A) The merger of two or more companies. Usually one being larger than the other, having as a main purpose the dismantlement and restructuring of the small company(ies). The banking sector is a pioneer in M&A. Major banks or enterprises

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merge in order to survive in a time of high levels of information, strong competition and pressures from global integration and globalization (Bitzenis, 2004a). The fourth way of foreign involvement is employed by MNEs when they perceive a strong need to complement and reinforce their knowledge through collaboration with other MNEs, in order to cope with pressures of intense global competition and increasingly complex and rapid technological development. Collaboration can be achieved through participation in a strategic alliance. An alliance is a weaker form of contractual agreement or even minority shareholding between two parent companies and usually falls short of the formation of a separate subsidiary. The fifth way of foreign involvement concerns agreements that do not involve money transfer on the part of the foreign partner. Instead, the foreign partner contributes its knowledge and experience around the investment project in return for a reward, either financial or other (strategic). Such involvements include: Licensing agreements, Franchising, Management contracts and Turnkey projects. In the latter, a foreign company starts the facilities from scratch in the host country, and the company operates for a short period of time, after which it hands over the operation to another local or foreign company. A management contract may follow if necessary. It involves transfer of know-how, training the local workers and the managerial staff of the local company (Buckley and Casson, 1985). The world is becoming less domestically oriented as companies aim to increase profits by growing beyond their own borders. However, empirically they do this mainly in two entry ways: exports and/or FDI (Rugman, 2003). Thus, the choice of the appropriate entry mode is a key strategic decision for international business. A ‘greenfield investment’ gives investors the opportunity to create an entirely new organization, specific to their own requirements. However, this is a gradual entry mode. On the other hand, an acquisition facilitates a quick entry, but the acquired company may require restructuring. Sometimes this restructuring is so extensive in emerging markets, that the new operation resembles a greenfield investment. This investment can be called a brownfield investment since it is a hybrid entry mode (Meyer et al., 2001, 575). Each company has a different way of fully exploiting the potential of an investment besides the usual direct contact with the foreign country or the longterm involvement with foreign operations: (a) Offshore company: this is a method rather than a way of undertaking FDI. The parent firm creates the ‘offshore’ company in a country where certain aspects about the relationship between MNEs and the government, like taxation, are favourable, in order to undertake all FDI activities presenting as parent company the offshore company from a country with lower taxation rates. These countries are sometimes referred to as tax-heavens (e.g. Cyprus, Bermuda ($7.7 billion FDI outward stock), Cayman Islands ($20 billion FDI outward stock), and the Virgin Islands ($23.7 billion FDI outward stock)); (b) A Fade-out or planned divestment agreement may also be applied in all kinds of FDI agreements that involve a local partner. The agreement states that

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the foreign company agrees to liquidate the investment by selling its stakes after a certain period of time. 3.1.1 Defining FDI According to the Balance of Payment Manual (IMF, 1993), Direct investment is a category of international investment made by a resident entity in one economy [home country] (direct investor) with the objective of establishing a lasting interest in an enterprise resident in an economy [host country] other than that of the investor (direct investment enterprise). ‘Lasting interest’ implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated.

The IMF’s definition emphasizes ‘a lasting interest’, ‘a significant degree of influence’ of the investor over the company outside the home country (Brewer, 1994, 117). ‘FDI is defined as investment in equity to influence management operations in the partner company’ (Meyer, 1998, 125). ‘There are many different operational definitions of FDI, but all aim to encompass the desire of a home country firm to obtain and manage an asset in a host country’ (Barrell et al., 1997, 64). ‘A Foreign Direct Investment is the amount invested by residents of a country in a foreign enterprise over which they have effective control’ (Ragazzi, 1973, 471). Some definitions use ‘lasting interest’ and ‘significant amount of influence’ to define FDI. This is more accurate in explaining the current status of several FDIs, but it remains vague as it does not specify the target of the ‘influence’. ‘Influence management operations’ is more accurate, but again insufficient. In fact, in order to clarify this issue, one must first specify the amount of control the investing company needs over the company that receives the investment. This differs according to what the investing company expects from the investment. Through time, many theorists studied the concept of investing abroad, and foreign direct investment in particular. What FDI is cannot be defined in a fourline definition, since it involves much more than a simple money transaction which aims at profit. The complications begin with the very first step economists might take; measuring and comparing FDI flows among several countries. This is because each country may have different standards for a foreign investment to be considered direct. The IMF/OECD (1999) has recommended that the minimum equity stake for an investment to qualify as direct should be 10%. The international manuals recommend that this 10% or more of the ordinary shares or voting power (for an incorporated enterprise) or the equivalent (for an unincorporated enterprise) establishes a direct investment relationship; the so-called ‘10% rule’.

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The differences though, among countries are distinct. For example in the USA, Canada and Australia the minimum is 10%, in France and Germany 20%, and in New Zealand 25%. It is obvious that any comparison among the state records of these countries on FDI would be unequal (Dunning, 1993, 12). 3.2 Difficulties in Defining Foreign Direct Investment: Statistical Inaccuracies during the Transition Period Despite the difficulties in defining FDI, there are generally accepted characteristics of FDI that coincide with the following definitions taken from several sources. The issue of control and influence is important in defining FDI, but does need further clarification. The fact remains that, depending on the host country, when an entrepreneur or a company acquires more than 10% or 20% or even 25% of a foreign company, it is considered FDI. But does such a small percentage ensure control for the investor? The ownership rights issue over a company is a complicated subject. The individual who has control over the decisions affecting the company’s decision making process is determined by the complex workings and characteristics of each company; as such these vary greatly enough to preclude assumptions and generalizations. Sometimes an individual may have management control owning 10% of the company (if, for example, the given company’s shares are divided among many shareholders through the stock market); or have no management control even if he/she owns more than 50% of the company; or have both management control and over 50% of the shares and he/she and still not be able to make important decisions (if the agreement of all parties dictates that in order for a decision to be valid, two thirds of the owners must agree). Thus, one must keep in mind that not all investments over 10% or 25% aim for, and lead to, control. As mentioned above, not all countries use the 10% threshold for defining FDI. Although the 10% criterion is specified for defining direct investment in the balance of payments, some countries choose other criteria. For example, data on inward FDI in China is based on information collected from foreign-funded enterprises, which are resident enterprises with an aggregate of 25% or more of their equity funded by non-residents. In Malaysia, FDI data is collected through a survey of a limited number of companies, and foreign controlled companies are those in which non-residents hold more than 50% of the equity capital. Another rule to the% threshold is applied by Portugal. According to this, when the total foreign ownership in a resident enterprise is greater than a certain percentage, the transactions between the enterprise and its foreign investors are recorded as FDI, even though no single investor owns 10% or more of the enterprise. The threshold of total foreign ownership used in Portugal is 20% (IMF/OECD, 1999). Another difficulty is how to specify the components included in FDI measurement. The following components should be used in FDI when reporting to the IMF:

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Equity capital: the value of the initial investment. Reinvested earnings: all earnings of the affiliate company that are reinvested on the initial investment. Other capital: the transfer pricing (this is really difficult to be measured) between the parent company and the affiliate (short and long-term capital).

A problem arises because many countries tend not to record at least one if not two of those components. Brewer (1994, 117) argued that ‘The reinvested earnings component of FDI is particularly problematic. It is the most difficult component to measure because the data are not collected from foreign exchange records, but are based on surveys of the firm’. Consequently, this component is left out in many national FDI records. Another problem that often appears is the failure of many countries to record cross-border real estate transactions. A significant number of countries exclude all cross-border purchases and sales of real estate in reporting FDI flows, while many other countries exclude ‘non-commercial’ real estate transactions from the statistics. A further problem appears when incremental rather than accumulated ownership is used to define FDI. For example, if an investor purchases 5% of the shares of an enterprise as a portfolio investment, and subsequently acquires another 7% of the shares of the enterprise, only the 7% is recorded as direct investment. In other words, shares previously classified as portfolio investment are not reclassified in the balance of payments (BOP) as an FDI when the 10% threshold is reached. Moving now to the sources from which one may find data on FDI, it can be said that these are numerous. The primary sources of information are the company itself and the government of the home and the host country. The secondary sources are the international and regional economic agents. Some of them are the United Nations on Trade and Development (UNCTAD), the United Nations (UN), International Monetary Fund (IMF), the Organisation for Economic Cooperation and Development (OECD), the European Bank for Reconstruction and Development (EBRD), The Economist Intelligence Unit (EIU), the WIIW (Vienna Institute), the World Bank, EUROSTAT, the United Nations Economic Commission for Europe (UNECE) and its Economic Analysis Division (EAD), the industrial and commercial trade associations and academic scholars. In general, one should be careful when using statistical data on FDI because of several inaccuracies. Dunning (1993) has presented some of them: •

•

The book value of the capital assets of the MNE’s is noticeably underestimated compared to the replacement value estimated with current market price. The way home governments deal with foreign currency translation adjustments, regarding outward FDI, differs from country to country, so the affiliated firm’s capital gains and losses are either included or not in the parent firm’s reports.

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• • •

• •

• •

The accounting techniques concerning depreciation are different from country to country. Some countries base the data on FDI intentions (passive and active), while others only on those in progress (active only). The collection of data by governments is derived in different ways and at different time periods. There are also many variations of the quality and accuracy of the research, depending on the level of confidentiality and how willing the firms are to produce all the data the government asks for. Because of cross-border transfer pricing, some of the economic data of a company may be inaccurate. When investigating the country of origin of an FDI, we have biased results if the investment is contacted through an offshore company, which is directed by a third country firm. Companies may overestimate their capital assets in order to be able to repatriate more profits and to avoid double taxation. Many of the entrepreneurs choose not to take the legal way of transferring/ repatriating money, and move great quantities illegally through borders. This is easier if the countries are neighbours and the investors are small and medium enterprises (SMEs). This results in an underestimation of the total FDI inflows, since money capital is invested in a foreign country without being declared anywhere.

Sometimes the deviations are so significant that the FDI outwards (outflows) of country A to country B are markedly different when measured as inwards (inflows) for a country B received from a country A. Such deviations also exist when the data is derived from two different sources regarding the same variable. According to the Polish research department of PAIZ (until December 2002 ), Poland had received $65115 million, while at the same time (until the end of 2002) according to UNECE, Poland had received less than $40 billion (see Table 3.1). Table 3.1  FDI inflows in Poland (in US$ millions) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 10

117

284

580

Total

542 1132 2768 3077 5130 6474 8293 6995 4119 $39521m

Source: UNECE, 2004 .

As is obvious, global capital flows can be examined by looking either at capital outflows (flows coming from the source home country – outward FDI) or at capital inflows (flows received by the recipient host country – inward FDI), which

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theoretically should be equal in magnitude. In practice, world capital inflows tend to be larger than world capital outflows. Since there is little anyone can do about those inaccuracies, a researcher should always consider that all estimates are only as good as the data on which they are based.

3.3 Major Developers of Foreign Direct Investment Theory The expansion of a company’s operations across the same value chain of production in the same or in a differentiated sector is referred to as horizontal integration. It is a strategy used by a company that seeks to sell a ‘similar’ product in various markets (local or foreign) by creating subsidiary companies. The purpose of horizontal integration is mainly to expand the company’s market share, eliminate competition, or if applied to a different sector, to employ the company’s expertise in a specific level of production (raw materials supply, production, distribution channels, etc.) in order to exploit an opportunity. Vertical integration is the acquisition of control of other stages of a product’s passage from being raw materials to becoming available for retail sale. Vertically integrated companies share a common owner and produce different but integrated products or services. For example, a producer of a certain product expands in retail (forward vertical integration) or a car producer, expands the production of its inputs (e.g. tyres) (backward vertical integration). At the end, balanced vertical integration occurs when a company decides to produce, supply itself with inputs, and distribute its products. All the above can be done either within a country or internationally. As in the case of horizontal expansion, the company will search for the most cost effective site that simultaneously fulfils the quality requirements. The new location may offer easier access to production factors, such as physical resources or skilled labour, if the integration is backward (or limited competition suitable for a new company for both backward and forward integration). 3.3.1 FDI Theories Based on Market Imperfections Through his early analysis, Coase (1937), was the first to recognize that the market is imperfect although he did not put it in exactly these words. Coase (1937; 1960) suggested that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts, and managing organizations. Coase also added the marketing costs such as the price mechanism costs (information, knowledge, searching or uncertainty costs), the costs of negotiating or costs of contracting, the bargaining, decision, policing or enforcement costs, and the costs of organizing – which subsequently became known as transaction costs. Today, transaction cost economics are used to explain among other things: vertical integration, outsourcing and corporate governance. Coase’s theory discusses the

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costs of market transactions and how the internal organization of a firm may help avoid them. The minimization of these costs is an incentive for the firm to try an approach of vertical integration, so as to control the intermediate products. Vertical integration is efficient only if the costs mentioned above are very high, or if there is no market for the intermediate product that the firm requires for the final product. Coase (1960) also argued that the power of analysis may be enhanced if it is carried out in terms of rights to use goods and factors of production, instead of the goods and factors themselves. These rights can be called property rights in economic analysis. Coase concluded that there are transaction costs for preparing, entering into and monitoring the execution of all kinds of contracts, as well as costs for implementing allocative measures within firms in a corresponding way. A large amount of legislation would serve no material purpose if these transaction costs were zero. Coase also concluded that transaction costs are never zero, which indeed explains the institutional structure of the economy, including variations in contract forms and many kinds of legislation. In cases where transaction costs absolutely prevent a contract, there is a tendency for other institutional arrangements to arise, e.g. a firm or an amended legislation. Hymer’s work (1960; 1968; 1970) is best known for its application of an industrial organizational approach to the theory of foreign production. In order for a firm to undertake an FDI project, it relies on certain advantages, which may be called monopolistic, exclusive, or ownership advantages, such as monopoly control of raw materials, financial or marketing advantages, managerial and research skills, etc. He argued that FDI involvement was merely a geographic expansion that exploited the power coming from the use of the above advantages, and pointed out that a MNE is a creature of market imperfections. He over-emphasized the market power advantages of a MNE and mentioned that a MNE transfers its assets abroad in order to minimize risks and to achieve monopolistic power. Hymer (1960) distinguishes FDI from portfolio investment in terms of the presence of control in the former case, and its absence in the latter. Hymer showed that FDI can not be explained by the interest differential theory (as portfolio investment) since, if FDI is motivated by higher interest rates abroad, the practice of borrowing substantially abroad seems inconsistent. Hymer also explicitly distinguishes between different foreign entry modes such as joint ventures, licensing, tacit collusion, and FDI. He also concluded that if markets were perfect and if a firm could buy everything at a fixed price determined by competition, then the incentive for direct investment would be weak. Finally, he thought (as Coase did) that market imperfections can also be exploited through vertical integration (Hymer 1968). Williamson (1973; 1992) suggested that there are market failure reasons which favour the internalization of a firm’s activities in the field of market operation. It can be argued that these are also reasons for FDI. He created a framework that leads to the advantages of the hierarchical organization instead of markets, and mentioned the contractual costs, which may be considered as transaction costs.

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These are: information costs (the cost of informing traders), bargaining costs (the costs of reducing – bargaining) and enforcement costs (the costs of enforcing the terms of trade). He added that transaction costs would be zero if individuals were honest and possessed unbounded intelligence. Thus, Williamson’ types of limitations exist in reality as transaction costs. All individuals are unable to absorb all available sources information in order to facilitate decision-making. Thus, there is a cost in the acquisition and absorption of information. According to Williamson, the factors mentioned above are the reasons why a company may internalize through vertical integration which may happen through FDI. Williamson’s contribution to FDI theory also introduced the importance of managerial skills in the operation of a firm and the importance of internal organizational structure in the efficiency of a firm. In a later article – based on earlier studies by Coase – Williamson (1992) examined the value of transaction costs in the cost-efficient operation of a firm and how they work as incentives for internalization. This study, despite its microeconomic nature, constituted the base for many contemporary theories of FDI. 3.3.2 FDI Theories Based on a Company’s Strategic Behaviour Aharoni (1966) initiated the behavioural explanation of FDI, especially the initial decision of where to locate FDI. He mentioned the reasons why FDI is more complex and risky than investing in a home country. Among others, he also directed attention to the lack of knowledge concerning the host country regarding the level of political, business and financial risk. The behavioural approach has been extended and improved by internalisation theory which explains not only the initial FDI decision, but also the reinvestment decisions. Kogut (1985) also treats FDI as a sequential process that leads to the creation of MNEs. The experience of managing diversified activities in different locations and the spreading of environmental risk gives the company a significant edge, when competing in either local or international markets. Conversely, the Capital Arbitrage Theory assumes that there is a movement of equity capital from countries where returns are low to countries where they are higher, in order that profit is generated from the difference (arbitrage) among returns. Aliber (1970) went on to update this theory and mentioned that there are substantial differences among countries in terms of their nominal and real interest rates. Because nominal interest rate differentials are poor forecasts of future changes in exchange rates, a wedge is introduced between returns on similar securities denominated in different currencies. In essence, Aliber treats exchange rates as an incentive for MNEs if favourable and as a barrier if unfavourable in regard to the MNE’s home and host country. Graham (1978) hypothesized that an MNE that found its home territory invaded by a foreign MNE would retaliate by penetrating the invader’s home turf. A firm may even predict the invasion by a significant competitor and take the first step itself.

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Knickerbocker (1973) argues that in oligopolistic industries which are characterized by high seller concentration, one reason for FDI is the tendency of firms to ‘match their rivals move to move’. The firm that takes the first step in a new market exploiting any business opportunities draws the attention of similar firms that can exploit the same opportunities (first mover, be the leader, follow the leader, prevent the leader). Finally, Kindleberger (1966) argued that a significant part of the decision to undertake FDI is based on the advantage of knowledge and the existence of high economies of scale that enable the MNE to operate the subsidiary more efficiently and with less cost that any local firm. Before undertaking FDI, a company analyses all the alternatives (exports, licensing, FDI) and decides on the optimal solution. 3.3.3 FDI Theories Based on Internalization Dunning (1973; 1981a; 1981b; 1988; 1993; 1995; 1996 with Narula; 2000) was the first to provide a more comprehensive analysis based on ownership, location, and the advantages of internalization (OLI). Dunning’s Eclectic Theory provides some answers for the geographic distribution of FDI by analysing location factors. His taxonomy of location factors emphasizes possession of raw materials, labour costs, government incentives, and the servicing of local markets. According to Dunning, the level of FDI of a firm is governed by three sets of factors; namely ownership (firm-specific) advantages (O), location (country-specific) advantages (L) and internalisation advantages (I). The advantages discussed are different in separate countries, industries, and firms and in different time periods. The optimal use of these advantages may lead a firm to FDI. Rugman (1980; 1982) developed a general theory that studies the FDI activities of the MNEs using the concept of internalization to link various theories of FDI motivation. Based on the market imperfections theory and several early theories about internalization, Rugman incorporated many of those FDI theories in one general theory of internalization. The first step towards accepting the absence of free trade was the realization that imperfections exist in all markets (goods and factor markets, capital markets, etc.), which make arm’s length transactions a utopia. Market imperfections may relate to various trade barriers, the asymmetry of information and technology, the transactions costs (real and nominal), while other factors emerge when trade activities have aims that run in parallel to smooth and efficient trade (making profits for governments, firms and individuals). These market imperfections suggest that there is no absolutely free trade. Instead, transactions are affected by external forces as well as the maximum benefit of the parties involved. What Rugman and previous researchers suggest is that companies turn to internalization in order to bypass imperfections by developing an internal market and thus achieve maximum efficiency and profits in their operations. When internalization is conducted outside national borders, then an MNE is created.

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According to Rugman, if the world were characterized by a model of free trade, there would be no need for MNE’s. Finally, Buckley and Casson (1976; 1981; 1985; 1991) discussed the internalization process as a response to market imperfections. The two theorists added several variables to the internalization theory such as the management decision making, the cultural influence in management decisions, innovation, entrepreneurship, and arbitrage. Buckley and Casson (1985; 1991) discussed the internalization process as a response to market imperfection. The two theorists added several variables to internalization theory: •

•

•

•

•

Management decision-making has a significant influence in all company actions. The same external environment may lead managers of different mentalities of different firms to different decisions. Cultural influence in management decisions is acknowledged and the parameters are examined both by economic concepts and anthropological or organizational behaviour theories. Cultural differences and the physical distance between the home country and the host countries, may cause difficulties in terms of language or mentality when doing business (cultural shock). Cultural differences may be observed in different regions of the same nation, but on international level they are usually more obvious. Multinationality is a great asset for a company, since MNE’s have easier and cheaper access to information and technology and can distribute them to the subsidiaries at minimum cost. Innovation, entrepreneurship and arbitrage. The entrepreneur ‘must take important decisions that are difficult to make’ (Casson 1985, 171–172). The entrepreneur may be the owner of a firm or a manager hired by the owners. Any wrong decision, any mistake will be very costly for the firm. Successful entrepreneurship requires the synthesis of different kinds of information from different sources. Innovation must be used in order to synthesize the technology, the inputs, the demand price and the law and institutions which govern transactions in the markets. On the other hand, the arbitrager must combine information about technology, price differentials and laws and institutions that govern transactions in the markets.

Buckley (1995) also placed great significance to the role of the manager in the firm. An effective management may achieve economies of scale and economies of scope, which are primary goals of a MNE. The management role is also vital in reducing the transaction costs arising from multi-plant enterprises.

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3.3.4 FDI Theories Based on Trade Theories One of the most discussed trade theories is the Factor Endowment Theory of Heckscher and Ohlin (H/O Theory or H/O Model). The theory states that a country will produce and export products that depend mostly on the production factors (particularly capital and labour) that are relatively abundant in the country and will import products that depend mostly on production factors that are relatively scarce in the country. The H/O Theory assumes that the production factors are completely mobile domestically and that capital and labour factors are completely immobile internationally. Moreover, H/O Theory assumes that production functions are the same and that technology is freely and instantly available in all countries. Although the H/O Theory is not absolute, it reflects the locational specific advantages of a country that an MNE takes into consideration before directly investing there. David Ricardo created a model in which trade is based on comparative advantages such as international differences in labour productivity. These differences result from differences in production functions and the use of technology. Differences in productivity functions are exogenous or derived from differences in national characteristics such as climate and the quality of natural resources. It can be said that these differences can also be called country-specific advantages. This model also assumes complete international immobility of factors of production. The model considers technological differences which result in productivity differences. Neither the H/O Theory nor the Ricardian model can explain FDI. However, extensions of these models such as the H/O extension model (neo-factor trade theories) which introduces additional factors such as human capital and natural resources and the Ricardian extension model (neotechnology theories) which introduces economies of scale, product differentiation, etc., can both be used as a basis for a significant number of FDI theories. It can be said that there is a link between trade and FDI using the Ricardian model if we expand it with factor endowments mobility and keep in mind the international differences in technology and production functions as a firm specific advantage and country-specific advantage. Vernon (1966; 1979) was the first to focus on the so-called country-specific/ locational advantages. Given that cross-national trade occurs and all natural and human resources are immobile, Vernon points out that trade also depends upon the technological capability of firms to upgrade these inputs and/or to create/ innovate new ones. The ability to renew ones’ resources may be considered as an ownership/competitive advantage. At first, the firm is willing to export its products to foreign markets with similar demand patterns and supply capabilities. When the product matures and the demand becomes more price elastic, the attraction of establishing foreign direct investment activities in a foreign location increases. The final decision of choosing the host country depends on various factors such as the macroeconomic and market conditions in the host country. The distance between home and host country is also an important factor, as the MNE may be

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intent on having the products manufactured in the host country available for reexportation to the home country. 3.3.5 FDI Theories Based on New Trade Theories Governments are the main source of impediments to the free flow of products between nations. Barriers of trade are much more complicated than mere tariffs (quotas, government restrictions, etc.). By placing tariffs on imported goods, governments can increase the cost of exporting, as an entry mode, relative to other entry modes such as FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and other forms of foreign involvement. For example, the wave of FDI by Japanese automobile companies in the USA during the 1980s was partially driven by protectionist threats and quotas imposed by the US government on the importation of Japanese cars. Krugman (1983; 1991) suggests that firms of certain industries tend to concentrate in regions that already have a high sectoral activity. In his opinion, this happens for sector-specific reasons rather than location-specific reasons. When many firms of the same sector are concentrated in the same location, then skilled labour, technology and suppliers are similarly concentrated. Therefore, the location will attract other firms, assuming that they can overcome the transportation cost and trade barriers of exports. The firm may establish a subsidiary in a certain location in order to be close to the technological information flow, supporting at the same time the production stage that is not complicated by exploiting location specific advantages (like cheap unskilled labour) in another location. A typical example of agglomeration is the Silicon Valley in the USA, which is the centre of R&D activity concerning computer technology. Helpman (1984) in his conclusions mentioned that cross-country penetration of multinational corporations is a result of impediments to trade (such as transport costs or tariffs). This theory explains the simultaneous existence of intersectoral trade, intra-industry trade, and intra-firm trade. 3.4 Factors that Influence Company Motivations and/or Barriers of FDI Empirical studies regarding the determination of FDI motives have shown that the majority of foreign investors have undertaken such projects to service domestic demand in the host country, particularly to overcome natural or policy-induced barriers to trade. Most investors further emphasize that their goal is to invest in countries with large markets and promising growth prospects. At the same time, investors with efficiency-seeking investments prefer low labour force costs, while those engaged in extractive activity note that foreign investments will be driven largely by the availability of natural resources. However, investors engaged in

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efficiency-seeking activities, cite the significance of the availability of skilled labour and wage-adjusted labour productivity. Generally, investors prefer sound macroeconomic fundamentals (stable exchange rate, low inflation, and sustained growth), the availability of infrastructure, a stable and favourable tax regime and stable institutional and regulatory factors and policies. At the same time, investors cite the importance of free trade agreements and regional trade integration schemes. Most investors stress the importance and availability of infrastructure (electricity, water, transportation links, and telecommunication), rather than their costs in influencing FDI location decisions. One of the key factors a company considers before undertaking FDI is the minimization of the investment risk. When a country has an unstable legal system (i.e. frequent changes in the regulations), lacks appropriate laws, and insufficiently enforces the existing ones, then the investment risk increases. From the economic point of view, if the exchange rate is volatile and the country suffers macroeconomic instability (inflation); and from the political point of view, if the country suffers from political instability or social instability (e.g., high labour unrest and strikes), the risk of investing in this country is also enhanced. This is exacerbated in transition economies when the transition process is delayed due to unclear property rights, delays in solving restitution problems, slow progress in privatization, in the banking reform, and in liberalization, the existence of the mafia, nomenclatura, corruption, briberies, bureaucracy, etc. In such circumstances economic and political instability is heightened, and risk increases. Moreover, a significant number of investors observe that the financial crises of the 1990s have highlighted the underlying risks of investing in emerging and transition markets and made it necessary to pay greater attention to issues relating to political and macroeconomic stability, the legal framework, corruption and bureaucracy. 3.4.1 Reasons, Incentives, Motives, Possibilities, Opportunities for FDI Based on Dunning (1988) and Bitzenis (2003b), from the theoretical point view, we can outline the motives for FDI according to their content as follows: 1. Market seekers (size of the market of the host country, market growth prospects of the host country, the host country is a new market for the MNE to expand its operations). 2. Market seekers from a strategic point of view (e.g. meeting local needs and tastes of the host market, a perceived lack of local competition in the host country, a local unsatisfied demand for products, an MNE acquires the assets of a local company in the host country (through a joint venture or a M&A, etc.). A MNE may decide to substitute prior trade relations with a country by undertaking local production in order to avoid trade barriers. Lastly, if a company finds it profitable to expand, either vertically

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4. 5.

6. 7. 8.

9.

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or horizontally, it may look for opportunities abroad, and thereby expand through FDI). Factor seekers (availability of natural resources, exploiting managerial, organizational, marketing and entrepreneurial advantages existing in the host country, access to high technology, low cost of acquiring and using raw materials and human resources in the host country). Efficiency seekers (economies of scale, economies of scope, diversify the risk). Locational seekers (climate and infrastructure in the host country, geographical proximity, cultural closeness and/or cultural distance between home and host country). Exploiting ownership advantages (strong brand name, product innovation, know-how, marketing expertise, existing business links, multinationality) Seekers of financial benefits (tax relief or other financial incentives). Political reasons (existence of ethnic minorities, special government treatment for a company due to the specific ‘nationality’ of the foreign firm, discrimination of specific companies coming from a specific country). Others (overcoming imperfections). In general, motives may be derived from the solutions in order to overcome market imperfections. Thus, there might be other solutions for the same imperfections that may produce many other motives (an MNE may avoid search and negotiating costs of acquiring raw materials from other companies, by moving to vertical integration). However, we can argue that a lot of examples of FDI could fit in more than one of the above categories.

Moreover, as outlined by Bitzenis (2004c; 2006a) and Bitzenis and Szamosi (2005) the motives of FDI can be categorized according to their source of creation into the following groups: 1. Incentives offered directly by the host government (e.g. financial incentives, tax relief). 2. Motives ‘derived’ from the host market or the host country, or given indirectly by the government, or ‘derived’ from the passive behaviour of the host market (e.g. climate, market size, raw materials, lack of local competition, political and macroeconomic stability, stable legal framework, transparency, liberalization, and unsatisfied local demand). 3. Motives that stem from the interrelation of the home and host country; motives which can only be connected with the multinational, its origin country, and the host country (e.g. geographical proximity, cultural closeness, historical links) (Bitzenis, 2004c). 4. Internal incentives owned and ‘provided’ by the MNEs (strong brand name, experience, know-how and expertise). 5. Motives/incentives which have been created from an external event (from outside the host country), or from the global market pressures or even yet that are derived from exogenous reasons outside the host market (war,

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globalization pressures, a saturated home country market, collapse of the communist regime and transition). More specifically: 1) Market hunters •

•

•

The size of the market of the host country is one of the major factors (if not the most important) that an MNE takes into consideration in the decision making process on FDI. The prospects of the host country for market growth are am important factor and along with the market size are the most frequently considered. Empirical studies suggest that these are the main determinants of FDI. An MNE is profit oriented and in order to generate more profit it is constantly seeking new markets to expand its operations. This process aims at increasing the company’s market share in the host country.

2) Market hunters from a strategic point of view • •

•

•

•

•

•

When managers of an MNE realize that there is lack of local competition in a host country, they will try to exploit the opportunity. According to the product cycle theory, when a product is losing market share in the home country, the company starts searching for other markets elsewhere to introduce the product. If the company’s market share, either because of increased production cost or low quality of the product (low competitiveness of the product), is gradually but dramatically reduced, the company will turn to another market, sometimes abandoning the home market as a way to stay in business (a way to survive). In a similar manner, pressures of competition in the home country that result in the reduction of the company’s market share lead the company to try to substitute the lost market share with participation in a foreign market. When a company is not strong enough to become a multinational but spots an opportunity in a neighbouring country, which is within the company’s capabilities, then the former company undertakes FDI just to become a multinational firm (for marketing reasons for the home country, for reputation). This is the case of most Greek investments in the Balkans. Some companies realize that their presence in a given market may assist their efforts of meeting the local needs and tastes of that market, since the direct contact will provide them with more adequate information. When the company concludes that its production line has potential, but the home market is too saturated to allow it to exploit this potential, they seek new markets.

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A MNE is motivated to undertake an FDI project in a host market when there is a local (host) unsatisfied demand for products. Companies may undertake strategic moves in response to the actions or expected actions of competing firms in the same or a related industry. Many theories have studied such cases. In some instances the investment is aimed at thwarting a competitor. When a competitor enters a foreign market, the company follows its ‘market leader’ in order to prevent the competitor from acquiring a significant share and dominating the foreign market (follow the leader). In many cases, this strategy brings losses in the first years for the company that follows and even for the leader, but the follower may still persist in order to prevent the ‘leader’ from being the only company to establish brand recognition in the host country. Many firms follow their competitors in order to exploit their competitors experiences; following their successful steps and avoiding their mistakes (follow the competition). Firms in sectors such as financial services follow their clients in the host country in order to ensure their clients do not hire a local firm or another multinational that might, in time take up their operations in the home country; and to exploit the ready-to-use clients in foreign markets. For firms that utilize raw materials which are supplied only by a given number of suppliers, an FDI may open the way for the firm to follow (follow the supplier). The pressures of globalization leads companies to undertake FDI in multiple countries in order to secure their physical presence in most of them and establish an advantageous economic position. In many cases, the selection of the region is done according to the ‘fashion trend’ of the time that suggests which regions are profitable or offers investment and privatization opportunities (ex. Central and South America, Asia, Central and Eastern Europe and CIS countries). Acquiring the assets (via a joint venture or a M&A, etc.) of a local company in a host country for (a) increasing market share in the global market, or (b) decreasing the global competition (becoming a global leader) in the specific industry/sector (decrease competition or weaken the competition), or (c) for a geographical dispersion of knowledge-based assets from foreign locations. A company may decide to undertake FDI if they find a market where no foreign company from the same industry has any operations (first mover). When a foreign competitor ‘invades’ the company’s home market it ‘steals’ some of its market share that the company hopes to replace by entering the competitors home market (defensive/counterattack). When the competitor’s move is predicted by the home company, it ‘attacks’ the competitor’s home market first, in order to cause problems in the competitor’s market share (offensive/attack).

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•

An MNE may decide to substitute prior trade relations with a country by undertaking local production in order to avoid trade barriers. If a company finds it profitable to expand, either vertically or horizontally, it may look for opportunities abroad, so that it expands through FDI.

3) Factor hunters A company may seek either factors unavailable in the home country or ways to minimize factor costs (availability of natural resources). Examples include: •

•

Exploiting managerial, organizational, marketing and entrepreneurial advantages, technological skills, labour skills (of the host country), access to high technology, etc. There are companies which seek the location that offers the optimum production factors necessary for their operation. The factors that dominate production are the ones that determine their choice of location. The companies might look for: • • • • •

•

A skilled, educated (and preferably low cost) labour force. A semi/unskilled low cost labour force. Availability of natural resources and an adequate labour force. Low cost of raw materials. Inexpensive land (the low cost of acquiring and using raw materials and human resources).

Companies that focus on intensive production search for a cheap labour force. When an export base is focused on minimizing the cost of production with the intention to re-export raw materials and human resources in the home country, the company is a factor hunter.

4) Efficiency hunters •

•

When companies own certain assets that are mobile and transferable at a low cost, such as technology, R&D findings etc. they may choose to create subsidiaries either local or more usually foreign in order to achieve economies of scale by distributing the fixed costs of obtaining such assets. When companies are focused on achieving economies of scope, they require larger markets in order to supply significant quantities of their diversified goods or services. These products or services are offered in order to cover most of the consumer needs.

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Many companies create foreign subsidiaries either by multi-sourcing (many production sites in different countries) and/or by participating in other companies in related industries, in order to diversify the risk of operating by having alternatives in times when a certain industry or location experiences difficulties. Multi-sourcing is also efficient for companies, with many parallel production stages, that may exploit the factor endowments of each country by assigning each stage to the country that most efficiently provides the dominant production factors for the given stage of production. Companies diversify their product either to secure the survival of the product in different markets, or to meet needs and tastes of the host market. As factor hunters search for cost minimizing, efficiency hunters search for managerial expertise, new and advanced technology, common governance, arbitrage of currency, cost incentives and entrepreneurship in order to maximize efficiency. Synergistic economies and geographical concentration (agglomeration) may also constitute reasons for FDI.

5) Locational hunters •

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The specific climate of a region may attract the kind of companies that can exploit it, such hotel chains, or farming companies. Moreover, international transport, communications’ networks and infrastructure facilities are also considerations. The openness of a country is one of the major factors that may attract foreign investors and led the author to the argument about fashion trends of the MNEs to a region in different time periods. During a certain time period a country, a combination of neighbouring countries, or a whole region (e.g. CIS, Central and Eastern Europe, North America etc.) open their borders, liberalize and stabilize their economies and provide their state-owned enterprises for privatization programs. They also provide incentives for FDI inflows, which will help their macroeconomic development. Many companies recognize opportunities to exploit the cultural closeness of their country with another country by providing products for the host market similar to the products provided in the home market or according to their tastes, needs and mentality. Cultural distance may also be exploited by a MNE that introduces a totally unfamiliar product in a host country that might attract customers by raising their curiosity or their admiration for the foreign culture. The geographical distance is mirrored by cultural differences, especially so in Central and Eastern European countries which tend to follow the trends of Western civilization. Although the advanced infrastructure in the host country is a factor that encourages FDI decisions, lack of infrastructure in certain sectors may

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• •

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encourage a company to undertake FDI in order to provide infrastructure for the sector in need (telecommunication or other service activities). Historical links between the home and the host country may encourage FDI decisions. Geographical proximity plays an important role in the choice of location, since there are low transportation costs and sufficient information on the country’s conditions and investing opportunities. Economic, social, financial and political stability is also considered by MNEs. Any instability in the above sectors increases the risk of the investment. Companies which face difficulties in their home market when trying to reduce the production cost, undertake an FDI project in order to create an export base in the host country either to exploit trade agreements with surrounding countries or free trade zones, or to use the host country as a link to other neighbouring countries.

6) Exploiting ownership advantages •

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Companies that hold advanced technology, a strong brand name, product innovation, know-how, marketing expertise, or high managerial skills which allow them to dominate the local market may, eventually feel the need to exploit these advantages abroad. Past trade relations or existing business links provide the company with an advantage that will lead to a successful investment. If an MNE with prior trade relations with a country identifies favourable conditions for local production or unfavourable conditions to trade, it may undertake FDI that might substitute or complement trade. Companies which have gained experience by investing in many countries hold the characteristic of multinationality, giving them the ability to better recognize business opportunities and undertake investments. Familiarity of the MNE regarding local (host) tastes, needs, customs, and language, is an element that helps in the decision of undertaking an FDI project. Exploiting existing favourable terms of obtaining inputs, exploiting agreements with local firms, friendly relationships with host governments, exploiting the ‘influence’ derived from its brand power, firm size, creating synergistic economies, common governance etc.

7) Hunters of financial aspects •

Empirical studies have shown that tax relief is a minor factor in the investment decision. However, small companies that have geographical proximity with the host market do consider them either when transferring the whole production site or part of the production site, or when creating

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an export base. Tax relief or other incentives may be given by a host government in order for economic growth to take place in the host country (macroeconomic development). Some countries provide incentives for the establishment and operation of offshore companies that are trivially taxed due to discriminatory tax policies. A method for reduction of the taxation of both the subsidiary and the parent company is transfer pricing. This method allows the company to manipulate financial results, and may be an incentive for internalization of operations in another country. Double taxation avoidance may be a way for a company to choose among different countries that present similar investment opportunities in a specific region. The existence of double taxation is a burden on financial results unless it can be overcome by finding methods of not declaring profits. The above reasons belong to the smaller category of taxation minimization or avoidance that forms an important group of incentives for an MNE. In a world with fluctuating exchange rates, it is sensible for companies to consider currency differences, either waiting for the currency to strengthen (timing) or by seeking locations where the acquisitions in the home country are major investing opportunities. Companies from countries with a strong currency have the opportunity to arbitrage the currency more easily. The state-owned enterprises offered for privatization (especially in Eastern European countries) have difficulties valuating the assets offered, which usually results in overvaluation. Investors seek lower privatization offers in order to cover the cost of the risk of failure, as a result interesting and profitable offers may arise. Subsidies and grants that are provided either from the home country or by wider organizations like the EU to companies that undertake FDI in specific regions to spur on economic development, provide incentives for FDI. Availability of cheap local (host) financing of the FDI project (whole or partial) (exploiting interest rate differentials).

8) Political reasons Home and host countries and firms may have political reasons of supporting or discouraging FDI. The host country may seek FDI in order to support the economic growth of the country, decrease unemployment, balance deficits, and generally gain from FDI spillovers. The political reasons are apparent by the governmental intervention in the form of subsidies and other incentives (Sergi, 2004). This intervention negatively affects free competition, a factor causing the EU to consider the general abolishment of government or EU grants inside the Union.

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On occasions the decision of the host government to allow or discourage a foreign company to acquire a formerly state-owned firm might depend on the ‘nationality’ of the foreign firm. A decision taken for political reasons. There are cases when the home country provides financial incentives to local companies to invest in a specific country in which there are ethnic minorities or there is another reason for the home country to dominate economically the host country and/or influence political decisions, demonstrating its influence through the presence of many companies.

9) Overcoming imperfections In general, the incentives demonstrated by the model are derived from the solutions in overcoming market imperfections. Thus there may be other solutions for the same imperfections which produce other incentives. Some well-known imperfections are: •

• • • • •

Many FDI theories have studied the transaction costs or the market imperfections and argue that FDI may be undertaken in order to minimize or avoid them. To avoid the search and negotiating costs of acquiring raw materials (vertical integration in a host country). To avoid the cost of introducing or breaking a contract of licensing. For the control of quality and the price of the product. In order to keep monopolistic-ownership advantages. To avoid lags, delays and lacks of inputs for the volume of production.

3.4.2 Obstacles, Barriers, Disincentives for FDI As outlined by Bitzenis (2004c; 2006a), the obstacles/constraints of FDI can be categorized according to their source of creation into the following groups: 1. Country/geographical/location constraints (geographical distance from the West, lack of raw materials/natural resources, high crime rate [including a high economic crime rate], social instability, lack of security, absence of tourist opportunities [absence of sea, mountains, landscapes, mild climate], etc.). 2. Business environmental (market) constraints (bureaucracy, corruption, briberies, lack of entrepreneurship, lack of managerial skills, lack of skilled labour force, high competition, problems in co-operation with local citizens [problematic joint ventures], social instability [strikes], technological backwardness, low labour productivity, etc.). 3. Legal constraints (unstable legal framework, constant changes of laws, lack of laws, uncertain or imprecise property rights, inability to enforce the laws, discrimination in the enforcement of the laws, etc.).

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4. Taxation constraints (high taxation, high VAT, constraints regarding the repatriation of profits, etc.). 5. Political/governmental constraints (political and government instability, high government intervention, blockage of fund transfers, takeovers, slow pace/progress in the transition process, government inability and government unwillingness for successful reforms, etc.). 6. Macroeconomic constraints (exchange rate volatility, high inflation, low per capita income, etc.). 7. Infrastructure constraints (technological backwardness, lack of infrastructure [telecommunications, roads, networks, internet], lack of financial intermediaries, etc.). 8. Cultural constraints (lack of knowledge of the local business mentality, cultural consideration constraints, scepticism shown by local people of foreign investment, privatization and consumption, and are unwillingness to buy foreign products, etc.). 9. Religious constraints (Muslims do not ask for loans [because of interest rates]) (Bitzenis and Nito, 2005; 2006a; 2006b). 10. Environmental constraints (environmental constraints can be legal constraints that determine specific functions of production [e.g. health and safety, product safety laws]; social constraints that determine the tastes and buying patterns of consumers [e.g. healthy foods]; ecological constraints that determine the necessary conditions of avoiding aspects of pollution). 11. External constraints (war, domino effect of an economic crisis, etc.). 12. Others (lack of future prospects for market/economic growth, disintegrated economy, lack of participation in regional initiatives, in international organizations and Unions [such as IMF, OECD, NATO, EU, EMU], lack of favourable bilateral treaties, lack of financial incentives, etc.). These may include: •

If a country does not have regulations allowing the repatriation of profits, then FDI is discouraged. All CEE countries, except for Hungary, at the beginning of the transition had limitations in the repatriation of profits (either a specific percentage in the class of 10–20% of profits or in relation with the availability of foreign exchange). Partial or even full liberalization of the repatriation of profits was later established, first in Poland and Czechoslovakia and later in the remaining CEE countries. i. The author’s research suggests that investors find ways to overcome this barrier. For example, in the early years of transition in Bulgaria the law allowed only the initial volume of the investment to be repatriated. Knowing that, investors overvalued the machinery they transferred to the foreign subsidiary in order to repatriate the future profits.

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If the country in question lacks local managerial skills, natural resources or other factors that a company is looking for in the host country, or if the above factors are available but at high prices, then the company that requires these factors will not invest in the country. If the country has a high crime rate or the state cannot sufficiently protect investors from illegal actions or organized crime, then the company will not feel safe investing in this country. If the banking system the financial intermediaries-stock market or other transaction services are not capable of handling big companies efficiently, or transaction costs are high, financing companies becomes very difficult. When a country lacks favourable bilateral treaties, subsidies, cheap privatization opportunities, favourable tax policies etc., then the country may not offer sufficient incentive and motivation for FDI on its own. The culture and local behaviour regarding consumption, labour attitude and productivity, etc. may be a barrier if it is negative in relation to the company. This is particularly so in former communist countries, where the mentality of the people evolved through years of state domination, attitudes tend to be against excess consumption, privatization and non-nationals, in general. Corporate culture is also relatively passive in the sense that the job security, low targets of state owned companies and the limited motivation of employees during the communist years resulted in very low productivity rates. Another grave barrier in the former communist countries is the power and complexity of the state bureaucracy that dominated the country for many years. The low per capita income and negative consumer consumption patterns (low tendency in consumption) certainly discourage companies from investing. Low per capita income may be the result of a previous economic crisis, devaluation of the local currency, high inflation rates and the low economic development. As mentioned previously the consumption patterns in former communist countries are low not only due to the low income but also due to the negative attitude towards excess consumption. The low level of development of technology in the country as well as the low level of infrastructure may prove discouraging for a company, especially for one that requires significant technology and infrastructure for the operation of the company in general.

3.5 Concluding Remarks Regarding FDI Determinants Behind the overall conclusion that several factors are important (or unimportant) as motives or barriers, some researchers (Bitzenis, 2006a; 2006b; Iammarino et al., 2000) claim the existence of other factors, that may play a decisive role in perceiving motives and obstacles of FDI from a company’s point of view. These include:

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The country of origin of investors together with the size of the investing company and the size of the country of origin along with the expectation of the company, regarding the market share that it will obtain. The sector (industry) of the investing company. The strategic plans of the investing company (which market to serve, etc.).

The influence of the investor’s origin has been examined by several researchers who concluded that it plays an important role in determining FDI (e.g., Sass, 1996; Andersen, 1994). For example, a company from Germany and another company from Greece are both aiming to invest in Bulgaria. However, there are lower expectations for profits and market share for the Greek company because it is a small company and comes from a weak economy. The Greek enterprise considers the market size of Bulgaria (Bulgaria is ‘another Greece’ based on population). On the other hand and for the opposite reasons, the German company in Bulgaria has higher expectations. In addition, if the investing company comes to Bulgaria from a country with a relatively cheap labour force (like Romania), the factor relative to labour costs in Bulgaria will not be so important for the Romanian investor as it will be for some investors from Western Europe where these costs are higher (Bitzenis, 2005; 2004b). Furthermore, small companies will be satisfied with a very small market share in a host market. Along the same lines, a company may perceive the market size of a smaller host country as more significant than its home market, if there is an opportunity for obtaining a large market share. In this way, the company could reach a higher absolute number of customers in the host country than in the home country, due to the significant market share. MNEs from various sectors/industries perceive motives and barriers in a particular host country differently. The lack of infrastructure in the telecommunication industry, for an investing company in the specific sector, may be perceived as an incentive in order for the company to enter in that country. However, the same lack of infrastructure will be an obstacle for other companies which belong to the services sector (e.g., banks). Similarly, low labour cost is an incentive for labour intensive industries (e.g., textile companies). However, it is not a major incentive for banks which require a skilled labour force and managerial skills and are more indifferent to the cost of the labour force as cost does not significantly impact the total cost of the offered product. Similarly, market size may be an important incentive factor for some companies but not for others. A company that produces luxury products may not consider a country with a huge population and low per capita income for investment. The actual market for such a company could be a very small country but with a high per capita income and a high expected market share (Bitzenis, 2006a). The strategy of an investing company basically differentiates companies upon considering the importance of motives and barriers. For the companies that invest in a host country which consider only the production costs and the creation of an export base, the most important FDI motive could be the low labour or raw

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material costs. On the other hand, an investing company with a strategy for selling and serving the foreign (local) market may perceive market size, GDP per capita or market growth as more important motives for FDI. (Benacek et al., 2000; Pye, 1998; Lankes and Venables, 1997).

Chapter 4

Determinants of Foreign Direct Investment: Empirical Evidence

4.1 Literature Review of Questionnaire Surveys Regarding FDI Determinants in Central and East Europe (including the Balkan Region) At the outset it is worth underlining that each survey (see Table 4.1) can present different findings explainable by various issues, such as: the different chosen sample, the different response rate, the different distribution of the interviewed companies among sectors and industries, the different date of conducting the survey, the different way of approaching the companies, the different methodology used to approach them, and the different statistical or econometric method used to examine and interpret the results. All these factors must be taken into account in order to avoid biased results. To create a survey population, specific criteria must be imposed in order to create the best possible sample. We ran a questionnaire survey in a specific country, Bulgaria, in order to identify the Bulgarian business conditions/factors (obstacles – motivations) which had been considered by foreign enterprises entering Bulgaria. These factors had been examined by MNEs in order to familiarize themselves with the Bulgarian business environment and assist their objectives of profitable and successful investment projects. In this way, we extracted valuable information regarding the determination of FDI in Bulgaria during its transition period. Our purpose was to identify the motivations and entry barriers for inward foreign direct investment that foreign firms had considered when deciding whether or not they to invest in Bulgaria. Benacek et al. (2000) concluded that econometric evidence supports the findings of survey studies. However, in research which conducted in 1999, where the Czech Republic, Hungary, Poland, Slovakia, Romania, Slovenia and Russia were included, it was concluded that political and economic stability and large market size were the most important FDI motivations. We agree with this outcome, in the sense that political and economic stability existed in the Czech Republic, Hungary, Slovenia, Slovakia and Poland but not in Romania and especially not in Russia. However, the large market size factor was not an FDI motive for MNEs to invest in Slovakia and especially in Slovenia. However, research where a small number of host countries participate in the sample but conclusions are drawn which involve all the host countries as a whole might result in misleading findings. Moreover, as can be seen from the following discussion of the literature review; it is often the case that the questionnaire samples and surveys lacked proportional

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participation of companies among the countries. Thus, as in the example quoted above, 200 companies from the Czech Republic, 50 from Hungary, 40 from Russia, 20 from Slovakia, 15 from Slovenia and 7 from Romania can suggest misleading conclusions for the case of Romania. A study, however, that does include Hungary and the Czech Republic may indicate that their relative political and economic stability can explain why such a large share of investment in the transition economies has been directed towards these two countries. This rationale would also support the notion however that, in order to minimize potential biases, multi-country FDI studies need to take into account similarities in country development, stability, and market size as well as comparable sample sizes from the countries included. Another approach is to undertake individual country studies and draw comparisons between the countries as opposed to ‘grouping’ them. More often than not in the literature there is a disproportional participation of companies among countries which may infer misleading conclusions. There are also multi-country studies in which no similarities exist in terms of levels of development, market size and stability. Thus, a study which includes a group of countries from the former Yugoslavian region (Slovenia, FYROM, Croatia, Serbia & Montenegro and Bosnia & Herzegovina) may conclude that there is lack of infrastructure, or weak economic development, although this may not necessarily be true for Croatia and especially Slovenia. However it may be more representative of the situation in FYROM, Serbia & Montenegro and Bosnia & Herzegovina. On the basis of these facts, we drew the conclusion that it was necessary to conduct a questionnaire survey for a specific country. We chose Bulgaria, a Balkan country that received over US$8 billion (mid 2004), and which had positive prospects for becoming an EU member. We ran the chi-square statistical test, paying attention to the origin of each MNE, for each sector of the Bulgarian economy in order to determine with accuracy the motivations and barriers for FDI inflows in Bulgaria. The following discussion attempts to provide a complete literature review (attention has been given only to those surveys that have included at least one Balkan country) of the relevant articles on our subject (presented chronologically, oldest first) (see Table 4.1).

  The three groups of sectors contain the following: 1: (Power Industry, Non-Ferrous Metallurgy, Metalworking Industry, Electrical Industry, Non-Metallic Minerals and Building Material, Chemical and Pharmaceutical Industry, Woodworking Industry, Glass Industry, Cement Industry, Textile Industry, Leather and Footwear (Clothing) Industry, Paper Production and Processing (productive-industrial companies – thus Heavy – Light Industry, productive and industry and textiles), 2: Banking – Finance – Telecommunications – Hotels (Tourism) – Banks – Transport (thus services), 3: Food Processing Industry, Catering and Trade, consumer products – retail sector (thus Food and Trade).

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Table 4.1  Determination of FDI inflows according to the literature review: Survey based approach Surveys

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KPMG International (1998)

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Klaus (1995; 1996a; 1996b)

Genco et al. (1993)

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Pye (1998)

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Countries

Motivations

Barriers

Czechoslovakia, Hungary, Poland, CSFR, Romania, Bulgaria and Yugoslavia

• To penetrate new markets • To broaden the market for companies’ own products • To accumulate experience on the Eastern markets • To acquire dominant position on new markets • To exploit cheap labour and technicians • Fiscal incentives

• Lack of clearly-defined legislation • Lack of property rights • Lack of developed market economy • Lack of capital market • Complicated permit procedures • Inadequate credit system

Czech Republic, Hungary, Poland, Romania, Russia

• The local market (the size) • Factor cost orientation (low cost) • Geographical proximity • Purchasing power of consumers • Qualified labour force • Political and economic stability • Lack of local competitors

• Limited purchasing power of consumers • Overall instability

Bulgaria

• Skilled labour force • Low labour cost • Former business contacts • Strategic geographic location • Good local market • Proximity to home operations • Tax incentives

• Incoherent and unstable legal system • Bureaucracy • Limited purchasing power • Excessive taxation • Lack of infrastructure • High investment risk • Crime and corruption

Poland, Slovakia, Hungary, Czech Republic, Romania

• The size of the market, • The market growth potential • Maintaining market share • First mover, follow the clients, serve other markets • Labour cost advantages • Overall stability • Profitability and local market access • Serving regional and EU markets • Skilled labour force • Supplying neighbouring CEECs • Privatization process

• Unskilled labour force • Political and economic instability

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Table 4.1  continued Surveys

Countries

Motivations

Balkan Region

• Political and Economic instability • Crime – lack of transparency – corruption • Deficient infrastructure • Insufficient legal and administrative framework • Inadequate policy towards foreign investments (bureaucracy, difficulties in land ownership) • Negative business environment (inexistent financial and banking systems, black market)

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Bitzenis (1999–2002b)

Southeast European Cooperative Initiative (SECI) (1999)

5

Pfefferman and Kisunko (1999)

7

8

Bulgaria

• Market size • Low labour cost of unskilled workers • Geographical proximity • International pressures from competition, globalization • Prospects for market growth • Link to other neighbouring countries • Lack of local competition

World wide survey (taken into consideration 20 countries from CEE region)

• Unstable legal system • Bureaucracy • Corruption, crime and mafia • High investment risk • Limited purchasing power • Lack of infrastructure • Macroeconomic instability

• Inadequate infrastructure • Unpredictability of judiciary • Corruption • Crime and theft or • Inflation • Tax regulation and high taxes • Financing problems • Crime, instability, corruption

Romania, Bulgaria Simona and Pitelis (2000)

Barriers

• Expected economic growth • Geographical location • Investment incentives • Labour costs • Increase in domestic market share • Increase in regional market share • Proximity to the EU market • Source of raw materials • Cultural similarities

• Bureaucracy/administrative constraints • Business infrastructure constraints • Legislative constraints • General economic climate constraints • Incoherent and unstable legal system • High investment risk • Slow-pace transition • Uncertain or imprecise property rights • Undervalued local currency • Political uncertainty

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Table 4.1  continued Surveys

10

IDRA et al. (2001)

EBRD (2000)

9

Countries

Motivations

World wide survey (taken into consideration only central Europe and SEE countries)

• Access to attractive host/ regional market • Proximity to home market • Cheap skilled labour • Cheap labour (unskilled) • Favourable regulatory environment • Favourable tax treatment • Strong institutional link with home country • Access to raw materials

FYROM, Albania and Bulgaria

Barriers

• Unpredictability of laws and regulations (legal instability) • High costs of corruption • State bureaucracy • High taxes • Financing problems • Political instability • Unfair competition

Source: Bitzenis, 2002b.

A questionnaire survey carried out from September 1991 through March 1992 (Genco et al., 1993) attempted to analyse some of the factors which might have the greatest influence on the scope and the timing of private western investments in the countries in eastern Europe. The questionnaire survey consisted of parent companies from France, Germany, the United Kingdom and Italy. These companies had made various investments in Eastern Europe. With a 27% response rate, Genco et al. received 82 replies (18 replies from Czechoslovakia, 17 from Hungary, 9 from Poland, 17 from the Commonwealth Independent States (CIS), 4 from Bulgaria, 9 from Romania, and 8 from Yugoslavia) from 34 parent companies (22 French, 9 German, 20 Italian, and 31 British). The survey was conducted in the early transition years, before even the breakup of Czechoslovakia and Yugoslavia and is generally of limited use for the countries in question. However, the FDI barriers in these countries (most of these countries have now become members of the EU) in such an early transition period can be used for possible comparisons with the present situation in the Balkan countries. Similarities may exist. Moreover, a survey with limited observations for each specific Balkan country (Bulgaria, Romania and Yugoslavia), having less than 10 surveyed MNEs in each host country and where only MNEs originating from Western Europe have invested, is of limited use for decisive comparisons with our survey. However, Genco et al. (1993) among others, concluded that lack of clearly defined legislation was the most important risk factor in all the Central and East

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European region (CEE) countries examined, except in the case of Czechoslovakia where the lack of property rights was the key risk factor and in Romania where lack of developed market economy ranked first. Furthermore, they also concluded that complicated permit procedures proved to be the main weakness in the legislative-institutional framework in all the examined countries. They also searched for risk factors or for main weaknesses in the legislative framework according to the size (number of employees) and the economic activity per sector for each survey company. However, their results concerned all countries as a whole and not each country separately. The same is true when Genco et al. (1993) allude to the main reasons for investing in the CEE region. In this case, countries of smaller market size and with a larger number of observations (or vice versa) may dominate and prevail in the final findings of the survey. However, according to the importance of FDI motivations for the whole region, Genco et al. gave the following ranking: (1) the desire to penetrate new markets and broaden the market for ones own products; followed by (2) the expectation of accumulating experience in the eastern markets; (3) to establish a foothold there, followed by the expectation; (4) to acquire a dominant position in new markets; (5) the prospect to exploit cheap labour and technicians; (6) the desire to obtain immediate profits; and (7) to use local fiscal incentives. In another survey by Meyer, E. Klaus (1995; 1996a; 1996b), a questionnaire was sent to 677 German and British companies in the winter of 1994/95. The companies were selected randomly from a database (AMADEUS). The companies belonged to the following sectors: food and beverages, chemicals and petroleum, and machinery, including electronic and transport equipment. Of those sent the questionnaire 269 (39%) companies responded that they shared business relations with the Czech Republic, Hungary, Poland, Romania and Russia. However, only 212 companies were included in the study, as the rest of the questionnaires had incomplete or misleading observations. According to the findings, the local market was the dominant attraction and the cost orientation factor came almost exclusively in combination with the market-oriented investment factor. The most prevalent conclusion drawn was that labour costs play a secondary role in the investment motivation of western investors in the CEE region. Those aiming towards the low cost factor preferred the Czech Republic (38%), Poland (31%), Hungary (29%), Russia (26%) and Romania (21%). Meyer took into account limited investors’ preferences, in the sense that he examined only the British and German FDI outflows in specific destinations such as the Czech Republic, Hungary, Poland, Romania and Russia. All these host countries have common characteristics, such as a large population (except for the Czech Republic), and the majority are Central European countries, except for Russia and Romania. Meyer also found that Germany prefers neighbouring countries such as the Czech Republic and Poland. This means that geographical proximity, a significant

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market size and stability played a decisive role in the choice of these FDI destinations, even in this early stage of transition (late 1994, early 1995). For Meyer’s classification regarding Romania, we can say that the ranking of importance for decisive factors and barriers of Romanian FDI inflows can be of limited use when comparing them with our survey results for the case of Bulgaria (another Balkan country). In this case, one must consider the different mentality (different motivations) of western foreign investors who invested in Romania (namely the Germans and the British) compared with Greek, Turkish and Russian entrepreneurs who invested in Bulgaria. Moreover, in this survey we have an early stage of transition and even the preferences of western foreign investors have changed throughout time, especially for host countries such as the Czech Republic, Hungary and Poland which at the moment are EU member countries. In April 1998, KPMG International (a consultant company) initiated a survey of the foreign investors in Bulgaria, in order to identify the key factors behind the motivations and barriers to foreign investment and to present business opportunities and future investment considerations. Approximately 200 foreign investors were addressed, including the top 50 foreign direct investors identified by the Bulgarian Foreign Investment Agency (BFIA). The response rate was 35.4%. The origin of foreign investors was as follows: the USA (26%), Germany (20%), Austria (9%), Switzerland (8%), Greece (6%), and the Netherlands (6%). Around 70 MNEs replied to the KPMG survey. This sample proved not to be significant due to the fact that around 50% of the total sample had invested less than US$1 million (non-important investments according to the official BFIA catalogue – therefore a large part of the surveyed companies had a limited amount of investment interest). More specifically, about 38% companies had invested less than US$250 thousand dollars. Another 13% of the respondent companies had invested more than US$250 thousand dollars but less than US$1 million. Moreover, only 50 companies out of the 200 (the sample of the KPMG survey) were listed in the official BFIA catalogue in that time period. Nearly half of the investors (47%) had pointed to the customer base in the region as a key factor. The skilled labour force had been one of the driving considerations for more than a third (36%), followed by low labour costs (34%), former business contacts (34%), strategic geographical location (31%), good local market (29%), proximity to home operations (9%), and finally, tax incentives at only 2%. On the other hand, the majority of foreign investors (84%) had indicated that the incoherent and unstable legal system was one of the most serious problems for their operations, followed by bureaucracy (80%), and limited purchasing power (71%). Next came excessive taxation (57%), lack of infrastructure (55%), high investment risk (32%) and lastly, crime and corruption (8%). The crime and mafia factors which rank extremely low as an investing obstacle for the case of Bulgaria, was in contrast with our research results. In another questionnaire survey (February–August 1996), Pye (1998) studied investments from major European and North American countries into the Czech Republic, Hungary, Poland, Romania and Slovakia between 1989 and 1996 (a

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sample of 1,222 companies was conducted by mail, 334 firms replied, 324 of which were used in the survey). 82 respondents were from the Czech Republic, 88 from Hungary, 87 from Poland, 44 from Romania and 23 from Slovakia (destinations of FDI). Moreover, regarding the origin of MNEs, 82 were US companies, 56 German, 46 French, 32 Austrian, 30 Swedish, 30 British and 26 Swiss. Pye provided information regarding the key motivations of FDI in a region in which he included a Balkan country (Romania), together with more advanced countries from Central Europe and large countries in size such as Poland and Romania. The results showed that the primary motive for investments in 34% of the sample was the size of the market, together with the growth potential and the need to maintain market share. Strategic motives (first mover, follow the customers, follow the clients, serve other markets) (29%) were listed as secondary. He concluded that market factors were the most decisive group of FDI factors in the Czech Republic (41%), in Poland (39%) and in Hungary (28%). Strategic position factors at 33%, were the highest group of FDI factors in Romania and in Slovakia. However, Pye, as with Meyer, included only one Balkan country together with three Central European countries, from which the results may be of limited use when comparing them with our survey findings. The Southeast European Cooperative Initiative (SECI) carried out a survey between 23 October and 2 November 1998 (the last completed questionnaire was received on 17 November), to investigate companies active in the SECI countries, namely Albania, Bosnia & Herzegovina, Bulgaria, Croatia, Hungary, Moldova, Romania, Slovenia, and the Former Yugoslav Republic of Macedonia (FYROM). The survey did not include Turkey (a SECI member), but did include one nonmember, Yugoslavia (now Serbia & Montenegro). The survey also included the Russian Federation, which supports the SECI. Two hundred and seventy (270) questionnaires were returned for processing from 92 companies and organizations from 11 countries. The SECI survey revealed that Greek companies show a preference for Bulgaria, Romania and the Former Yugoslav Republic of Macedonia (FYROM), because of their geographical and cultural proximity, their common religious beliefs, existing trade relations and the lack of other significant western investment interest. At the same time, Greek companies consider these three countries and the Balkans, in general, as an initial investment opening with a view to later expanding via these nations into Russia and the Black Sea states. The most notable obstacle to development in all the countries under examination proved to be political and economic instability. However, as mentioned previously, this outcome may be somewhat skewed since political stability did exist in that time period in Slovenia but not in the other countries, thus, the limited observations in some countries such as the Slovenian ones and the consideration of all countries as a whole, created problems. The possible positive MNE inputs regarding political stability in Slovenia have been ‘lost’ and MNE inputs regarding political instability in other countries affect the overall survey results. This is a limitation when one

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considers cross-country questionnaire surveys with limited observations in some countries and the searches for FDI motivations or FDI barriers in a whole region, such as the Balkan region or the CEE region. The problem is even more apparent when countries with significant political and economic inequalities participated in the region (or/and in the survey). Decisive barriers according to SECI were: crime, lack of transparency, corruption, deficient infrastructure, insufficient legal and administrative framework, inadequate policy towards foreign investments (bureaucracy, difficulties in land ownership), and negative business environment (non-existent financial and banking systems, and the black market). To be more specific, SECI provided the following information as regards the most decisive FDI barriers in each specific country: Political and economic instability for Albania, Moldova, Yugoslavia, Romania and Russia; crime, lack of transparency and corruption for Bosnia & Herzegovina, Bulgaria and Hungary, and insufficient legal/administrative framework for FYROM. The selection of companies can be considered skewed. The companies that participated in this survey were either members of the Federation of the Industries of Northern Greece, organizations such as IFC (World Bank) or economic and commercial services offices of the Greek embassies. Furthermore, some partial results which suggest an inadequate policy towards foreign investments (bureaucracy, difficulties in land ownership) to provide the key barrier in Croatia and especially in Slovenia are questionable. Lastly, that the crime and corruption factor was the main barrier in Hungary is also questionable. It would be an error not to mention that the SECI survey was carried out in many Balkan countries in search of investing barriers. However, the survey had an unclear sample (the selection of companies’ criteria was also unclear). Bulgaria was only one country out of eleven surveyed countries and only 92 companies participated in the whole research. However, whilst there is an outcome regarding Greek FDI outward behaviour in the Balkan region there is not one for each specific country. For example, one of the survey conclusions which ranks corruption, crime and mafia as an investing obstacle for the case of FDI inflows in Bulgaria, is in accordance with our survey results. World Bank conducted a worldwide questionnaire survey between August 1996 and February 1997 (see 1997 World Development Report) with the assistance of Pfefferman and Kisunko (1999). The survey covered 3998 firms in 74 countries. The majority of the firms were in the manufacturing and services sector (about half each), alongside some agricultural firms. On average, Pfefferman and Kisunko received 54 responses per country from 69 countries. The average in Central and Eastern Europe was 70 replies. The survey analyses the most significant obstacles for enacting or doing business. Focusing only on the Balkans, the most decisive barriers for Albania proved to be the inadequate supply of infrastructure, followed by the unpredictability of the judiciary, corruption, crime and theft, respectively. For the Bulgarian business environment, inflation, tax regulations or/and high taxes, general uncertainty

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on costs of regulations, crime and theft, foreign currency regulations, policy instability, corruption, financing problems, inadequate supply of infrastructure and unpredictability of the judiciary, respectively proved to be the most important obstacles. Finally, in FYROM tax regulations and/or high taxes and financing problems were the key obstacles. The survey by Iammarino Simona and Pitelis Christos (2000) focused on the Greek outward FDI in Bulgaria and Romania (our survey, however, focused on worldwide inward FDI flows in Bulgaria). The overall number of FDI companies was 85 although there were 76 Greek parent companies, because some of them had invested in both countries (Bulgaria and Romania). Iammarino and Pitelis reported the most important motivations perceived by the investors as the most decisive factors in determining their decision to invest. According to their importance, motivations can be ranked as follows: expected economic growth, geographical location, investment incentives, labour costs, increase in domestic market share, and increase in regional market share. Less important factors were: proximity to the EU market, source of raw materials, cultural similarity, transport costs, political and economic climate, likelihood of accession to the EU, historical links, energy costs and finally, labour skills. Iammarino and Pitelis classified their results according to three types of foreign investors: distributors, exporters or local suppliers. For example, both geographical location and proximity to the EU market are, in relative terms, more significant for exporters than for local suppliers, whilst for the latter relatively higher emphasis is placed on factors strictly linked to the local social environment, such as cultural similarity and historical links. Furthermore, the source of raw materials is relatively more important to exporters than to the other two categories, and quite surprisingly, labour skills seem to be relevant in none of the cases. Moreover, the constraints and risks faced by investors in undertaking production activities were: bureaucracy/administrative constraints, business infrastructure constraints, legislative constraints, general economic climate constraints, incoherent and unstable legal system, and high investment risk. Less important were slow pace transition, uncertain or imprecise property rights, political uncertainty, custom tariffs and policy constraints, cultural considerations, technological backwardness, high foreign indebtedness, and overvalued local currency. Bureaucracy and administrative constraints ranked first for distributors, exporters and local suppliers. Cultural considerations are again perceived as relatively more significant for local suppliers and distributors, as well as custom tariffs, while technological backwardness, foreign indebtedness and local currency strength do not seem to be influential. Another worldwide survey was undertaken by the EBRD (2000, Transition Report) from May 2000 to June 2000. EBRD selected a total of 11,000 companies, including the largest companies in each region of the world from a Worldscope database (4,250 from western Europe, 2,000 from the USA, 1,000 from Japan, 1,000 from East Asia, 1,000 from Latin America, 500 from Africa/the Middle East,

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500 from Canada, 500 from Oceania and 250 from Eastern Europe). A total of 424 replies were obtained (their origin mainly from Western Europe [343 replies]). The results from the host countries/the destinations of FDI were: 120 companies in Central Europe and the Baltic states (28%), 44 in South-Eastern Europe (10%) and 44 in the CIS (10%) – the destination places were 422. Around 50% of the replies had as their destination the CEE region. EBRD concluded that the most important factors for foreign investors across all regions of destination were: access to an attractive host market, cheap skilled labour, favourable regulatory environment, proximity to the home market and favourable tax conditions. The survey is of limited use again since it lacked a precise evaluation of the origin of all MNEs and their preferences; and EBRD reported the most important factors for whole regions and not for each country (due to limited observations). Furthermore, it paid attention to the decisive FDI motivations for each region of destination and it concluded that the access to an attractive host market, proximity to the home market, cheap skilled labour, favourable regulatory environment, and favourable tax conditions were the main motives for Central Europe and the Baltic states. Access to an attractive host market, cheap skilled labour, proximity to the home market, cheap labour and a favourable regulatory environment were the decisive FDI motivations for the case of South-Eastern Europe. One further survey regarding the problems faced by foreign firms in Albania, Bulgaria and FYROM was conducted in the period December 2000–January 2001 by the Institute for Development Research and Alternatives (IDRA), the Institute for Contemporary Studies (ICS) in Albania, the Center for Strategic Research and Documentation in FYROM and the ARC Fund in Bulgaria (2001). From a sample of 300 foreign companies (100 in each country) with at least 25% foreign participation in Albania, Bulgaria and FYROM, 74 foreign companies in Albania, 84 in Bulgaria and 100 in FYROM replied via face-to-face interviews. The sample was selected randomly from the lists of firms taken from: (i) Albania – the General Tax Department; (ii) Bulgaria – Bulstat; and (iii) FYROM – the Department of Statistics. It was found that the most decisive problems that impede the attraction of foreign investments in Albania were the tax level followed by state bureaucracy, lack of political stability, unfair competition and a low physical infrastructure level. In FYROM, the main problems were state bureaucracy, corruption, unpredictability of laws and regulations, problems with technology/production, and an unstable exchange rate. In Bulgaria, the barriers were unpredictability of laws and regulations, corruption, state bureaucracy, high tax level, and problems in financing.

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4.2 Literature Review of Econometric Studies Regarding FDI Determinants in Central and East Europe (including the Balkan Region) Based on an extensive review of empirical literature, Demekas et al. (2005) concluded that studies on FDI in SEECs are scant, mainly due to the lack of comparable data. Their econometric study on FDI determinants was the first to cover all seven SEECs (7). The cross-section regression of bilateral FDI flows between 15 host and 24 source countries (averaged for the period 2000–2002) revealed the following: a high significance of gravity factors, the significant positive impact of the EBRD index of foreign exchange and trade liberalization, the positive impact of infrastructure (in some specifications), the negative impact of unit labour costs and the significant negative impact of the corporate income tax. Tax incentives and the ‘bribery tax’ were reported as statistically insignificant (14). In general, the results obtained are largely consistent with the findings in the existing literature, thus confirming that the basic mechanisms of attracting FDI also function in the area of SEE. Stating that the gravity factors, as most prominent FDI determinants, are exogenous by their nature, Demekas et al. (2005) stressed that policy-makers should concentrate on policy-making, as they are controllable, endogenous variables, and although they may be limited, they can still have a significant impact. Using the actual values of exogenous variables and the ‘best’ value of the policy variables (determined as the best values of these variables across the sample), the researchers attempted to measure the potential non-privatization FDI stock that might be achieved in each host country. The findings showed a significant gap between the actual and potential FDI in all CEE and SEE countries. This gap (i.e. the potential for attracting further FDI) varies from 18% in Hungary to an amazing 82% in Bosnia & Herzegovina. The gap for FYROM was estimated at a respectable 64%, thus ranking the country as fifth in terms of FDI potential among the 15 host countries. As Demekas et al. conclude, the countries with the highest gap have most to gain by implementing more beneficial and effective policies. Furthermore, they point out that the determined ‘best’ values of the policy variables are not static and can be further improved, extending the potential for generating FDI (20). Interestingly, Botric and Skuflic (2005), investigated FDI determinants into 6 SEE countries during the period 1996–2002, they found that market-seeking  Albania, Bosnia & Herzegovina, Bulgaria, Croatia, FYROM, Serbia & Montenegro and Romania.  Source countries include EU(15) plus Croatia, Cyprus, the Czech Republic, Hungary, Poland, Russia, Slovenia, Switzerland and the USA, and the host countries are Albania, Bosnia & Herzegovina, Bulgaria, Croatia, the Czech Republic, FYROM, Hungary, Moldova, Poland, Romania, the Slovak Republic, Slovenia, Serbia & Montenegro and the Baltic States.  Albania, Bosnia & Herzegovina, Bulgaria, Croatia, Serbia & Montenegro and FYROM.

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determinants (GDP level and growth, GDP per capita, and population) exerted either a very small or even a negative influence, suggesting that the market-seeking motives might not be the dominant motives for existing investors. No conclusive evidence was drawn on the impact of labour costs and unemployment. The only variable that remained robust in all specifications was trade openness, showing a significant and positive influence (17–21). Most of the studies reviewed confirmed the hypothesis that larger and growing markets are potential FDI hunters. Studies were carried out by Galego et al. (2004), Merlevede and Schoors (2004), Janicki and Wunnava (2004), Carstensen and Toubal (2003), found that market considerations were the most robust determinant amongst the traditional variables. Kottaridi (2002), points out that market size has less influence than wages. Estrin et al. (2001), additionally concluded that FDI is stimulated by the economic potential, i.e. the ‘financing ability’ of the source country. Chakrabarti (2001), analysing a large set of cross-country studies, found that host country market size in terms of GDP per-capita is the only factor that remained robust in all specifications. Yet, some studies revealed a different impact of the market determinant. Garibaldi et al. (2001) found that the market size seemed to exert very limited influence on attracting FDI (131). The results of Kinoshita and Campos (2003) are controversial as they differ depending on the method. Several studies provide evidence that a liberal trade regime is positively associated with FDI: Carstensen and Toubal (2003), Kinoshita and Campos (2003), Estrin et al. (2001), and Garibaldi et al. (2001). The significance of the trade variable (Galego et al., 2004; Janicki and Wunnava, 2004; Holland and Pain, 1999; Lansbury et al., 1996) implies that FDI could also result from well-established trade links. The stream of works confirming that lower labour costs attract FDI is represented by Galego et al. (2004), Janicki and Wunnava (2004), Merlevede and Schoors (2004), Carstensen and Toubal (2003),10 Kinoshita and Campos

 Garibaldi applied a more extensive approach by analysing the determinants of both direct and portfolio investment in 25 European and former Soviet Union transition countries for the time period 1990–1999. Only the results related to direct investment are presented however they are derived from the whole sample of countries.   The fixed effect method showed that investors are attracted by large market size and, under the generalized method of moments estimations, the market size was insignificant.  Galego et al. used the relative wage rate of the host country as it was compared to the wage rate of source country.   Janicki and Wunnava used a wage rate.  Merlevede and Schoors used relative (compared to other potential host countries) unit labour costs (ULC). ULC is a measure that combines both the wage rate and productivity. 10 Carstensen and Toubal used unit labour cost.

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(2003)11, Kottaridi et al. (2002),12 Estrin et al. (2001),13 Bevan and Estrin (2000),14 and Lansbury et al. (1996). Contrary to the findings above, Garibaldi et al. (2001, 113) found that aggregate unit labour costs are insignificant. However, his analysis included Russia. An identical comment to that on Meyer’s (1995) similar finding on factor cost might be appropriate in this instance. Surprisingly, Kinoshita and Campos (2003)15 and Kottaridi et al. (2002)16 found that labour quality is an insignificant variable. On the other hand, Lansbury et al. (1996) noted that patent indicators, reflecting the ‘research intensity’ of the host economy, have worked as FDI ‘hunters’, especially in the case of Hungary. The findings of Galego et al. (2004) and Bevan and Estrin (2000) indicate that distance is ‘negatively associated’ with FDI inflows (16). This was also confirmed by the analysis of Estrin et al. (2001), revealing that geographical distance reduces FDI flows and that common borders exert the opposite effect (the latter was also proved by Holland and Pain, 1999). According to Holland and Pain (1999), risk perception is likely to affect the selection of an investment site. Bevan and Estrin (2000) claim that ‘studies on FDI in emerging markets’ have emphasised the importance of the ‘economic and political risk’, measured by macroeconomic, institutional and political stability (8). The private sector share of GDP, denoting the pace and method of privatization, proved to affect FDI pattern (Lansbury et al., 1996, 111). Similarly, Carstensen and Toubal (2003) confirmed that the level and method of privatization and the country risk have a strong influence on FDI attraction. As expected, Merlevede and Schoors (2004) and Holland and Pain (1999) found that direct sales stimulate foreign investment, while insider privatization reduces it. Janicki and Wunnava (2004), using the Institutional Investor country risk rating, provided evidence that higher risk reduces FDI receipts. Kinoshita and Campos (2003) provided evidence that rule of law and quality of bureaucracy, are significant FDI drivers. On the other hand, the FDI restrictions were found to be efficient barrier to FDI inflows. The analysis of Baniak et al. (2002) showed that stable macroeconomic performances and the legal system exert stimulating influence on FDI inflows, and that an unstable host country environment may lead to ‘adverse selection of 11 Kinoshita and Campos used wage rate. 12 Kottaridi et al. used wage rate. 13 Estrin et al. used differentials in ULC between source and host country. 14  Bevan and Estrin used ULC. They claimed that their result confirms that investment is attracted by ‘relatively inexpensive and productive’ labour. They argue that, ‘this result did not emerge in previous tests …’ that measured the labour costs by the wage instead of ULC (16–17). 15 Kinoshita and Campos used a quality of education indicator. 16 Kottaridi et al. used the secondary and tertiary enrolment ratios.

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investors’, meaning that it would primarily attract ‘short-run speculative’ foreign capital (17).17 The results obtained by Garibaldi et al. (2001) confirmed the positive relationship between FDI and macroeconomic stability, the level of economic and trade liberalization, and a fixed exchange rate policy. As expected, the legal barriers and insider privatization reduce FDI inflows (129). Surprisingly, the market perception variable18 had substantial significance, because, as suggested, it might substitute the missing piece in information mosaic at the moment of investment decision (132). Tondel’s results (2001) proved that FDI inflows are driven by the transition progress (the transition index being the only significant variable). The author claimed that higher risk sensitivity suggests ‘a role for the efficiency seeking or vertical investments’. Bevan and Estrin (2000) provided evidence that private sector share of GDP is highly significant and suggested that this is a ‘… key factor in determining perceived country risk’. Also, higher industrialization, direct sales privatisation, lower government deficits and increased reserve stocks all improve country credit rating. As expected, the corruption indicator had a significant and negative value (19). The study of Holland and Pain (1999) showed that the risk indicator19 and FDI were negatively correlated. Investigating a larger set of institutional development indicators, Estrin et al. (2001, 23) found that the following are principal FDI driving factors: privatization and the private sector share in GDP, development of the banking sector and legal institutions, and foreign exchange and trade liberalization. Surprisingly, the privatization method seemed to be insignificant. Utilizing firm-level data of around 4,100 foreign manufacturing plants in Bulgaria, Hungary, Poland and Romania for the period 1995–2001, Pusterla and Resmini (2005) found that agglomeration, abundant and cheaper labour force and urbanization externalities have a positive and statistically significant effect on attracting FDI. Labour force skills did not seem to exert any effect. Walkenhorst (2004), using an econometric analysis of the FDI drivers in eight manufacturing industries in Poland, concluded that unit labour cost is an important factor in all industries, except for non-metallic and minerals industries. This conclusion reinforces the importance of this factor, as found in the surveys of FDI factors in manufacturing. GDP and proximity transpired to be significant drivers for the whole sample and seven manufacturing industries, with the exception of 17  Baniak et al. developed a model focusing on two random variables (exchange rate and marginal production costs) in order to test the legal and macroeconomic stability as FDI determinants (2–3). 18 Euromoney bi-annual country-risk ratings. 19  The risk indicator was constructed from GDP growth, consumer price inflation, EBRD Transition Indicator and the reserve cover ratio.

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the metal products industry. Only the textile industry revealed the same significant determinants as the whole sample, and only two industries (paper products and basic metals) shared the same FDI-influencing factors. Referring to Resmini (2000), the author concludes that these results further prove the ‘considerable differences … across sectors’ and that it seems impossible to make ‘deductive claims’ on FDI determinants based on aggregate evidence (21). Elango and Abel (2004) studied the ‘effect of host country factors in determining US firms’ foreign investments in service and manufacturing sectors’, based on the data for US firms capital expenditures in 39 host countries (recipients of 92% of total US capital expenditures) for the period 1989–1994. Their findings were: (i) country wealth (represented through quality of infrastructure, skilled and educated labour, lower country risk, higher labour cost, higher income and living standards) is more related to service rather than to manufacturing investments; (ii) surprisingly, there was no relationship between the market potential and the investments in either of the two sectors; (iii) cultural differences are a significant barrier to both types of investments; (iv) bilateral trade, although significantly correlated to both types of investments, is more relevant for the manufacturing sector; and (v) the market size is more important for attracting manufacturing investments (36). Alvarez’s (2004) analysis on factors determining outward direct investments of Catalan manufacturing firms (sample of 117 firms owning 268 overseas subsidiaries in 46 different countries), revealed that firms are likely to be attracted by host countries possessing large markets, being relatively risk-free and socioculturally similar. Furthermore, they are host countries with lower labour costs, and located in an area where the investors have acquired substantial trade experience. Interestingly, the Catalan firms tend to invest in less developed countries as these environments enable them to exploit their ownership advantages (13–15). Altamonte and Guagliano’s (2001) econometric study, consistent with Alvarez’s (2004), found that market size is significant and positive for all sectors in CEECs sample. It also showed that labour costs significantly affect investment in all sectors, especially in the economy of scale manufacturing industries. The statistical analysis of a dataset of 1,760 foreign manufacturers in Hungary for the period 1992–2001 (Bekes, 2004) revealed that most industries strongly tend to locate where other similar firms are already present. This confirms the functioning agglomeration factor (as in Pusterla and Resmini, 2005). Moreover, Bekes claimed that input-output linkages are important, suggesting the need to strengthen the supplier-multinational business links in order to stimulate further investment (21). The econometric study conducted by Resmini (2000) for the CEECs, revealed that the market variables, although significant for all manufacturing sub-sectors, have the strongest influence on traditional manufacturing. This sub-sector also revealed itself to be the only one where the FDI is influenced by the level of openness and the agglomeration phenomenon. Both the transition progress and the proximity to Western Europe are significantly considered, particularly in

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the science-based and capital-intensive sectors, while labour costs differentials are significant FDI drivers in the scale-intensive (reconfirming Altamonte and Guagliano, 2001) and science-based sectors. Benacek and Visek (1999) tested the determining factors of FDI (capital stocks as of 1994) into 91 industries within the Czech manufacturing sectors and found that 82% of industries and 88% of all inward FDI can be explained by the following factors: a negative approach to the capital intensity of production (only indirectly implying that labour intensive industries were the possible investors’ target), a preference for industries with high total factor productivity and showing increasing returns to scale, and high requirements of production for R&D (17). Stemming from the previous studies, in a later work Benacek and Visek (2000) concentrated on studying the cause and effect of FDI in 15 manufacturing industries in the Czech Republic over the period 1991–1997. The results showed that the capital per labour ratio was the key factor determining the industrial structure of FDI, implying that ‘the role of capital was overshadowing the role of labour’ after 1994. The authors defined this as a surprising outcome that reversed their original hypothesis, i.e. ‘it is not the efficient and cheap labour that attracts FDI but the (locally) expensive and scarce capital’ (6). Both survey and econometric studies largely cluster around several factors as the most potent determinants for undertaking an investment operation abroad. These factors are summed up in the following part. Primarily, the influence of the market size was convincingly confirmed both by the survey and econometric evidence, and also proved to have a significant impact on the investments in the manufacturing sector, although relatively less than labour costs. Moreover, the market determinant was found to be the most robust one in the econometric studies analysing aggregate FDI, even under rigorous estimates. However, as Lim (2001) claimed, the ‘… robust significance and the positive size … in virtually all the studies …’ may be due to the prevalence of horizontal FDI in the structure of global investments (14). To be more specific, the literature is unanimous that market size and market growth (indicating the host market demand) are the principal drivers of marketseeking investors. Based on their research review, Kottaridi et al. (2002), state that both traditional trade theory and new trade theories consider large markets as significant FDI drivers as they represent the host country’s potential to ‘… absorb production …’ and to ‘… capture scale economies …’ (6). The works reviewed also confirm the significance of the labour cost factor. In particular, its influence is remarkable in virtually all presented surveys and econometric studies that focus on the manufacturing sector. Some of these works provide evidence that for particular countries and industries the labour cost is the decisive factor for the investment decision. The assumption that vertical, especially export-oriented, investment will primarily look for low labour cost countries, has a strong intuitive appeal. Thus, as Kinoshita and Campos (2003, 8) claim, findings indicating that lower costs are associated with higher FDI receipts, would be expected ‘if vertical FDI is dominant’.

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The evidence of labour qualification importance is inconclusive, being absent from the list of the most important drivers in almost all survey results (with the exception of Pye, 1998, and, partly, OECD, 2002, and Dedek and Novak, 1998). The econometric evidence in support of this factor is even less. However, as Kinoshita and Campos (2003) claimed, this result might be caused by a ‘lack of cross-country variance’ as the analysed countries have similarly educated labour. Both trade liberalization and trade linkages exerted a significant influence in the econometric studies on aggregate FDI in CEECs. This is in line with the prevailing concept in the literature that trade and FDI are complements rather than substitutes, suggesting that countries with a higher degree of trade liberalization may attract a larger FDI inflow. However, Markusen (2000), differentiating between the two basic FDI types, concludes that trade liberalization, under the assumption of a relatively liberal investment regime, could discourage horizontal investments and stimulate vertical investments.20 Geographical proximity also proved to be amongst the influential FDI drivers for both survey and econometric findings. In this regard, Estrin et al. (2001) wrote that ‘psychic distance’, including geographical, cultural, political and linguistic similarities between the interacting countries in interaction, ‘… affects costs of internal organisation and economic risk …’, implying that the proximity and similarities between the interacting countries would stimulate FDI flows (15). However, it should be noted that proximity is expected to be negatively associated with vertical investments ‘which are cost-motivated’ and positively associated with horizontal investment, which occurs in order to avoid distancerelated costs (Kinoshita and Campos, 2003, 9). All transition specific factors, although proxied by a wide range of heterogeneous variables in econometric studies, undoubtedly proved to influence the selection of investment sites. The survey findings on transition specific factors, represented as political, economic and legal stability, country risk, bureaucracy and corruption, strongly support their prominent role in attracting/inhibiting FDI inflows. These findings are consistent with Lankes and Stern (1998), who claim that the progress in transition determines FDI flow. In addition, they argue that FDI in countries in early stages of transition progress are predominantly of marketseeking type and, as the transition progresses, the country will increasingly attract efficiency-seeking investors, due to the influence of stability on the level of production costs. However, the findings do not give conclusive answers on the type of FDI projects analysed. For instance, market size determinant suggests a strong presence

20 Markusen (2000) has provided important insights into the relations between the FDI and international trade based on a review on the recent works that have led to the integration of the theory of the multinational enterprise into the theory of international trade.

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of market-seeking investments. On other hand, labour costs, trade liberalization and the overall stability speak in favour of vertical, export-oriented investments.

4.3 The Impact of FDI on the ‘Parties’ Involved 4.3.1 The Impact of FDI in the Host Country FDI has a significant impact on the host country and its possible transition process, on the home country and on the MNE itself. Generally, foreign firms may influence the productivity and growth of the domestically owned firm; they may change the nature and evolution of consideration; and they may alter financing, marketing, technological and managerial practices (Sergi, 2003). However, FDI significantly affects the host country in many aspects, both directly and indirectly. The effects of FDI in the host country may be either positive or negative, depending on the way they are handled by the local government and industry. The effects of FDI may be seen either in the short-run or in the longrun. The short-run effects may be different from the long-run effects in terms of maturing conditions. For example the unemployment rate may increase in the short-run by acquisitions but decrease in the long-run if the company expands production. Blomström and Kokko (1995) concluded that MNEs play an important role for productivity and export growth in their host countries, but that the exact nature of the impact of FDI varies between industries and countries, depending on country characteristics and the policy environment. According to the theory and empirical evidence, there are four groups of areas in a host country which possibly could be affected. Resource transfer effects (technology and capital) MNEs play a key role especially in developing countries by applying and transferring new technology. Technology can stimulate economic development (growth) and industralization. Technology can be incorporated into a production process, into a product, into research development and into upgrading the labour skills (management skills, skilled labour force and entrepreneurship). The technology transfer may lead to an increase in the efficiency of the local firms (efficiency spillover). In some cases, countries do not absorb the technology provided by the MNE. Thus, they cannot use or develop it locally without depending on the foreign company. This results in short-term benefits from technology transfer, since the country may fall behind in later years. As the speed of technology transfer increases, local firms become interested in the new technology. If the MNE is far more efficient than the other firms in the industry, it does not positively affect the efficiency rate of the whole industry. Technology transfer may also occur through employee and management training, which familiarizes people with hitherto unknown technologies and upgrades their skills; this may in turn be transferred via them to the rest of the

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industry. Technology spillover is more likely to be significant when the gap between the technology level of the MNE and that of the local industry is wide. Managers who initially work for an MNE subsidiary may later become available for the whole economy. The entrance of foreign firms impacts on the structure of the host economy and the performance of the local firms (spillover effect for related industries). Other companies of the same industry may ‘steal’ managerial techniques from the MNE, improving their own organizational structure. The ‘ownership structure’ of MNEs may provide an example of structure for the other firms in the industry. The entrance of MNEs may also trigger the development of related industries which recognize the opportunity to provide necessary services or inputs for the MNE for profit. The services sector in particular benefits from the presence of MNEs, particularly as their operations necessitate the existence of banks, insurance companies, financial consultants or financial intermediaries. This provides incentives for those industries to seek improvement and development. It should be noted that the effects of FDI are stronger in a small market of a developing country rather than in an already large market of a developed country. Different researchers express different opinions, about the significance of FDI spillovers in a host country. Several empirical studies on different countries support the assumptions that FDI has significant positive effects on the productivity of labour in the related industries of the MNE and generally on productivity levels and growth rates. Other studies find little or no evidence of consistent significance of the spillovers of FDI, in all industries or in all countries. Foreign firms seem to positively influence large local firms, in terms of growth rate and multi-factor productivity, especially in low technology industries. The weaker firms in an industry cannot keep up with large MNEs, find difficulty in absorbing the technology transferred, and cannot afford the higher rate of competition; therefore the entrance of a large foreign firm may lead to their elimination or their further weakening. Consequently, the technology spillover is only valuable when the local firms are strong enough to absorb them, and there is not a wide productivity gap between the foreign firm and the local industry (Kokko, 1994). The host country not only gains from the capital transfer and from the company’s own capital sources (funds that have been invested or will be invested), but from the revenue gleaned from the taxation of profits of foreign companies and by the creation of tax heavens as well. Such capital flows are supposed to finance the budget or other deficits of the host country or to cover and repay the government debts or even to generally improve the BOP position of the host country. Employment effects The employment effects may be either positive or negative, depending on a variety of circumstances. Although MNEs may provide the country with new job positions (especially in the case of green-field FDI), they may have a negative effect on the employment rate when they tend either to invest in capital-intensive production

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or to participate successfully in a privatization programme. In this case, the MNE may restructure and decrease the employment positions in order to increase its efficiency. Furthermore, it can be argued that the entrance of large and financially strong MNEs in a host country creates problems for local companies due to increased competition. This in itself may cause local companies to shut-down. However, the effect on the employment rate may be positive if, for example, the MNE aims to exploit the low labour cost in the host country and thus create a labour-intensive industry (e.g. textile production). FDI may also increase the total real wages of the labor force, especially in transition or developing or less developed countries. Furthermore, an indirect positive employment effect occurs when the establishment of MNEs in a specific industry creates a favourable environment for related industries to appear and operate. Economic growth, productivity efficiency, living standards and competition effects FDI has an effect on the gross domestic product (GDP) of a country since the production sites increase or, if we consider the acquisition of existing companies, the productivity rate rises. The ‘competitive pressure’, meaning the increase in the industry’s level of concentration (larger number of firms) provides tougher competition, a factor commonly accepted as a motivation for higher efficiency. It is also possible that increased competition will lower the prices of products. Furthermore, local firms are pressured by foreign competition to seek better and more efficient methods in their operations. FDI may bring changes by supporting industries, as well. The demands of an MNE, in terms of quality of goods and services from local producers, may influence the latter to pursue better operations, such as better time of delivery, stock control, supply networks, etc. The local government may block FDI through buyouts in order to encourage ‘green-field’ investments that encourage competition rather than foreign acquisition of local firms that eliminate competition for the MNEs. Lastly, FDI and the participation of MNEs in a host country may increase consumer choice, the quality and variety of products, modernize the infrastructure, increase wages, the production, the GDP, the GDP per capita, and thus living standards. To sum up, the host country gains by the creation of ‘external economies’ (Blomström et al., 1994). However, negative effects appear when the MNEs acquire greater economic power; when a creation of private monopolies in the host country occurs, when the MNEs threaten the national sovereignty of the host country, and finally, when the economic independence of the host government is eroded by the increased power of MNEs. The highly developed and sophisticated MNE and the increased competition may result in the elimination of local firms that are relatively small and weak, if they fail to keep up with the MNE. Balance of payments (BOP), trade and capital balance effects FDI provides valuable financial assistance. Money capital inflows that result can be utilized in covering the BOP deficit or the interest payments on international debt. Although foreign companies tend to export rather than simply serve the local

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market, the empirical evidence demonstrates that they also tend to import much of their inputs. That, on average, has a negative effect on the trade balance. The effect on the trade balance, though, may be positive (current account) if FDI is a trade substitute (an MNE stops exports to the host country and moves to FDI), or aims at establishing an export base (the MNE starts exports to the home country or to any third country). However, the initial capital inflow of the FDI has a one-time positive effect on the BOP of a host country, although the outflow of MNEs earnings (repatriation of profits) to the parent company or to any other MNEs foreign subsidiary acts negatively on BOP. 4.3.2 The Benefits and Costs of FDI for Home Countries FDI also ‘produces’ costs and benefits to the home country. The benefits of FDI outflows to the home country are numerous. Firstly, the capital account of the home country’s BOP profits from the inward flow of foreign earnings (repatriation of profits). The current account of the home country’s BOP will also profit if the MNE requires its home country to exports capital equipment, intermediate goods, complementary products, etc. Secondly, stemming and from the latter, the employment rate rises when the MNE imports particular raw materials which are produced in the home market. Thirdly, the home-country MNE ‘acquires’ valuable skills from its exposure to foreign markets that can subsequently be transferred back to its home country (superior management techniques, superior product and process technologies, entrepreneurship, etc.). Alternatively, FDI can act negatively on the home country’s BOP. Firstly, the capital account of the BOP suffers from the initial capital outflow required to finance the FDI. Secondly, the current account of the BOP suffers if the purpose of the foreign investment is to serve the home market with imports from a low-cost foreign production location (creating an export base). Thirdly, the current account of the BOP becomes problematic if the FDI is a substitute for direct exports. Finally, with regard to employment effects, a problem also arises when FDI has been seen as a substitute of trade (increases home country’s unemployment rate). 4.3.3 The Impact of FDI on the MNE In general, a company investing abroad aims to increase its corporate profitability. For example, by reducing costs, increase sales and profits and investing only in the instance that either real returns are positive or when other gains from investments seen feasible. The company has to establish business relations with the host market government, taking into account a series of factors: the favourable or unfavourable infrastructure of the host country, difficulties in establishing ownership structure, the unstable legal framework, difficulties in financing its operations, problems in creating a culturally applicable human resources strategy and the importance of positive or negative financial indicators of the host country. Furthermore, the company has to work through the many different issues essential for the

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operation of the new subsidiary. Lastly, the MNE must consider state bureaucracy, corruption, the different mentality of the workers and the consumers born and raised under a different business environment, such as the one created by the communist regime of the transition economies. In general, and more often than not, the cultural differences and the different language are significant drawbacks for foreign managers. 4.3.4 The Impact of FDI in the Transition Process Foreign ownership may be of great help in the transformation of a state-owned firm to an efficient ‘market’ firm. However, it also put pressure on the government on various issues such as (a) the establishment of a legal framework, especially concerning company’s rights and obligations; and (b) the need to proceed to reforms in order to stop monopolies; (c) to eliminate the government subsidies; (d) to accelerate the competitive pressures in the market; (e) to enforce hard budget constraints and consequently; (f) to embrace the ‘fair play’ rules of an open market. Foreign ownership will certainly reform the objectives of a firm from output and rent-for-the-state maximizing, to profit maximizing. The foreign firm will contribute to the legal reform because it does not jeopardize its investment by relying on ‘bluer laws’ and regulations. It may also contribute by minimizing the exploitation of state bureaucracy or at least the dependence on it, although MNEs are known to be able to receive favourable government treatment. FDI also assists the transition process of the country as a whole since the money capital invested helps the stabilization of the economy. Thus, apart from the financial help, FDI helps clarify property rights, the reallocation of resources, and the establishment of profit orientation. FDI also helps the effective corporate governance system and it brings about technological, management and employment advancement. To conclude, it provides significant assistance for the transition process from a centrally planned to a market economy.

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Chapter 5

Trends of FDI under Globalization: The Case of Regionalization of FDI Inflows

5.1 Globalization, Regionalization and the Concentration of FDI Globalization is a term used to express the tendency for the world economy to integrate, not only in respect of markets, finance, technology, and crosscountries’ trade and investments, but also in regard to the harmonization of laws and regulations of every day activity (political, economic, social, cultural and ideological). The core of the concept of globalization is that the world displays a strong tendency to become one entity. To be more specific, the term globalization describes the increase in international trade and financial flows that have taken place since 1960, but more so in the post-1980 period. Although, the term is used extensively in the international bibliography, it is also highly debatable. The growing interest in the concept of globalization increases the probability that the term will be used in contradictory ways. To a certain extent, these views eventually tend to divert globalization from its true meaning and intent. In doing so doubts about globalization become more profound. Globalization in its economic form, envisages an interdependent world economic system dominated by global corporations not identified with any individual country and is based on liberalization of international trade, goods and services and the free market. Globalization should not be perceived entirely as an economic concept, or simply as a development of the world system, or even as a development of large-scale global institutions, but also as an increasingly prevalent phenomenon with the ability to impact our lives, even at a distance. Hence, globalization encompasses other aspects of life. The huge capacity for, and rapid circulation of, information, mainly through the Internet and the facilitation of communication among people from all corners of the earth through the satellites of mass media, through e-mail, fax, and telephone are other examples of the globalization concept. This international communication network allows the transmission of political and cultural ideology, fashion-trends, and ideas worldwide. Apart from the easier interaction of the intangible components of life, and the reduction of distances through the reduction of the time needed to get from one place to another due to the revolution in the means of transportation, globalization facilitates the movement of tangible elements, such as people or commodities. For example, increasing numbers of people study abroad, either by physical presence or even by distance learning through the use of internet facilities.

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Moreover, the growth of the services sectors, especially those dealing with knowledge and information, and the rapid growth of a new generation of technology are indicators of the transformation of the global perspective of business operations. Development in technology has led to a boom in foreign investment and to a certain degree of openness. Thus, enterprise activity is no longer constrained by national boundaries. Both capital and labour migrate to whatever points on the globe yield the highest returns. Labour becomes mobile from markets with a lack of employment opportunities to markets with shortages of labour, especially throughout the European Union. The mobility of capital is almost unrestricted, since in the 1980s and 1990s many countries significantly reduced or even abandoned international capital controls. The international facilitation of economic and financial transactions (the stock market, for example) through electronic means, and computerized information networks reduced transaction costs and the time needed to the minimum. Compared to the international mobility of capital, labour mobility has remained rather steady. This is a reflection of a variety of factors, such as the immigration laws, which are still restrictive in many countries, as well as of other factors that in the future may be eliminated by the rapid acceleration globalization. Migration not only affects the economic environment of the country, but also the cultural environment, since the culture of the immigrants continues to develop, affected by the new culture, and in turn will affect the culture of the new country. The past two decades have been characterized by the rapid integration of financial markets. The Bretton Woods system (1944–1971) rested on the foundation of closed capital accounts and fixed exchange rates. As a result financial globalization was not on the policy agenda at that time and the world functioned within a system of separate national financial markets. However, the breakdown of the Bretton Woods system in 1971 prompted drastic changes. The world monetary system underwent three revolutions at once: deregulation, internationalisation, and innovation. Financial liberalization accelerated and improved knowledge of foreign markets, the development of financial transactions and the emergence of new financial instruments, especially derivatives. UNCTAD (1996, 43) documented that globalization is characterized (a) by the progressive removal of barriers on merchandise trade throughout the period since the Second World War; (b) by the deregulation of financial markets in the 1980s; (c) by the geographic dispersement of production processes controlled by the MNEs; and (d) by the technological revolution which has greatly reduced the costs of information processing and international communications. 5.2 Is Globalization a New Phenomenon? Similarities and Uniqueness of the Latest Phase of Globalization with Previous Ones Globalization involves steady declines in the importance of the national political boundaries and geographical distance and increases complex interdependencies

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among countries. Globalization can be frightening, stimulating, overwhelming, destructive or even creative. Globalization has its own set of economic rules, its own dominant culture, and its own defining technologies. It forces the integration of people, trade, FDI and financial policies, technologies, markets and economies. Globalization is not a new phenomenon, but it is in a new phase; a phase that is more pervasive, deeper, and different from anything previously experienced. For example, in 1914, at the end of a previous phase of globalization, west European foreign investment was more globally oriented before the First World War than in the 1990s (UN/ECE, 2000, 7–8). People, goods and services, financial capital, enterprise, technology, ideas, culture and values now move more easily across national frontiers than at any other time since the beginning of the First World War. Between 1870 and 1914, the international trade in goods and services was as free as it is today. Although the range of financial instruments that traded internationally was much more limited at that time, the mobility of people (including international migration) was less restricted during the Gold Standard days than it is today. Moreover, in 1973 exports and imports as a percentage of Gross National Product (GNP) in most countries were lower than in 1913 due to the fact that international trade had suffered from two world wars and from protectionism induced by the economic slowdown after 1929 (Kleinkencht et al., 1998, 638). The UN/ECE, 2000 (7, 8) argued that: What is clear from the data is that far from becoming more global, west European trade has become more and more concentrated on the European region itself … the extensive trade liberalisation which occurred in eastern Europe and the Baltic states after the revolutions of 1989 has led to a rapid re-orientation of trade away from the former CMEA towards western Europe … Thus the general evolution of European trade has not been towards a more global distribution of relationships but instead towards a more intense integration with close neighboring countries. Interdependence among the economies of the region has strengthened but with the rest of the world it has weakened … In 1914, at the end of a previous phase of globalisation … west European foreign investment was more globally oriented before the First World War than in the 1990s.

In the period from around 1870 to the beginning of the First World War, economies were relatively open; goods and capital moved in great quantities and freely across countries, and large numbers of individuals had migrated internationally with the prospect of gaining better opportunities (Tanzi, 2004, 525). However, in the current globalization phase, the world is more integrated than it was in the period between 1940 and 1980. As with the collapse of the Eastern Bloc, worldwide more countries open their borders and receive FDI flows, and thus, more countries participate in the globalized system. A mapping of FDI   The period from 1880 to 1914 is known as the classical gold standard. During that time the majority of countries adhered (in varying degrees) to gold.

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inflows indicates the extent to which host countries integrate into the globalized world economy and the distribution of benefits of FDI. Through the comparison of the world’s FDI maps, we can conclude that in the year 2000 more than 50 countries (24 of which are developing countries) have an inward stock of more than $10 billion, compared with just 17 countries 15 years ago (7 of which are developing countries). Moreover, the world’s top 30 host countries account for 90–95% of the total world FDI inflows/stocks. The top 30 home countries account for around 99% of outward FDI flows and stocks and are mainly industrialized countries (UNCTAD, 2001, 4–5). In developing countries and especially in developed countries, globalization has resulted in an increase of foreign direct investment as the share of cross-border capital flows increase. In this way, the role of MNEs becomes more significant. However, the share of FDI is not the same in all countries and the FDI inflows in less-developing or poor countries show little growth or no growth at all. In other words, the distribution of FDI and trade is unequal as only a small number of countries receive the majority of FDI and trade flows. The pervasiveness of the current form of globalization has more to do with the liberalization of trade, the expansion of FDI and the emergence of massive cross-border financial flows. As a result, competition in global markets is on a rise due to the combined effect of two underlying factors: policy decisions to reduce national barriers in international economic transactions and the impact of new technology. The growth of the services sector, particularly those services dealing with knowledge and information, and the rapid growth of a new generation of technology are the most important factors directly connected and supportive of the latest globalization phase. These features, absent in the previous phases, make globalization an established, unstoppable and irreversible process. The current phase of globalization is much more pervasive, deeper and different from previous phases due to new technologies, the facilitation and rapid distribution of the information, trade liberalization, the reduction of transportation costs of goods, capital and people, and finally due to the ‘abolishment’ of the countries’ isolation and the loss of their independence (Tanzi, 2004, 526). The economies that lag in adopting new technologies cannot participate in the globalization process and their transition to a market economy is hindered. As a result, they experience a lag in economic development and in living standards. On the other hand, countries with high levels of economic development are either free/open economies or earlier adopters of the transition reforms, because economic developments have created healthier conditions for the onset of globalization.

5.3 The Impact of Globalization The academic community is divided regarding the question of the existence of globalization. Many contend that it is a trend toward integration of the world economy by means of trade and FDI. However, there are others who deny its

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existence. A third group argues that globalization is a phenomenon that does exist, cannot be stopped, is long lasting, beneficial, brings about greater prosperity, equality, increases living standards, increases the domain of democratic institutions and strengthens the basis for peace. Another group accepts that globalization is an established process, unstoppable and irreversible, but although they share the view that it is likely to be beneficial, they are as certain that this will in fact be the case in the future. This group is more sensitive to the risks created by social disruption and increased anxiety. Moreover, some view globalization as a reality and argue that it is a phenomenon, not solely a new economic trend but an integration of markets, finance and new technologies which minimize the geographical and cultural distances among people. Furthermore, this phenomenon has its own dominant culture and this is why integration tends to be homogenized. Such events have continually taken place throughout history. The Romanization of Western Europe and the Mediterranean world, the Islamisation of Central Asia, the Middle East, North Africa, and Spain by the Arabs, and even the Russian/Soviet Union impact (Russification) of Eastern and Central Europe and parts of Eurasia, are examples (Friedman and Ramonet, 1999, 111). Alternatively some researchers believe that globalization is a phenomenon which may cause social disruption, and increase tension amongst countries. It increases insecurity amongst large sections of the population and thereby increases inequalities within and amongst countries. It is further suggested that globalization leads to a steady deterioration in the environment. Others still argue that globalization, as well as global strategies, are a mere myth; since business dealings carried out by large multinational corporations take place in regional blocks. This ‘regionalism’ perspective argues that governments’ regulations, differences among cultures, technological advances, have all divided the world into the three blocks: EU, ASEAN, and NAFTA. Furthermore, managers of large corporations are the driving force of the globalization process which is actually regional and takes place inside the triad blocks (Rugman et al., 2001; Rugman, 2001). Rugman et al. (2001) analysed the strategies of specific well-known multinationals such as McDonalds, Coca Cola and Euro Disney in order to prove that these MNEs adjusted their global strategy to fit into the local one. In this way, these companies accept the tastes of the local population and offer services closely related to local population preferences. Moreover, Moore and Rugman (2003, 2) argued that US companies are regional companies and not definitively global at all. They also suggested that: … if you examine the data on the US’ 25 largest multinationals it becomes clear that they are what we would call home-region based. Of the US’ 25 largest MNEs, 22 have more than 50% of their sales in their home region of North America. None of these US MNEs are ‘global’. For example, Wal-Mart has 94.1% of its sales in the North American Free Trade Area; GM has 81% – and so on. Indeed, the average intra-regional sales figures for all the 185 US MNEs

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Tanzi (2004, 526) argued that countries with a less educated population, strong traditions, and more ethnically diverse populations are likely to have difficulties benefiting from globalization. They require more time to make the changes and adjustments required by globalization. According to Tanzi, the opposite is true for well educated and more ethically homogeneous populations that are not excessively bound by strong traditions. However, Tanzi (2004, 529) added that when globalization makes the whole country richer, it may still generate discontent and discord if the increase in income is not evenly distributed. Many researchers view globalization as a commitment to, and desire for, a better future. In a sense it will convey optimism and offer infinite possibilities for growth, renewal, and revitalisation for every member of the world society. Globalization was created to describe what many felt to be a new and central reality of the times. Thus, a major debate continues, regarding the question of the benefits and the costs of globalization. On the one hand, proponents of the globalization process who have accepted the globalization process as a reality, maintain that this is a beneficial phenomenon. Since globalization makes integration processes easier, and that in the long run, economic growth and employment are and will be on the highest level. In particular instances, multinational corporations (MNCs) have more power and more money than specific developing countries, although it can be said that their activities in free and open markets can be the best contributors and indicators of the economic progress in these markets. It is for this reason that governments ask for FDI inflows and thus, investments from multinationals, offering at the same time significant incentives in order to attract FDI inflows. Opponents who acknowledge the globalization process minimize its advantages and emphasize its disadvantages. They contend that globalization brings about increased levels of poverty as well as inequality amongst people worldwide. The gap between the developed and rich countries and the poor countries deepens. Furthermore, globalization puts under risk the independence of the countries, and the employment rate, etc. They also support the idea that global integration, FDI flows, and competition are part of an unfair game. It is true that there are cases in which globalization tends to increase both insecurity among large sections of the population as well as inequalities within and among countries. It can also lead to a steady deterioration in the environment and in the general quality of living standards. In certain instances globalization may be responsible for increasing poverty, and even, in some cases, for impeding growth. Some countries have largely managed to take full advantage of globalization, receiving the benefits, while others have taken more of its costs. For example, Stiglitz (2003) suggested that East Asia provides the strongest example in favour of the positive effect of globalization on growth. On the other hand, the global financial crises and their aftermath brought home the dark side of globalization.

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Furthermore, the anti-globalists assume that the globalization pressures stemming from the large financial institutions such as the IMF, World Bank, and the WTO create greater dependency between them and the other developing countries, something not seen since the era of colonialism. Stiglitz (2003, 509) added that it is not true that liberalization measures are undertaken voluntarily. He concluded that politicians and governments in power believe that the gains from the liberalization measures outnumber the losses from the consequences of not undertaking such measures. 5.4 Globalization from a Statistical Point of View Summarizing both the supporters’ and the opponents’ arguments for and against the globalization process, we can argue that globalization cannot be classified as either simply ‘bad’ or ‘good’. It is its evaluation that matters most, as challenges and threats are subject to continuous change. Even with the use of statistics, globalization cannot be classified as a ‘bad’ or ‘good’ procedure because statistics are either misleading, inappropriate, or can be read from different perspectives. For example, those opposed to globalization argue that the three richest men in the world own more wealth than 600 million people in the world’s 48 poorest nations. Of the 100 largest economies in the world, 51 are transnational or multinational corporations. Economically speaking General Motors is ‘bigger’ than Indonesia. Microsoft Corporation enjoys annual profits of $12.5 billion, while $9 billion would give every child on the planet a basic education. In 1998, the richest country in the world possessed 115 times more per capita income than the poorest. Twenty per cent of the richest countries of the world had a per capita income 13 times more than that of the 20% poorest. The GDP of developing countries as a group grew faster than that of developed and high income countries. Almost a quarter of the world’s inhabitants live in poverty (1.2 billion out of 6 billion people live on less that $1 a day). The richest fifth of the world’s population owns 80% of the world resources, while the poorest fifth owns barely 0.5%. Even in the EU, there are 16 million unemployed people and 50 million living in poverty. The combined wealth of the 358 richest people in the world (billionaires) equals more than the annual revenue of 45% of the poorest in the world or 2.6 billion people (Ramonet in Friedman et al., 1999). World income inequalities have been rising during the last two or three decades, a trend seen at it sharpest when incomes are measured by market-exchange rate incomes and not by PPP-adjusted incomes (Wade, 2004). Conversely, proponents of globalization argue that the poorest countries, including 50% of the world population, had a share of world income between 10 and 20% in 1965 as well as in 1997, but that this share was higher in 1997 due to globalization. Over the past 20 years, the number of people living on less than $1 a day has fallen by 200 million, after rising steadily for 200 years (James Wolfensohn, president of the World Bank). The proportion of people worldwide

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living in absolute poverty has dropped steadily in recent decades, from 29% in 1990 to a record low of 23% in 1998. The best available evidence shows that the wave of globalization, since around 1980, has promoted economic equality, and in turn provided reduced poverty. Evidence suggests that the 1980s and 1990s were decades of declining global inequality which provided reductions in the proportion of the world’s population in extreme poverty. As already stated, the GDP of developing countries as a group grew faster than that of developed and high income countries. However, the absolute gap between a country with an average income of $1,000, growing at 6% and a country with an average income $30,000, growing at 1% continues to widen until after the 40th year (Wade, 2004). When evaluating the impact of globalization, the basic criterion is to look at what has happened to the rates of economic growth (GDP, and GDP per capita in PPP), both globally and across countries. On the one hand, the expanding global markets for goods and services provided new outlets for their exports. On the other hand, the emergence of a global production system and the liberalized investment rules generated new opportunities for MNEs, increasing their global reach and market power. Moreover, the growth of global financial markets provided expanded opportunities for investments with higher returns in emerging markets. A minority of developing countries reaped significant benefits that have been highly successful in increasing their exports and in attracting large inflows of FDI. FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration, a goal increasingly recognized as one of the key aims of any development strategy for an increased growth rate. It can be argued that there was a continuous increase in worldwide FDI flows up to 2000 and a significant decrease afterwards. The dramatic increase in FDI was based on the following: (a) globalization and economic integration; (b) technological improvements in communications, information processing and transportation; (c) new organizational structures and restructuring processes adopted by companies in order to become more competitive and effective; (d) the changing framework of international competition; and (e) the deregulation of key sectors such as telecommunications, which led to the liberalization of capital flows among countries. The increase in FDI flows was also largely related to the sharp increase in (f) investments in the high-tech and telecommunication sectors in the advanced economies and in (g) the increased M&A cross-border transactions. Lastly (h) developing and transition countries were increasingly liberalizing their regimes and abolishing barriers and obstacles in order to receive decisive inward foreign direct investment flows. Thus, an increase of FDI flows is also due to (i) the abolition of monopolies, the elimination of tariffs and quotas, and the increased free trade transactions as a complement to the FDI flows. Conversely, there are major factors responsible for the dramatic decrease in FDI flows after the year 2000. The first cause is the slowdown in the world economy which has reduced world demand and accelerated the global restructuring process of major MNEs in sectors characterized by excess capacity. The decline from 2001 onwards was influenced by the terrorist attacks of 11 September 2001 in New York

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City. The decline in 2001, which was mainly concentrated in developed countries, was also a result of a decisive drop in cross-border mergers and acquisitions (M&As). Another cause is the economic recession, especially in the USA and the EU(15), that has intensified competitive pressures (globalization and competition pressures) and thus forced companies to search for cheaper locations (a reason for the stable FDI flows to the CEE region). Furthermore, the issue of lower demand (the economic recession resulted to lower GDP per capita) can be offset by lower prices and lower production costs which may increase the demand. This trend has resulted in increased FDI flows in activities that benefit from relocation to low-wage economies (e.g. increases of Japanese FDI outflows in China and EU outflows in the CEE region). In general, there has been a redistribution of FDI towards developing countries where growth has reportedly been higher than in developed countries. The rise in developing countries’ shares also reflects the further liberalization of their FDI regimes and the openness of their borders, reinforced by the growth in the number of bilateral investment promotion and protection treaties. However, on account of a strong increase in FDI flows to developing countries, 2004 saw a slight rebound in global FDI after three years of declining flows. At $648 billion, world FDI inflows were 2% higher in 2004 than in 2003. Several factors help to explain why the growth of FDI was particularly pronounced in developing countries in 2004. Intense competitive pressures in many industries lead firms to explore new ways of improving their competitiveness. Two of these ways are by expanding operations in the fast-growing markets of emerging economies to boost sales, and by rationalizing production activities with a view to reaping economies of scale, and lower production costs (WIR, 2005). The globalization concept implies that a growing share of FDI is worldwide in scope and transition countries, in particular, should attract increasing percentages of FDI. However, this has not always been the reality. Globalization in terms of openness of borders, abolition of currency restrictions, liberalization of trade and prices, technological and transportation advances facilitates decisions for FDI and creates opportunities for efficient, less risky and less costly FDI projects. On the other hand, FDI inflows and outflows by MNEs and the consequent direct and indirect effects of FDI on the host countries’ economy may be viewed as a vehicle of globalization. There are many countries that opened up their economies to trade and received FDI inflows. However, as previously noted, the share of foreign direct investment is not the same in all countries and FDI inflows in less-developing or poor countries show little or no growth at all (Bitzenis, 2003b; 2004b; 2005). The limited extent of reforms or the ineffective transition programs, the increased and highly competitive worldwide investment environment, which offers various alternative opportunities to the MNEs, together with the changing opportunities that a country has to offer through time, and the different ways in which MNEs evaluate those opportunities, suggests that globalization and transition reforms can indeed help countries in order to attract FDI flows and to become market economies.

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The interest of MNEs is not concentrated on one part of the world constantly, but follows opportunities in different areas (Latin America, the UK and Ireland, Spain, Greece, Eastern Europe, CIS, SE Asia, etc.) at different periods of time. Each host country offers its comparative locational advantages and incentives for FDI (Bitzenis, 2004b). The MNEs evaluate these incentives and select the most appropriate country for their investment. From worldwide statistical information, one finds countries with near zero FDI inflows and simultaneously others that hold a high percentage of the total amount of FDI inflows. For example, there is limited Western investment interest in Central and Eastern Europe (CEE) considering that only 3% of the worldwide FDI outflows reach this region. Since 90% of the worldwide volume of FDI belongs to the MNEs, their attitude towards it may reflect the nature of the world FDI (Bitzenis, 2005). The CEE region received throughout the transition period (1989–2003) more than US$225 billion. At the same time, the Commonwealth of Independent States (CIS) received around US$75 billion and the South East European region (SEE) received less than US$40 billion. Moreover, the FDI per capita on average, in the transition period in a country from CEE is between US$200–500. At the same time in a SEE country the FDI per capita per year is less than US$100, with the only exceptions being Slovenia and Croatia (US$250 each). The South East European countries (except for Slovenia) lag behind most of the other CEE countries since they have not yet recovered economically in terms of either GDP or in industrial output (most of the SEE countries have not even reached the levels of GDP that they had in 1989) (see also Hunya, 2002; 2003). Fortanier et al. (2001, 113) stressed that increased liberalization, debilitated trade barriers, investments and financial support reforms, privatization and regulatory reforms are factors that contributed to a considerable growth in international investment over the past decades. Furthermore, regulatory reforms and harmonization of European legislation merged with a liberalized internal market. This leads to intensified intra-European investments and trade patterns. In addition, NAFTA, Asia (ASEAN4), Africa (SADC6), Australia and New Zealand (ANZCERTA) applied regional integration systems in order to liberalize trade as well as investment paths. Currently, bilateral investment treaties are a significant factor for promotion and protection of investment flows which legally provide security for the investors. Many bilateral investment agreements were signed which were designed to protect and increment the FDI flow in 1990; hence governments tried to facilitate FDI flows. By 1997, there were 1330 bilateral investment agreements in 162 countries. The key fact is that these numbers increase every year. In the 1980s and 1990s, many countries from Central and Eastern Europe entered into bilateral regional agreements, between themselves as well as with the developed and developing countries. Brewer et al. (1997) argues that there is an increased use of incentives by national and subnational governments in the newly more competitive worldwide environment under the pressures of globalization and new regionalism.

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A broader use of incentives is evidenced by the exploitation of the international investment multilateral agreements (regional initiatives) by foreign investors. These agreements produce welfare gains, influence legal framework, boost economic growth, increase the number of potential consumers, increase opportunities for market growth and provide stability, peace, unity and prosperity. Multinational enterprises (MNEs) tried to enter into markets, which have established not only bilateral regional agreements, but also multilateral agreements (e.g. CEFTA, SECI, BSEC, CEI, SEECP, etc.). Floyd (2001) considered whether there exists a situation of globalization in the strictest sense (according to the recent developments in the business environment), or whether in reality we have a case of regionalization or ‘Europeanization’. Floyd concluded that if we used an interdisciplinary approach we could deduce that this is not globalization, but rather regionalization or ‘Europeanization’. In the 1980s many bilateral regional agreements were signed among developing countries such as China, Chile, Algeria and the Republic of Korea. Latin America and the Caribbean countries have only recently commenced implementing these agreements (UNCTAD, 1997). Bilateral and regional agreements were signed in order to improve the investments conditions whilst at the same time improving the relationship between the triad members (UNCTAD, 2003). It can be argued that a regional concentration of FDI exists, as can be seen from the examples of Greek MNEs that became dominant entrepreneurs in the Balkan region; the Austrians in Slovenia and Croatia; and the Nordic countries (Sweden, Norway, and Finland) in the Baltic region (Estonia, Lithuania and Latvia). Germany, France, and the UK have become dominant entrepreneurs in the exVisegrad Group countries (Poland, Hungary, the Czech Republic, and Slovakia). Spain has become dominant in Latin America. The UK, France, Germany and the Netherlands have dominated other advanced economies (e.g. Belgium). The USA has dominated Canada and Mexico. Japan has dominated China, and across SE Asia (Bitzenis, 2004b; 2005). Rugman et al. (2001) argue that large MNEs take place in regional blocks (EU, ASEAN, and NAFTA) and that MNEs are shifting from a global strategy to a ‘glocal’ one (think global and act locally). Moreover, Rugman (2003) concluded that even the 20 most ‘international’ MNEs (those with the highest ratio of foreign-to-total sales) are mainly home-tRIAd based on their activities, as such strategic management of MNEs needs to be regionally focused, rather than global. FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration (globalization), a goal increasingly recognized as one of the key aims of any development strategy. In a ‘truly’ global economy that conforms to the assumptions of neoclassical methodology, there would be a virtually perfect substitution between goods, factors of production and financial assets, and MNEs would respond to global incentives and locate their activities wherever they found it to be most profitable and without any regard to national jurisdictions. The latest developments associated with the aforementioned features of globalization in conjunction with the technologies of

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communication led to a boom in FDI and to an openness of some degree (measured by the ratio of merchandise trade to GDP). It can be argued that many governments and policy makers, especially in North America and Western Europe, as well as MNEs, tend to see the world as a single entity. Hence, open trade and foreign investment supposedly will lead not only to faster growth for the world economy but also to increasing convergence of national incomes across the world. Supposedly again, the developing and transition economies can expect to benefit more than average from increased openness. The normative programme in transition economies was therefore to achieve these objectives by giving as free a reign as possible to market forces and to keep any form of interference with market forces, including state interference, to a minimum. The globalization agenda in transition economies transpires to be the traditional neoclassical, neoliberal agenda, up-dated for a world where geographical distance is alleged to have little significance for business activity. The collapse of communist regimes in the early 1990s weakened the political and intellectual resistance to the enlarged programme of liberalization, exemplified by the Uruguay Round of 1986–1994 and the creation of the WTO. Nevertheless, under the abnormal economic conditions of transition, … the proclaimed goal of becoming a developed capitalist state in the mould of Great Britain or France is simply objectively unattainable. It is naive in the extreme to think that the gulf in levels of development and wealth can be bridged with the help of a few salutary laissez-faire prescriptions. If such was feasible, after all, poor and backward countries would have ceased to exist long ago. (Kagarlitsky, 1993, 88)

According to Obstfeld and Taylor (2002), after the Second World War, the global economy changed. In 1960, taking into consideration the increasing trend of world trade, capital flows moved across national borders. According to the Keynesian view, Post World War II financial markets were inherently unstable, a fact that resulted in intervention by the state in economic affairs. By the 1970s, these assumptions were opposed by neoliberalism, which favoured monetarism, structural policy and financial liberalization, a free flow of international capital, and a decreased role of the state. It is argued that the major evidence provided by the inefficiency of government regulations was the collapse of economies with totalitarian regimes. However, at the beginning of the twenty first century, the financial integration of economies appeared widely disregarded. Thus, the financial crises in Latin America (1994– 1995), South East Asia (1997), Russia (1997–1998), Turkey (2000–2001), and Argentina (2001–2002) challenged the benefits of free financial integration. Hence, UN/ECE (2000) argued that although some countries experienced certain benefits in the wave of liberalization, empirical evidence suggests that higher capital movements were associated with lower growth rates, inefficient resource allocation and income inequality.

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5.5 Globalization and Alternative Terms Globalization today is perhaps most usually connected with the rise and power of global markets, economies, and multinationals. There are powerful minorities (superpower multinationals) on the global scale that seek to take full advantages of the market economies. However, there are many who consider globalization as an exclusive privilege for the elite or the dominant superpower; the United States of America. Thus, ‘Westernalization’ may be an alternative term for globalization. What is perceived as globalization may be interpreted under the scope of the rising influence of western civilization, culture and economic style on the rest of the world. There is a dominant concept that the western way of life and the western way of economic activities is the most developed and the most appropriate one. There is also a tendency of the less developed, and developing countries to ‘lookup’ to the western model. Such attitudes disguise the overwhelming persistence of western countries in favour of their culture, and globalization, at the expense of the rest of the world. The rapid development in technology, especially in communication related technology, that is usually produced and mainly consumed in western countries has underlined the domination of westernalization. It should be added that the world in its entirety does not necessarily accept Western or American civilization as the optimal way of living and if the countries in question could efficiently avoid economic dependence on Western countries they would attempt to fight off globalization. The conflicts that do arise are mostly on political issues, which are perceived differently by various civilizations in terms of culture, ideas and morals; rather than economic issues, which are more or less perceived in the same way by most countries. It can be said that globalization is one thing and the American Hegemony another. But it is obvious that the US is promoting globalization. An advantage for the US is the use of the English language in most international transactions and in international computer communication, along with the use of the dollar as a key currency in international transactions. The domination of the US is more economic, military, political and cultural. In recent years US domination has also been mirrored by a domination from the European Union, especially after the creation of the Economic and Monetary Union (EMU) and the introduction of the Euro. However, the EU as a trade bloc does not appear to be fully integrated with the world economy, as suggested by globalization. Less than 10% of the EU’s GDP tends to be exported to non-EU countries. Hence, there has been a clear trend of ‘Europeanization’ of export and import relations over the past 35 years and the EU seems to be a closed economy (Kleinknecht et al. 1998, 641).

5.6 Globalization, Neoliberalism and the Role of Multinationals Neoliberalism is a term used to describe the contemporary forms of worldwide economic restructuring occasioned by globalization. Neoliberalism is the

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economic liberalism which has become increasingly prevalent since the 1970s. It refers to a political and economic philosophy that rejects government intervention in the domestic economy. Neoliberalism favours privatization, deregulation, free markets, free and increased trade, unrestricted flows of capital, the expansion of multinationals provided by the end of Cold War and open borders; and therefore it favours globalization. Neoliberalism is the process of liberalizing national economies to facilitate the entry of multinational enterprises (MNEs) and the adoption of advice of the World Bank, WTO and IMF. Criticism has been levelled against these international financial institutions; primarily that they do not promote development, but instead ensure the position of the developed countries that dominate them. In the opinion of Wade (2004, 567), the neoliberal arguments suggest that the distribution of income among all the world’s people has become more equal over the past two decades and the number of people living in extreme poverty has fallen, for the first time in more than a century and a half. (This is true only when inequalities are measured using the ‘population-weighted countries’ per capita PPP adjusted incomes’, then taking a measure of average inequalities, and finally combined inequalities among and within countries). Neoliberalism claims that these progressive trends are due mainly to the rising amount of economic integration among countries, which has made for the rising efficiency of resource use worldwide as countries and regions specialize in line with their comparative advantage. In order to achieve their goals, MNEs from different countries often enter into the so-called cross-border agreements as a complement to traditional FDI activities. Analysis shows that the number of these agreements has consistently been increasing (UNCTAD, 1997). Most cross-border agreements were concluded within the TRIAD members. Rugman (2003) mentioned that a powerful indicator of triad/regional economic activity is the concentration of the world’s largest MNEs in the TRIAD. In 2000, of the world’s largest 500 MNEs, 430 were in the TRIAD. The US accounts for 185 of these companies; the European Union (EU) for 141 and Japan for 104. These 500 MNEs account for over 90% of the world’s stock of FDI and nearly 50% of world trade. The significant role of MNEs and FDI flows is profound, evidenced by the fact that world FDI inflows rose rapidly and faster than world GDP and world exports during the last two decades. In particular, world FDI inflows over the period 1991– 2000 increased 4.8 fold compared to the previous ten-year period, and surpassed the 4.5 fold increase attained in the 1970s and the 1980s. The dramatic increase in FDI over the last decade was based on globalization and economic integration, technological improvements and lastly, on the liberalization of various regimes with the abolishment of monopolies and barriers.

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5.7 Cross-border Transactions under Globalization As mentioned previously, FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration, a goal increasingly recognized as one of the key aims of any development strategy for an increased growth rate. It can be argued that there was a continuous increase in FDI flows up to 2000 and a significant decrease thereafter (Table 5.1). Global flows of foreign direct investment (FDI) fell sharply in 2001 and 2002 (the largest decline in the last three decades), following the boom during 1999–2000 during which time FDI flows in the world exceeded yearly $1 trillion (WIR, 2003). Table 5.1  FDI inflows by host country, economy or region in million US$ (1991–2002) Host region/Economy

1991–1996 (annual average)

1997

World Developed Economies Western Europe* European Union France Germany Greece Ireland United Kingdom Canada USA Australia Japan Developing Economies Africa Nigeria South Africa South America Argentina Brazil Chile Venezuela Bermuda (Caribbean) Mexico

254326 154641 91030 87584 18444 4700 1058 1469 16463 6571 46834 6238 890 91502 4606 1264 450 14982 4309 3633 2191 1150 2353 7351

481911 269654 139274 127888 23174 12244 984 2712 33229 11527 103398 7657 3225 193224 10667 1539 3817 48228 9160 18993 5271 5536 2928 14160

1998

1999

2000

2001

2002

686028 1079083 1392957 823825 651188 472265 824642 1120528 589379 460334 263025 496205 709877 400813 384391 249934 475542 683893 389432 374380 30984 46545 43250 55190 51505 24593 55797 203080 33918 38033 85 571 1089 1589 50 8579 18500 26447 15681 19033 74324 84238 130422 61958 24945 22809 24742 66757 28809 20595 174434 283376 314007 143978 30030 6015 2924 13071 4006 13978 3192 12742 8323 6243 9326 191284 229295 246057 209431 162145 8928 12231 8489 18769 10998 1051 1005 930 1104 1281 561 1502 888 6789 754 52424 70346 57248 39693 25836 7291 23988 11657 3206 1003 28856 28578 32779 22457 16566 4628 8761 3639 4477 1603 4495 3290 4465 3448 1318 5399 9470 10627 12584 9093 12170 12856 15484 25334 13627

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Table 5.1  continued Host Region/Economy Asia and the Pacific China Hong Kong, China India Korea Malaysia Philippines Singapore Taiwan Thailand Central and Eastern Europe and CIS** Czech Republic Hungary Poland

1991–1996 (annual average) 59826 25476 6057 1085 1234 5436 1226 6856 1311 1964 9218 1177 2205 2119

1997

1998

109282 100316 44237 43751 11368 14766 3619 2633 2844 5412 6323 2714 1261 1718 13533 7594 2248 222 3882 7491 22140 25476 1286 2167 4908

3700 2037 6365

1999

2000

2001

2002

108809 40319 24580 2168 9333 3895 1725 13245 2926 6091 27607

142209 40772 61939 2319 9283 3788 1345 12464 4928 3350 28244

106937 46846 23775 3403 3528 554 982 10949 4109 3813 28978

95129 52700 13718 3449 1972 3203 1111 7655 1445 1068 32744

6310 1977 7270

4984 1646 9341

5639 2440 5713

9319 854 4119

Note: * EU(15) + Gibraltar, Iceland, Malta, Norway, Switzerland; ** 27 countries. Source: World Investment Report, 2003.

World FDI inflows grew rapidly and faster than world GDP and world exports during the last two decades. In particular, world FDI inflows over the period 1991–2000 increased 4.8 fold as compared to the previous ten years period, and surpassed the 4.5 fold increase attained between the 1970s and the 1980s. From an all-time high of $1392 billion in 2000, world FDI inflows fell by around 50% to $651 billion in 2002.

5.8 Cross-border Merger and Acquisitions (M&As) Over the past ten years cross-border M&A activities have risen fivefold. Europe was an increasingly active player in the M&A market throughout these years, while Central and Eastern Europe remained out of favour for cross-border M&As. In actuality the increase in FDI flows was primarily due to large M&A activities. For example, in 1999 the four largest cross-border M&As in which German investors participated accounted for more than half of the German total investment abroad (outflows) (WIR, 2000). The value of international cross-border M&A activities attained record levels in the peak year of 2000 with over $865 billion (WIR, 2001). The importance of cross-border M&As can be seen by the following example: in 2002, Vivendi from France acquired USA Network for around $11 billion, in so

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doing it spent an amount almost similar to the total (stock) FDI inflows that Greece received in the last three decades. Just one cross-border transaction equals three decades of FDI inflows! Regarding the statistics for individual countries, the United Kingdom overtook the United States as the most active source (purchaser) of M&A investment. In terms of inflows, the United States has remained the most attractive location seller. The telecom industry is still the most important sector for M&A closely followed by the chemicals sector. The sale of state-owned companies to foreign investors represented a large share of the source of FDI, particularly among new members of the OECD and in some emerging economies. For example, the best country seller (inflows) in 2001 and 2002 was the USA with $185 and $73 billion respectively, in the EU(15) it was the United Kingdom with $68 billion and $53 billion, followed by Germany with $48 and $46 billion respectively. In the peak year of 2000, the USA ranked first once more with $324 billion, followed by Germany with $247 billion and the UK with $180 billion. Regarding the best country purchaser (outflows) in 2001 and 2002 it can be argued that the UK was first again in 2001 with $111 billion, followed by the USA with $96 billion, France with $59 and Germany with $57 billion. In 2002 the USA was first with $78 billion, followed by the UK with $69, Germany with $45 and France with $33 billion. In the peak year of 2000, the UK was first with $382 billion, followed by France with $168 and the USA with $159 billion, when only $58 billion derived from Germany. The best-preferred sectors/industries for crossborder M&As (either sales or purchases) were transport, telecommunications, finance, business services followed by food, beverages and tobacco, chemicals, petroleum and nuclear fuel, and electrical and electronic equipment (WIR, 2003; WIR, 2002). Specific M&A deals made the world’s leading countries and regions look closely at cross-borders M&As transactions. For example, two deals, Vodafone-Airtouch ($60.3 billion) and Zeneca-Astra ($34.6 billion), made the United Kingdom the world’s most acquisitive country (UK FDI outflows) for cross-border M&As in 1999. At the same time, the United States was the leading country for inward M&A deals (US FDI inflows) in 1999, due to another two major transactions including Vodafone-Airtouch and Scottish Power-Pacificorp ($12.6 billion) (WIR, 2000). In the last six years (1997–2002), the ratio of FDI flows over M&A transactions ranged from 27% to 62% (the peak year was the year of 2000 in which 62% of total world FDI inflows were cross-border M&A transactions). Thus, M&A deals are the key driving factors behind overall FDI flows when at least one third (two third in maximum) of the total FDI flows are due to the M&A cross-border deals (Table 5.2).

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Table 5.2  Cross-border M&As with values of over US$1 billion (1989–2002) Year

Number of deals

Percentage of total M&As

Value (billion US$)

Percentage of total M&As

M&As as a percentage of total FDI inflows

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

14 22 26 33 7 10 14 24 36 43 64 86 114 175 113 81

1.6 1.5 1.2 1.3 0.2 0.4 0.5 0.7 0.8 0.9 1.3 1.5 1.6 2.2 1.9 1.8

30 49.6 59.5 60.9 20.4 21.3 23.5 50.9 80.4 94 129.2 329.7 522 866.2 378.1 213.9

40.3 42.9 42.4 40.4 25.2 26.8 28.3 40.1 43.1 41.4 42.4 62 68.1 75.7 63.7 58.1

– – – – – – – – – – 129/482 = 27% 329/686 = 48% 522/1079 = 48% 866/1392 = 62% 378/823 = 46% 213/651= 33%

Source: UNCTAD, cross-border M&A database, World Investment Report, 2003, 17, author’s modifications.

5.9 Trends of FDI Regarding the regional distribution of FDI inflows for the period 1986–1990, more than 80% went to advanced economies, whereas developing countries absorbed less than 20% of world inflows. In addition in the period 1991–1998 only a ratio from 61% to 66% went to advanced economies when at the same time a ratio from 31% to 35% went to developing countries. However, in the period 1999–2000 we return back to the statistics of the 1980s, when advanced countries absorbed again 80% of total FDI inflows and developing countries absorbed only 18%. Lastly, in the time period from 1986–2001, Asia and the Pacific absorbed between 10% and 20% of the world inflows, Latin America and the Caribbean absorbed between 5% and 12%, while FDI inflows into Africa the Middle East and the CEE region remained throughout at less than 2.5% and 4% of world inflows respectively. The share of the FDI inflows in the transition economies in 2001 reached 3.7%, surpassing that in developing Asia excluding China (which had a much longer history of hosting FDI) (Table 5.3).

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Table 5.3  Distribution of world FDI inflows, 1986–2001 (percentage) Region Developed Countries Western Europe European Union Japan USA Developing Countries Africa Latin America and the Caribbean Asia and the Pacific Central and Eastern Europe Least Developed Countries

1986–1990 1991–1992 1993–1998 1999–2000

2001

82.4 38.4 36.2 0.2 34.6 17.5 1.8

66.5 46.0 45.3 1.2 12.7 31.2 2.2

61.2 33.7 32.1 0.3 21.7 35.3 1.8

80.0 51.9 50.2 0.8 22.6 17.9 0.8

68.4 45.7 43.9 0.8 16.9 27.9 2.3

5.0

11.7

12.3

7.9

11.6

10.6

17.4

21.2

9.2

13.9

0.1

2.2

3.5

2.0

3.7

0.4

1.1

0.6

0.4

0.5

Source: World Investment Report, 2002.

Cumulated FDI inflows in the developed countries were concentrated in the USA with over $1.3 trillion FDI inflows, followed by China (including Hong Kong) with approximately $900 billion and the UK with $600 billion and Germany and France with less than half a trillion US$ each (Table 5.4). In the developing countries FDI inflows were concentrated in a ‘handful’ of countries such as China, Brazil, Argentina, and Mexico. China emerged as a popular destination of FDI in the early 1990s and became the second largest FDI recipient in the world after the United States. Other main destinations of international investment within Asia in the 1990s are Singapore, Malaysia, Thailand, Indonesia, and Philippines. The four largest economies of Latin America – Mexico, Argentina, Brazil, and Chile – have been constantly receiving over 70% of the total inward FDI in Latin America since the 1970s. This trend remained unchanged in the 1990s. For the countries in transition in Central and Eastern Europe and the CIS, FDI only began to take off as they moved towards more market-based economies in the early 1990s. However, two thirds of the total inflows to these transition economies are concentrated in Poland, Hungary, the Czech Republic, and Russia. Furthermore, by the end of the nineties, only Hungary had shifted to postprivatization FDI, with annual inflows standing at US$1.5–2 billion without privatization projects. Other countries in the first group to receive significant FDI inflows still rely more on privatization-related FDI inflows, while developing countries may be characterised by pre-privatization FDI. The sectoral distribution of FDI depends on the privatization process or on a country’s endowments of natural and other production resources. Manufacturing companies are usually the first targets of privatization, so in the early stages this

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sector’s share is dominant in total FDI. The privatization of services usually comes second, with the sale of state-owned companies in telecommunications, financial services and in retail trade. Export-oriented investors attracted by the labour force – and in some cases by generous incentives – have in some cases undertaken greenfield investment in the vehicle and electronic industries (WIR, 1999; WIR, 2000; WIR, 2003). Table 5.4  FDI inward stock (cumulated FDI inflows) by host country, economy or region in million US$ (1980–2002) Host region/ Economy World Developed Economies Western Europe* European Union France Germany Greece Ireland United Kingdom Canada USA Australia Japan Developing Economies Africa Nigeria South Africa South America Argentina Brazil Chile Venezuela Bermuda (Caribbean) Mexico

1980

1985

1990

1995

2000

2001

2002

699415

977755

1954152 3002152 6146812 6606855 7122506

391946

570901

1399880 2041408 3988075 4277195 4594850

232717 217476 25927 36630 4524 32461 63014 54163 83046 13173 3270

286179 268253 36701 36926 8309 33361 64028 64657 184615 25049 4740

796179 748669 86845 119618 5667 34208 203894 112882 394911 73644 9850

1213733 2361428 2544445 2779857 1136387 2240506 2418136 2623903 191434 259775 289015 401305 192898 470938 413556 451589 12056 10957 12499 12006 40406 118550 138266 157298 199760 435422 552062 638561 123290 205129 209464 221468 535553 1214254 1321063 1351093 104074 109263 105391 128696 33508 50323 50319 59646

307469

406805

551481

920400

2029412 2173769 2339632

32162 2405 16519 29345 5344 17480 886 1604

33844 4417 9024 42238 6563 25664 2321 1548

50775 8072 9121 66625 8778 37143 10067 2260

77400 14065 15099 112150 27991 42530 15547 6975

144503 20184 47418 380061 72935 196884 44955 26944

157823 21289 50246 414979 75989 219342 44693 30392

170876 22570 50998 441110 76992 235908 46296 31710

5131

8053

13849

23997

56393

68977

78070

8105

18802

22424

41130

97170

140376

154003

Trends of FDI under Globalization

147

Table 5.4  continued Host region/ Economy Asia and the Pacific China Hong Kong, China India Korea Malaysia Philippines Singapore Taiwan Thailand Central and Eastern Europe and CIS** Czech Republic Hungary Poland

1980

1985

1990

1995

2000

2001

2002

224904 6251 177755 10274 1327 5169 1281 6203 2405 981

292832 10499 183219 24971 2160 7388 2601 13016 2930 1999

383743 24762 201652 38883 5186 10318 3268 30468 9735 8209

641245 137435 227532 50601 9451 28731 6086 65644 15736 17452

1275985 1310200 1406527 348346 395192 447892 455469 419348 433065 55836 60638 57359 43689 37106 40767 56505 52747 53301 9081 10468 11579 113431 116428 124083 27924 32033 33478 24468 29158 30226

-

49

2481

44205

145292

176590

212825

-

49 -

1363 569 109

7350 11919 7843

21644 19804 34227

27092 23562 41031

38450 24416 45150

Note: * EU(15) + Gibraltar, Iceland, Malta, Norway, Switzerland; ** 27 countries. Source: World Investment Report, 2003.

In terms of the major world sources of FDI (outflows), Western Europe supplied over 40% (in 1980), rising to close to 55% (in 2000s) of the world FDI outflows, followed by the USA with a share of 38% (in 1980) to 19% (in 2000s) and Japan with a share of less than 4% (in 1980) and with less than 5% (in 2000s) of the total world FDI outflows (OECD, 2002; OECD, 2003; OECD, 2004; WIR, 2003) (see Table 5.5). Table 5.5  FDI outflows by home country, economy or region in million US$ (1991–2002) Host region/ Economy World Developed Economies Western Europe* European Union France Germany Greece

1991–96 (annual average)

1997

1998

280550

476934

683211

240639

396057

140132 127762 24303 27908 5

244115 220953 35584 41797 156

1999

2000

2001

2002

1096554 1200783

711445

647363

630891

1021307 1097796

660558

600063

436525 415367 48611 88823 262

770608 731068 126856 109648 539

468807 451911 92974 42079 607

411665 394146 62547 24534 655

872422 819169 177449 56846 2102

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Table 5.5  continued Host region/ Economy Ireland United Kingdom Canada USA Australia Japan Developing Economies Africa Nigeria South Africa South America Argentina Brazil Chile Venezuela Bermuda (Caribbean) Mexico Asia and the Pacific China Hong Kong, China India Korea Malaysia Philippines Singapore Taiwan Thailand Central and Eastern Europe and CIS** Czech Republic Hungary Poland

1991–96 (annual average)

1997

1998

1999

2000

2001

2002

436 28331 8163 67057 3603 20943

1016 61590 23069 95769 6448 25994

3906 122820 34358 131004 3352 24151

6109 207235 17247 209391 -688 22745

4629 249783 46625 142626 561 31557

5864 68037 36642 103764 11014 38333

2706 39703 28793 119741 6828 31401

39439

76662

49837

72786

99052

47382

43095

1861 238 1204 2671 997 493 626 364

3788 58 2351 7902 3653 1116 1463 500

1997 107 1779 7689 2325 2854 1484 233

2574 92 1580 6766 1727 1690 2558 501

1309 85 271 7820 1018 2282 3987 107

-2522 94 -3180 -758 -200 -2258 1432 148

173 101 -401 3726 -1066 2482 464 893

183

4220

2980

18137

2426

-5407

-1823

257 31624 2571 16960 76 2446 1656 181 2967 2683 479

1108 49209 2563 24407 113 4449 2675 136 8955 5243 584

1363 28783 2634 16985 47 4740 863 160 380 3836 132

1475 39367 1775 19358 80 4198 1422 -29 5397 4420 349

984 84208 916 59375 336 4999 2026 -108 6061 6701 -22

846 41943 6884 11345 757 2420 267 -160 9548 5480 162

969 37151 2850 17694 431 2674 1238 85 4082 4886 106

472

4216

2663

2822

3953

3706

4970

84 21 25

28 433 45

125 478 316

90 252 31

43 532 17

165 337 -90

281 264 173

Note: * EU(15) + Gibraltar, Iceland, Malta, Norway, Switzerland; ** 27 countries. Source: World Investment Report, 2003.

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149

However, only a limited number of countries became net providers (outflows exceed inflows) of direct investments to the rest of the world. These are the UK ($400 billion), Japan ($270 billion), France ($250 billion) and the USA ($120 billion). In terms of net inflows (when FDI inflows exceed outflows) China has the largest net inflows ($475 billion), followed by Brazil ($180 billion), Mexico ($140 billion) and Ireland ($120 billion). Among the top 20 countries with the largest net inflows, five are economies from the Asian region, namely, China, Malaysia, Singapore, Thailand, and Indonesia (see Tables 5.6 and 5.8). Table 5.6  FDI outward stock (cumulated FDI outflows) by home country, economy or region in million US$ (1980–2002) Host region/ Economy World Developed Economies Western Europe* European Union France Germany Greece Ireland United Kingdom Canada USA Australia Japan Developing Economies Africa Nigeria South Africa South America Argentina Brazil Chile Venezuela Bermuda (Caribbean) Mexico Asia and the Pacific China Hong Kong, China India

1980

1985

1990

1995

2000

2001

2002

563997 499391 237694 215582 24281 43127 2923 – 80434 23783 215375 2260 19610

743267 665090 330825 304579 37753 59909 2932 8852 100313 43143 238369 6653 43970

1762963 1629259 874369 797322 110125 148456 2948 11588 229294 84837 430521 30507 201440

2901059 2583824 1463467 1298257 204431 258142 3004 13473 304847 118209 699015 53009 238452

5991756 5154968 3248357 2980615 445091 483946 5861 27925 902087 235512 1293431 83232 278445

6318861 5487592 3453487 3171860 489441 553315 6371 33748 906474 244638 1381674 91343 300115

6866362 5987746 3771452 3434297 652105 577849 7026 36453 1033003 273719 1501415 91249 331596

64606

78176

133088

310864

817450

806524

849464

6871 9 5722 46085 5997 39601 42 23 727 3589 6206 – 148 235

10960 – 8963 47356 5945 40496 102 165 1691 3957 11699 131 2344 250

20777 2586 14864 51476 6106 42101 178 2239 1550 4628 48953 2489 11920 281

33004 3975 23433 64620 10696 45530 2425 3918 2626 6130 187000 15802 78833 495

48591 4358 35277 95458 20681 53003 11793 5766 14942 11098 608673 25804 388380 1311

43066 4452 29155 94459 20473 50745 12976 5914 9535 11944 595552 32688 352602 2068

43574 4553 28755 98185 19407 53227 13439 6807 7712 12425 632702 35538 370296 2499

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Table 5.6  continued Host region/ Economy Korea Malaysia Philippines Singapore Taiwan Thailand Central and Eastern Europe and CIS** Czech Republic Hungary Poland

1980

1985

1990

1995

2000

2001

2002

127 197 171 3718 97 13

461 1374 171 4387 204 14

2301 2671 155 7808 12888 404

7787 11143 1220 35050 25144 2173

50552 18688 1597 53104 49187 2439

40825 18955 1273 67255 54667 2601

43500 20194 1358 71336 59553 2707

–

–

616

6372

19897

25504

30673

– – –

– – –

– 197 95

346 489 539

738 2068 1025

1136 4377 1107

1496 4641 1280

Note: * EU(15) + Gibraltar, Iceland, Malta, Norway, Switzerland; ** 27 countries. Source: World Investment Report, 2003.

According to Table 5.6, we can argue that there are significant cumulated FDI outflows (US$370 billion) from Hong Kong (China). This can be explained by the fact that there is a significant reliance on FDI flows from Hong Kong, close to 40% of total FDI inflows, to China. Moreover, regarding the case of Japan we can suggest that Japanese outward FDI has shown a strong correlation with the upward or downward movement of the yen–dollar exchange rate. Following the rapid appreciation of the yen in the late 1985, Japanese FDI outflows increased from US$12 billion in 1985 to the historical peak of US$63 billion in 1989. During that period, 70% of Japanese FDI went to North America and Europe. There was a limited share in manufacturing FDI and an increased share of FDI in the real estate and finance sectors and a starting point of significant Japanese FDI outflows in Asia. Cost minimization against the backdrop of the rapid yen appreciation and labour shortages due to demographic changes were among the major factors that motivated Japanese manufacturing firms to establish production networks in Asia. This was particularly the case during the 1990s as globalization pressures began to be felt, along with liberalization in SE Asia countries and especially in China, together with the stagnation of the Japanese economy and the sharp depreciation of the yen against the dollar, especially in early 1997. All of these factors led the Japanese FDI outflows to rebound – with a greater share flowing to Asia. FDI flows in the manufacturing sector constituted more than half of Japanese FDI flows to Asia. The intensifying competition in the global market and the market opportunities in China may lead to an added expansion of Japanese firms’ operations abroad future years (OECD, 2002; OECD, 2003; OECD, 2004).

Trends of FDI under Globalization

151

Therefore it can be argued, as mentioned previously, that there is a regional concentration of FDI, evidenced by statistical data and numerous examples.

5.10 Trends of Trade MNEs are the main vehicle of trade and FDI flows. Around 80% of the total trade and FDI flows worldwide belong to MNEs. MNEs when pursuing their own goals, seek options and cases for increased profit. Thus, they participate in specific countries and not in most of the countries around the world. A country’s willingness to open its borders and to participate in the globalized system is not enough. MNEs will be attracted to a country from which they will profit the most. The benefits from economic integration and globalization are derived from the accumulation of FDI and trade flows (Bitzenis, 2003b; 2004b; 2005). Table 5.7 shows the evolution of the structure of west European trade from 1928 to 1998. There are important differences in the levels of trade and in the openness of national economies over this period. It is clear from the data that west European trade flows, like the FDI flows mentioned above, became more concentrated on the European region itself rather than becoming globalized. Over two thirds of Europe’s exports and imports now consist of intra-west European exchanges, compared with some 55 and 46% in the inter-war period. Trade with the rest of the world, and especially with the developing countries, has tended to decline in relative importance. In so doing the general evolution of European trade has not been towards a more global distribution of relationships but instead towards a more intense integration with close neighbours. Interdependence among the economies of the region has increased but with the rest of the world it has tended to weaken. From Table 5.8 we can suggest that in the 1990s around 59% of all west European FDI has remained within western Europe, a much higher proportion (53%) than in the 1980s, with another 4% on average going to the European transition economies. In 1914, at the end of a previous phase of globalization, just below 20% of west European capital invested abroad went to other parts of western Europe; 40% was invested in Latin America, Asia and Africa, and less than 15% in Eastern Europe. In other words, west European foreign investment was more globally oriented before the First World War than in the 1990s. This suggests that the regional concentration of trade repeats the pattern of foreign direct investment.

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Table 5.7  Structure of West European trade, 1928–1998 (per cent) Western Europe

Eastern Europe and former Soviet Union

North America

Japan

Developing countries

7.7 6.4 8.3 4.4 4.7 4.9 4.9 4.8 3.7 4.4 5.7

8.6 7.4 6.6 8.9 9.2 8.6 6.7 7.3 8.9 7.3 8.9

1.2 1.1 0.9 1.0 1.2 1.4 1.2 1.1 1.9 2.1 1.7

22.5 22.9 23.4 18.2 14.8 13.9 17.6 21.2 12.8 16.3 14.2

7.4 9.4 8.9 4.5 4.5 4.7 5.3 5.8 4.4 4.4 4.9

17.1 12.3 14.8 13.9 12.0 9.4 8.4 9.3 7.8 7.0 7.7

0.5 0.8 0.7 1.0 2.0 2.4 2.2 3.0 4.5 3.5 3.4

24.0 26.1 26.0 19.4 15.6 15.2 18.4 20.5 10.9 12.2 12.6

Exports by destination 1928 1935 1938 1963 1970 1973 1979 1981 1988 1995 1998

55.2 56.5 54.3 63.7 67.2 69.0 68.0 63.6 71.3 69.1 68.9

Imports by source 1928 1935 1938 1963 1970 1973 1979 1981 1988 1995 1998

46.4 45.6 43.2 58.8 64.1 66.4 64.5 60.3 71.3 72.4 70.8

Source: UN/ECE, Geneva, January 2000.

Trends of FDI under Globalization

153

Table 5.8  West European foreign direct investment outflows, 1980–1997 (in billion US$ and per cent) Western Europe

Eastern Europe and former Soviet Union

North America

Japan

Developing countries

186.2 662.1 848.3

0.6 41.7 42.3

174.3 196.5 370.9

2.8 6.8 9.6

40.6 142.6 183.3

0.1 3.7 2.6

37.0 17.4 23.2

0.6 0.6 0.6

8.6 12.6 11.5

Billion dollars 1980–1989 1990–1997 1980–1997

Percentage shares 1980–1989 1990–1997 1980–1997

39.6 58.7 53.0

Source: OECD, International Direct Investment Statistics Yearbook 1998, Paris 1998, UN/ ECE, Geneva, January 2000.

5.11 Concluding Remarks What derives from the FDI literature review from 1937 up to 2006 is the comprehension of the relativity of each FDI theory; there is no single theory that dominates the decision making process of a company to undertake an FDI project. Some FDI theories may be viewed as static, while others may be considered dynamic. The static theories study only the factors that lead to the decision of FDI, while the dynamic theories also consider the evolution of the foreign company and its interaction with the host industry and the host country (Bitzenis, 2003b). One must consider that the market conditions are always changing and the changing character of the boundaries; globalization theory, the creation of the European Union, and the Economic and Monetary Union etc. will create new challenges and opportunities for a company to seek value-adding activities internationally in ways different from the ones studied up to now. As the authors of the FDI theories concluded on the reasons why a company may undertake FDI by examining certain subjects (countries, motives, barriers) in certain time periods, we could argue that no theory can be general and applicable for any one country, for any time period, to any foreign company. Since every country offers different motives and incentives for investment and has different obstacles that are subject to considerable changes over time. The MNEs choose the country that maximizes the possibility of success for their investment plan. Even when two countries hold the same properties, an MNE bases its investment decision on an evaluation of all factors in relation with the corporate priorities and needs. The choice requires examination on the part of the country, the MNE (or the industry) and always the choice must be in relation with the time period.

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Whether we accept the existence of globalization or not is subject to discussion. It is more than possible that the world will become increasingly globalized over time. Although globalization pressures, liberalization, economic integration and the constant increase of MNEs will facilitate a constant increase in world FDI flows, there remains a regional concentration of FDI flows since the opportunities presented are not equal in value throughout the world. Moreover, the investment opportunities a country ‘has to offer’ change through time and there are different ways by which MNEs evaluate these opportunities (Bitzenis, 2004b). The dramatic increase in FDI over the last decade (in 1990s and after 2004) was based on globalization and economic integration, technological improvements, as well as on the liberalization of various regimes with the abolishment of monopolies, and barriers. The globalization concept implies that a growing share of FDI is worldwide in scope and transition countries, in particular, should attract an increasing percentage of FDI. However, this did not happen in reality. It can be argued that there is a regional concentration of FDI evidenced by multiple examples. Globalization, which the transition economies struggled to become part of, in its economic form envisages an interdependent world economic system dominated by global corporations not identified with any individual country. At the same time, multinational corporations became more powerful, and since 90% of the worldwide volume of FDI belongs to the multinationals, their attitude towards it may reflect the nature of world FDI; the ‘vehicles’ of globalization are only managers within large corporations. The limited extent of reforms, ineffective transition programs, an increased and highly competitive worldwide investment environment (which offers various alternative opportunities to the MNEs), together with the changing opportunities that a country has to offer through time, along with the different ways in which MNEs evaluate opportunities, suggests that globalization and transition reforms can help countries to attract FDI flows and to become market economies. Finally, globalization is not a new phenomenon, but simply presents itself in a new phase, one that is more pervasive, deeper, and different than previous phases. Some researchers accept that globalization is an established process, that it is unstoppable and irreversible due to the liberalization of international trade, goods and services and free market, the significant growth of the services sectors (especially those dealing with knowledge and information), the rapid growth of a new generation of technology, the high degree of openness, and the huge and rapid circulation and distribution of information mainly through the Internet. A major debate continues as regards to the question of the benefits and the costs of globalization. However, summarizing both the supporters’ and the opponents’ arguments for and against the globalization process, globalization can not be classified as either ‘bad’ or ‘good’. It is its evaluation that matters most, because challenges and threats are subject to continuous change.

Chapter 6

The European Union (EU) and the Economic and Monetary Union (EMU): Prospects of the Balkan Countries Integrating into the EU

6.1 Economic Integration Regional economic integration has been one of the main interests of European countries after the Second World War. It is possible to distinguish six forms of economic integration. The first form is the preferential trading area, where a region becomes a block of trading countries with less taxation and fewer tariffs. The second form of economic integration is the free trade area (for example the North American Free Trade Agreement [NAFTA]). Regional initiatives are the principal means for eliminating trade barriers such as tariffs and quotas. The third form of economic integration is customs union, where countries adopt common external trade policies towards non-members. The common market is the fourth step along the path of economic integration, where barriers that inhibit the movement of factors of production – labour, capital and technology – amongst members are eliminated. The fifth form involves Economic and Monetary Union where the major goal is the coordination of economic policies (especially monetary policy, exchange rate policy, and fiscal policy) among country-members in order to integrate their economies into a single entity (for example the Economic and Monetary Union [EMU]). Finally, the sixth form of economic integration refers to a complete political and economic union, an example of which is the United States of America (USA), or the United Kingdom (UK) (see Figure 6.1). In this chapter, the European Union (EU) and the Economic and Monetary Union (EMU) are described as forms of economic integration among European country-members. We present a brief history of the European Community/Union, describing the five completed phases of the enlargement process (after the entrance of Bulgaria and Romania in the EU in January 2007). We discuss the Maastricht Treaty and the Copenhagen Criteria as regards to the European Union and the Economic and Monetary Union integration effort.

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UK, USA Forms of Integration

NAFTA

Preferential Trade Area

Free Trade Area

Customs Union

Common Market

Economic & Monetary Union

Complete Political & Economic Union

EMU 1999 EU 1992–98

Figure 6.1  Forms of integration

Furthermore, we focus on the three stages of integration leading to the introduction of a single currency (the Euro). We also evaluate the costs and benefits of the EU, the EMU, and the introduction of the euro to companies, people and to the economies of member states. We look at the issues regarding real or nominal convergence among the economies mainly from Central and Eastern Europe, which have become (or will become in the near future) EMU members, and the western advanced EU countries. Moreover, we argue that the Maastricht Criteria are only criteria that led the EMU countries such as Greece, Portugal, and Spain to the nominal convergence of their economies compared to the western advanced EU countries such as Germany, France, and the United Kingdom. At the same time, economic indicators such as unemployment rates, wage levels, GDP per capita, especially in purchasing power parity (PPP) prices, infrastructure level, human development indices, economic inequalities, and environmental and living standards for the countries are examined to conclude on nominal or real convergence. We discuss the likely prospects for the Balkan countries to integrate into the EU, by grouping them in four categories according to their progress towards EU accession.

6.2 History of the European Union based on European Treaties The European integration is a radical multidimensional transformation of the European region. For country-members the European Union serves as a means of coping with globalization challenges and achieving greater prosperity and wealth (Lisbon European Council, 2000).

The European Union (EU) and the Economic and Monetary Union (EMU)

157

Different definitions of integration are found in relative literature. The integration process is defined by Molle (1990, 8) as, ‘the gradual elimination of economic frontiers between independent states: as a result the economies of these states end up functioning as one entity’. According to Tsoukalis (1997), three dimensions of integration are defined: human migration, trade in goods and services and free movement of capital. Furthermore, Blondel et al. (1998) considers integration as an additional layer in the economic growth of European countries, making clear that integration does not imply substitutions of national identities. However, most researchers agree that European integration is a process, during which a single market is created by eliminating all economic and non-economic barriers that influence the political and economic climate (Tsoukalis, 1997; Mussa, 2000). As mentioned in Bitzenis and Andronikidis (2006), the integration process of Europe began with the Treaty of Paris when a European Community (EC) of coal and steel was created (Table 6.1). The European Coal and Steel Community (ECSC) was founded in 1951 (Treaty of Paris), by France, West Germany, Italy, Belgium, Luxembourg and the Netherlands to pool the steel and coal resources of its member-states. The Treaty of Paris came into force on 23 July 1952. The ECSC ceased to exist on 23 July 2002, and its responsibilities and assets (except for research funds) were then assumed by the EC. The ECSC served as the foundation for the later development of the European Economic Community (EEC) (later renamed the European Community (EC) by the Maastricht Treaty), and then the European Union (EU). Another effort, without success, took place in 1954 aimed at the creation of a European defensive community (Der Groeben, 1985; Pinder, 1991; Pryce, 1987; Urwin, 1991). European Communities is the collective name given to the European Coal and Steel Community (ECSC), the European Economic Community (EEC), and the European Atomic Energy Community (Euratom), when in 1967, they first merged under a single institutional framework with the Merger Treaty. Soon after the establishment of the ECSC two more European Communities were proposed: the European Defence Community, and the European Political Community. However, they were later rejected. The European Community (EC), most important of the three European Communities, was originally founded on 25 March 1957 by the signing of the Treaty of Rome under the name of European Economic Community (EEC). The European Economic Community (EEC) was an organization established by a treaty between the ECSC countries Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany, known informally as the Common Market (the Six). The Treaty of Rome (1958) was the beginning of the European Economic Community and the European Atomic Energy Community ‘EURATOM’. During this period of time, there were no specific criteria for admission to the European Economic Community (EEC) apart from the requirement that the applicant country should be from Europe, should be a democracy, and its economy should

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be developed enough to enable it to meet the obligations of membership and to be able to compete effectively within a free market (Preston, 1997). Since 1958, European enlargement has been the major goal of the European Economic Community (EEC). Enlargement primarily refers to the removal of obstacles relevant to free movement of goods, services, capital and human capital from one member-country to another (Szabo, 2003). Schimmellfeninning and Sedelmeier (2002) provide another definition of enlargement, describing it ‘as a process of gradual and formal horizontal institutionalization of organizational rules and norms’ (3). The six founder nations intended to achieve a gradual integration of the economic policies of each single country. In this way, different goals were set; goals that included: the development of economic activity throughout the Community, achieving political stability, the improvement in standards of living, the development of close relationships among member-countries, and finally, gradual expansion. On this basis the enlargement of the Community/European Union (EU) was accomplished in five phases: the UK, Denmark and Ireland joined in 1973 (phase one of enlargement), Greece in 1981 (phase two of enlargement), Portugal and Spain in 1986 (phase three of enlargement), Austria, Finland and Sweden in 1995 (phase four of enlargement) and Hungary, Poland, Slovakia, Latvia, Estonia, Lithuania, the Czech Republic, Slovenia, Malta and Cyprus entered in May 2004, and Bulgaria and Romania entered in January 2007 (phase five of enlargement). Under the sixth enlargement policy, Croatia, Turkey, FYROM and other Balkan countries are expected to enter the EU in the next decade. The European plan gained new impetus in the 80s with the Single European Act (1986). This was the first revision of the Treaty of Rome and ratified the undertaking to complete the internal market with the free circulation of people, goods, services and capital by 1992. It marked an important step forward towards economic integration. The political agreement on the programme to complete the internal market also led the way to institutional reforms. The Merger Treaty, signed in Brussels on 8 April 1965 and brought into force on 1 July 1967, gathered together the organizational structures of the three European Communities (the European Coal and Steel Community, the European Economic Community, and Euratom) of that time. The Treaty established a Single Council and a Single Commission of the European Communities. It created the European Commission and the Council of the European Communities to act as governing bodies for all three institutions, requiring them to share a single budget. This treaty is regarded by some as the real beginning of the modern European Union. The term European Communities or EC also came into use from this time onwards. It was abrogated by the Amsterdam Treaty signed in 1997. The Single European Act (SEA) was the first major revision of the Treaty of Rome. Besides re-launching community policies for social and economic cohesion, for research and technological development, and for the environment and health, the Single European Act had an innovating effect on international balance. The main interventions, although limited, were the extension of qualified majority voting in decision-making processes, and the mutual recognition of national rules

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and regulations which member states agreed to accept as equivalent to their own. The goals were to remove the remaining barriers between countries, and increase harmonization; this in turn would increase the competitiveness of the European countries. The act reformed/refined the operating procedures of the institutions and Qualified Majority Voting was extended to new areas. The aim of a single market by 1992 was set. The Maastricht Treaty marks a new phase in the foundation of the union, and can be considered as a response to challenges from the external environment. One of the major achievements of this specific treaty was the settlement of the objectives of the Economic and Monetary Union (EMU) which were described as continuous economic development, with low inflation, low unemployment and social protection (Pinder, 1995). More specifically, the committee proposed certain criteria and conditions for the integration of state-members into the European Union. Moreover, the treaty led to the creation of the euro, and introduced the three-pillar structure (the Economic and Social Policy pillar, the Common Foreign and Security Policy or CFSP pillar, and the Justice and Home Affairs pillar). The Amsterdam Treaty was agreed upon by the political leaders of the EU on 17 June 1997, signed on 2 October 1997 and came into force on 1 May 1999. It was the first of the fundamental Community Treaties to be programmed. Furthermore, it programmed the treaty’s revision. The Amsterdam Treaty placed a great deal of emphasis on citizenship and the rights of individuals. Moreover, it provided for increased democracy in the shape of increased powers for the European Parliament, new employment rights, security and justice, a Community area of freedom, and the beginnings of a common foreign and security policy (CFSP). Furthermore, it encouraged the reform of the institutions in the run-up to enlargement. The Amsterdam Treaty made substantial changes to the Treaty on European Union, which had been signed at Maastricht in 1992. Yataganas (2002), and Tsebelis and Yataganas (2002) suggest that the Treaty of Amsterdam was unable to resolve three critical questions: (a) the composition of the institutions (especially the size of the Commission); (b) the credibility of the votes in the Council; (c) and the extension of qualified majority voting related to the co-decision procedure under the fifth enlargement – since with the increase in members will come a major need for institutional reform. Hence, as suggested by Molle (2001), the aim of the Treaty of Nice was to amend the EC Treaties in two main ways: firstly, to fulfil the requirements of the Treaty of Amsterdam by introducing new institutional and decision-making arrangements to prepare the EU for enlargement of up to 27 members and secondly to amend existing institutional arrangements where weaknesses had been perceived. Tharakan (2002) points out that the treaties of Maastricht and Amsterdam brought about intergovernmental co-operation in Foreign Affairs, Defence, Home Affairs and in Justice, respectively. These treaties formed the second and third pillars of the European integration. It is the process of integration, which formed the basis for half a century of peace, stability and welfare in Western Europe.

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The Treaty of Nice, signed on 26 February 2001, came into force on 1 February 2003. Although, Austria, France, Finland, Germany, the Netherlands, Portugal, Spain, Sweden, the UK and Luxembourg ratified the treaty in 2001 and the other members followed in 2002, the ratification process was plagued by difficulties after a referendum in Ireland on 7 June 2001 rejected the treaty on the basis that more than 50% of the votes cast were negative. However, within a year and a half Ireland approved the treaty via a second referendum. Finally, the Treaty establishing a Constitution for Europe (TCE), commonly referred to as the European Constitution, is an international treaty intended to create a constitution for the European Union. It was approved at the European Council in Brussels on 18 June 2004 and signed in Rome on 29 October 2004 by the 25 Member States of the European Union. However, it was subject to ratification by all member states, two of which subsequently rejected it in referenda (French and Dutch voters). Its main aims were to replace the overlapping set of existing treaties that comprise the Union’s current constitution, to codify uniform human rights throughout the EU, and to streamline decision-making in what is now a 25member organization. The TCE was signed by representatives, and was in the process of ratification by the member states by 2005. However, French (29 May) and Dutch (1 June) voters rejected the treaty in referenda. The failure of the constitution to win popular support in these countries caused other countries to postpone or halt their ratification procedures, and the Constitution now has a highly uncertain future. After the rejection of the text by French and Dutch citizens, member states agreed to convoke a Reflection Period.

Treaty no.

Treaty title

Signed

Came into force

1. ECSC (1951)

The Treaty establishing the European Coal and Steel Community (ECSC)

Signed in Paris on 18 April 1951

23 July 1952, expired on 23 July 2002

2./3. EEC (1957) and EURATOM (1957)

Table 6.1  List of European treaties

The Treaty of Rome

Signed in 1 January 1958 Rome on 25 March 1957

Goal –

To establish the European Economic Community (EEC) and the European Atomic Energy Community (Euratom). Both were signed at the same time and the two are therefore jointly known as the Treaties of Rome.

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Treaty title

Signed

The Merger Treaty, which provided for a Single Commission and a Single Council of the three European Communities (ECSC, EEC, EURATOM) of that time

Signed in Brussels on 8 April 1965

1 July 1967

To establish a Single Commission in order for the dream of a united Europe to become a reality through a single institution, coordinating all relative activities.

The Single European Act (SEA)

Signed in Luxembourg and the Hague, 1986

1 July 1987

To provide for the adaptations required for the achievement of the Internal Market.

The Treaty of the European Union

Signed in Maastricht on 7 February 1992

1 November 1993

To change the name of the European Economic Community to ‘the European Community’, to introduce new forms of co-operation between the Member State governments, adding intergovernmental co-operation to the existing ‘Community’ system. The creation of a new structure with three political and economic ‘pillars’.

The Treaty of Amsterdam

Signed in Amsterdam, 2 October 1997

1 May 1999

To amend and renumber the EU and EC Treaties. The Treaty of Amsterdam changed the articles of the Treaty on European Union, identified by letters A to S, into numerical form.

The Treaty of Nice

Signed in Nice 26 February 2001

1 February 2003

The reformation of institutions so that the Union could function efficiently after its enlargement to 25 Member States. The Treaty of Nice, the former Treaty of the EU and the Treaty of the EC are merged into one consolidated version.

8. Nice (2001)

7. Amsterdam (1997)

6. Maastricht (1992)

5. SEA (1986)

Treaty no. 4. The Merger Treaty (1965)

Table 6.1  continued Came into force

Goal

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Table 6.1  continued Treaty title

Signed

Treaty to establish a Constitution for Europe

Signed in Rome 29 October 2004

9. The Constitution for Europe

Treaty no.

Came into force –

Goal The draft Treaty establishing a Constitution for Europe, aims to replace all the existing Treaties with a single text. The Constitution was adopted by the Heads of State and Government at the Brussels European Council on 17 and 18 June 2004 and was signed in Rome on 29 October 2004. It requires ratification by each Member State, in line with their own constitutional arrangements (i.e. by parliamentary procedure and/or by referendum). The Constitution will not take effect until it has been ratified by all 25 Member States.

Source: European Union , author’s modifications.

6.3 History of the Creation of the Economic and Monetary Union in Europe 6.3.1 Bretton Woods Prior to the creation and establishment of the EMU, the first step was the creation of the Bretton Woods System. The conference held in the American resort village of Bretton Woods (1–22 July 1944), New Hampshire, was the culmination of some two and a half years of planning for postwar monetary reconstruction by the Treasuries of the United Kingdom and the United States. It was attended by all 44 World War II allied nations, plus one neutral government (Argentina). The Bretton Woods system of international monetary management established the rules for commercial and financial relations among the world’s major industrial states. It was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Its political basis is in the confluence of several key conditions: the shared experiences of the Great Depression (1929–1930), the concentration of power in a small number of states, and the presence of a dominant power willing and able to assume a leadership role in global monetary affairs. Moreover, the floating exchange rates of the 1930s were seen as having discouraged trade and investment flows and having encouraged destabilizing speculation and competitive depreciations. Governments were at the same time reluctant to return to permanently fixed rates on the model of the classical gold standard of the nineteenth century.

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The Bretton Woods System (1944–1971) supposed that each country uses its monetary and fiscal policy in order to maintain an internal balance, in other words, low inflation with full employment. Under this system, the exchange rate should be at a level that would allow an external balance. Hence, the exchange rate of every country was handled by a monetary and fiscal policy without any restrictions. Reserves during that period consisted of local currencies and gold (Gros and Thygesen, 1998). Aiming to set up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Bank for Reconstruction and Development (IBRD) (now one of the five institutions of the World Bank Group) and the International Monetary Fund (IMF). These organizations became operational in 1946 after a sufficient number of countries ratified the agreement. The chief features of the Bretton Woods system were to oblige each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value (plus or minus 1%) in terms of gold; and the ability of the IMF to bridge temporary imbalances of payments. The strength of the US economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the US government to convert dollars into gold at that price, made the dollar as good as gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. What emerged was the ‘pegged rate’ currency regime. Members were required to establish a parity of their national currencies in terms of gold (a ‘peg’) and to maintain exchange rates within plus or minus 1% of parity (a ‘band’) by intervening in their foreign exchange markets (that is, buying or selling foreign money) (thus, we had the creation of a ‘pegged rate’ or ‘par value’ currency regime). The US currency now affected the world currency, the standard to which every other currency was pegged. As the world’s key currency, most international transactions were denominated in dollars. The US dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in the World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the US dollar was greatly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system. Member countries could only change their ‘par value’ with IMF approval, which was contingent with the IMF determination that its balance of payments was in a ‘fundamental disequilibrium’. However, the Bretton Woods System appeared to be inadequate and in 1971 the system ceased to operate. Thus, in the face of increasing strain, the system collapsed in 1971, following the United States’ suspension of convertibility from dollars to gold. The main reason was hidden behind a US payments deficit, which created different reactions from various countries, in order to face the dollar crisis. The majority of these countries tried to purchase dollars. All the while, the USA was scared of gold purchases by European countries. Under these circumstances,

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the United States forbade the access of gold to foreigners and the Bretton Wood System was formally dead (Williamson, 2000). The collapse of the Bretton Woods System and the decision of the US government to float the dollar in August 1971 produced a wave of instability on foreign exchanges which called into serious question the parities between the European currencies. By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce had become increasingly perishable. Gold outflows from the US accelerated. In 1970, the USA lifted import quotas on oil in an attempt to reduce energy costs. Instead however, this exacerbated dollar flight. Still, the USA continued to draw down reserves. After the end of World War II, the USA had held $26 billion in gold reserves, of an estimated total of $40 billion. In 1971 it had a reserve deficit of $56 billion. It had also depleted most of its nongold reserves and had only 22% gold coverage of foreign reserves. In short, the dollar was tremendously overvalued with respect to gold. By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit. In 1971 more and more dollars were being printed in Washington, to be pumped overseas, to pay for the government’s military expenditures and private investments. Thus, the attempt to maintain that peg exchange rate system collapsed in November 1968, and a new policy programme was attempted: to convert the Bretton Woods system into a system where the enforcement mechanism floated by some means. Due to this crisis, other developed countries had no other solution but to float. The major goal was to achieve a multilateral agreement, by which a par value system would be restored (thus we had a ‘floating’ Bretton Woods (1968–72)). By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce had become increasingly untenable. Gold outflows from the US accelerated, and despite gaining assurances from Germany and other nations to hold gold, the ‘dollar shortage’ of the 1940s and 1950s had become a dollar glut (the dollar glut is a term for the accumulation of United States dollars outside the United States, contrasted with the dollar gap that lead to the creation of the Marshall Plan following World War II). 6.3.2 Smithsonian Agreement On 17 and 18 December 1971, the Group of Ten (Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, the United States, Germany and Sweden), meeting in the Smithsonian Institute in Washington, created the Smithsonian Agreement which devalued the dollar to $38/ounce (around 7–8% – from $35 to $38), with 2.25% trading bands (the fluctuation of currencies was determined at +/- 2.25%, and in that way 4.5% over the dollar). Thus, in 1971, the Smithsonian Agreement was signed and each country tried to secure minimal change in their official exchange rates. Criticized at the time, and by design a ‘temporary’ agreement, it failed to impose discipline on the US government, and with no other credible mechanism in place, the pressure against

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the dollar continued. This resulted in gold becoming a floating asset, and in 1971 it reached $44.20/ounce, in 1972 it had increased to $70.30/ounce and was still climbing. By 1972, currencies began abandoning even this devalued peg against the dollar, although it took a decade for all of the industrialized nations to do so. In February 1973, the Bretton Woods currency exchange markets finally closed, after a last-gasp devaluation of the dollar to $44/ounce, and reopened in March in a floating currency regime. Snake in the tunnel Because of the exchange rate uncertainty, Europeans started to explore a regional arrangement. The original six EC members attempted to impart fresh momentum to monetary integration. In March 1972, the ‘Snake in the tunnel’ mechanism was created in order to alleviate the currency problems in the European Union. The European Snake first arranged to cut in half the intra-European margins of fluctuation. Furthermore, it managed to float currencies (the ‘snake’) within narrow margins of fluctuation against the dollar (the ‘tunnel’). To be more specific, currencies could fluctuate in a range of +/- 2.25% with the dollar (snake), which could move over a greater range of 4.5% (the tunnel). The Snake initially included the following countries: the six EC members (Belgium, Luxembourg, France, Italy, Germany and the Netherlands) as well as Denmark, Great Britain, Ireland, Norway and Sweden (Wyplosz, 2002). The Snake proved unsuccessful as a number of countries were left under speculative pressure (Dedman, 1996). Thrown off course by the oil crises, the weakness of the dollar and the differences in economic policy, the ‘snake’ lost most of its members (Great Britain, Ireland, Denmark, and Italy – Great Britain and Ireland left the Snake in June 1972, and Italy in February 1973) in less than two years and was finally reduced to a ‘marked’ area comprising of Germany, the Benelux countries and Denmark (France left in January 1974, rejoined in July 1975 and left again in March 1976). Due to the dollar crisis, Germany intervened on numerous occasions in the exchange market while other countries moved on to continuous controls in order to keep their currencies in the ‘snake and the tunnel’. The tunnel collapsed in March 1973 when the Smithsonian parities were abandoned in favour of floating exchange rates. 6.3.3 European Monetary System (EMS) and the European Currency Unit (ECU) During the seventies, and due to fierce pressure from the dollar, the Europeans started to talk about launching a programme to build a ‘zone of monetary stability’ within Europe in order that fluctuations in the exchange rate would stop (Williamson, 2000). The result was the European Monetary System (EMS), established in 1979 (Rose, 2000). Created by the United Kingdom, Germany and France, the EMS aimed to integrate national economies, based on the concept of fixed but adjustable exchange rates. The currencies of all the Member States, except for the United Kingdom, participated in the exchange-rate mechanism.

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In summary, the EMS was originally conceived as the solution to the end of the Bretton Woods System. Over the years, its nature changed and it became a kind of German Mark (DM) area, with the Bundesbank greatly in command. This and the speculative crisis of 1993, made the monetary union option attractive. Thus, the EMS is mostly the entry point for future monetary union members (Bordo and Jonung, 2000). When the EMS was set up in 1979, all the Member States of the European Economic Community (Belgium, the Netherlands, Germany, France, Italy, Luxembourg, Denmark and Ireland) except for the United Kingdom entered the EMS. The currencies had a fluctuation margin vis-à-vis their central rates of 2.25%, except for the Italian lira which had a margin of 6%. Greece, which entered the Community in 1981, did not join the Exchange Rate Mechanism (ERM) until 1998. The Iberian Peninsula countries (Spain and Portugal), which joined the Community in 1986, did not enter the ERM immediately: Spain entered in 1989 and Portugal in 1992, with a fluctuation margin widened to 6%. This meant that they could move within certain margins of fluctuation against each other. When the limits were breached, then the authorities responsible for the particular currencies were required to respond with appropriate policy measures. The ERM helped to stabilize participants’ exchange rates and the frequency of changes of parity steadily declined between 1979 and 1992. The ECU represented the weighted arithmetic mean of all member states currencies based on the percentage of GDP of the Commission’s GDP and on the percentage of trade of each member. Countries gave currencies in gold (20%) and in dollars (20%) to the European Monetary Cooperation Cashier and exchanged them with the ECU. The ECU was a basket portfolio composed of 12 EU currencies based on the Member State’s economic performance. On 1 November 1993, it was decided to freeze the same basket, not taking into account further new currencies coming from new adhesions. The euro replaced the ECU (officially and privately) on 1 January 1999. Table 6.2 presents the national currency weights to the ECU value during the three stages of the EMU.

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Table 6.2  National currency weights to the ECU value (per cent) Currency 13.03.1979–16.09.1984 17.09.1984–21.09.1989 21.09.1989–31.12.1999 BEF DEM DKK ESP FRF GBP GRD IEP ITL LUF NLG PTE

9.64 32.98 3.06 – 19.83 13.34 – 1.15 9.49 – 10.51 –

8.57 32.08 2.69 – 19.06 14.98 1.31 1.20 9.98 – 10.13 –

8.183 31.955 2.653 4.138 20.316 12.452 0.437 1.086 7.840 0.322 9.98 0.695

Source: .

The Exchange Rate Mechanism (ERM I) The Exchange Rate Mechanism (ERM) was at the heart of the EMS and provided for ‘fixed but adjustable’ exchange rates between currencies. In particular, the EMS was mainly constituted of the exchange rate mechanism, although there was also a European Monetary Cooperation Fund, which was responsible for defending exchange rate obligations. The ERM was much like the ‘snake’ but this time used the ECU instead of the dollar. Worth noting is that Great Britain entered the EMS in 1990 but it dropped out in 1992, as did Italy. Greece entered the ERM in 1998. Effective from March 16, 1998, the drachma joined the ERM at a central rate that implied a 12.3% devaluation against the ECU. The Greek drachma joined the ERM II on 1 January 1999 and observed a central rate of 353.109 and standard fluctuation margins (±15%). The principle of ERM was as follows: exchange rates were based on central rates against the European Currency Unit (ECU), a European unit of account, which was a weighted average of the participating currencies. A grid of bilateral rates was calculated on the basis of these central rates expressed in ECus, and currency fluctuations had to be contained within a margin of 2.25% either side of the bilateral rates (with the exception of the Italian, Spanish and Portuguese currencies, which were allowed a margin of 6%) (Williamson, 2000). The EMS was severely disrupted by the violent storm that hit the European currency markets in September and October 1992, following the difficulties over the ratification of the Maastricht Treaty in Denmark and France. The British pound and the Italian lira left the ERM in September 1992, and in November of the same year the Spanish peseta and the Portuguese escudo were devalued by 6% against the other currencies. In January 1993, the Irish pound was devalued by

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10%; in May the peseta and the escudo were again devalued. Finally, in August 1993, the Finance Ministers took the decision to raise the fluctuation margins to 15%. The years 1993–1999 were characterized by a distinct return to normal fluctuation margins. In 1996, all the participating currencies (including the lira, now reincorporated in the ERM, and the Austrian and Finnish currencies which entered in 1995 and 1996) had moved back within the original margin of fluctuation (2.25%). Sweden did not enter the ERM. As mentioned, in August 1993, the decision to widen the fluctuation margins to ±15% was taken, and the interpretation of the criterion, in particular of the concept of ‘normal fluctuation margins’, became less straightforward. The ERM lasted from 1979 until December 1998. It was superseded by the ERM II as of January 1999.

6.4 ERM I: The Reasons behind the Crisis Besides the ERM contribution to the European Monetary Union, various problems started to appear at the beginning of 90s. Firstly, due to reunification Germany needed to make changes to its fiscal policy, as East Germany required modernization and government funds had to be raised. Due to the devotion of the Bundesbank to price stability and stable exchange rates (ERM), Germany asked for a differentiation in the handling of the Deutschmark in the ERM but other member-countries rejected this suggestion. As a result tensions arose in the economic policy of the countries, which were reinforced by exchange market crises in the Nordic countries and the Danish rejection of the European Monetary Union. Moreover, 1992 saw a run on currencies such as the lira, the pound, the Irish pound, the Spanish peseta and the Portuguese escudo (Gros and Thygesen, 1997). It is apparent that the catalyst for the ERM crisis was the reunification of Germany in 1990; an event unprecedented in the history of the amalgamation of a large, rich economy with a smaller economy with a considerably lower standard of living. In order to make this assimilation work, the West German government spent an enormous sum of money: almost half of all West German savings were transferred to the East and the government budget deficit rose from 5% to 13.2%. East German consumers largely spent the transfers on consumption. After all, they had been deprived of most of the perks of capitalism for many years. Furthermore, the old East German Marks were converted to the DM at a rate of roughly 1.8:1, far exceeding the value of the East German Mark. This meant that East German business owners could not sell their goods nor could they afford to pay their workers. This in turn led to a large scale economic shutdown in East Germany. Most of the demand for goods from the East Germans would therefore fall on West German made goods and inflationary pressures started to build up in the economy. At the same time, the growth of the DM increased in 1990 as the central bank issued the DM in exchange for East German Marks. By 1991, the Bundesbank was

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becoming anxious about the prospects of high inflation in Germany and started pursuing contractionary monetary policy. The Bundesbank raised interest rates by almost 3% in the years 1991 and 1992. The combination of expansionary fiscal and contractionary monetary policy caused German interest rates to rise dramatically. The impact of Germany on the rest of Europe was obvious. German and world interest rates increased following reunification. There was an outflow of money from Europe and ERM currencies like the lira and the peseta. This also affected countries like Sweden and Finland that had stayed outside the EMS but had chosen to fix their exchange rates to the DM, perhaps in search of the anti-inflation credibility from the Bundesbank. At the time, the UK was in the worst recession since the end of World War II, with unemployment rates well in excess of 10%. In isolation, the UK would have resorted to expansionary monetary policy to get out of the slump but they were handcuffed by the fixed exchange rate system. While this loss of autonomous policy was stifling the UK economy, things went from bad to worse following the reunification process and the tightening of monetary policy (Weerapana, 2004). Similar problems afflicted other European countries. There were questions about the competitive position of Italy. Like a number of other EU member states with recent histories of inflation, Italy had used the EMS as a way of importing the Bundesbank’s anti-inflationary credibility. As in any exchange-rate-based stabilization process, not just the current inflation but also the cumulative effects of the past inflation were built into the price level, creating problems of overvaluation. Since inflation stabilized slower than the exchange rate, the lowering of interest rates was a slow process. Investors borrowed in low-interest-rate markets (Japan and the United States) and invested where interest rates were high on the assumption that ERM pegs were firm. These inflows fuelled bank lending and domestic credit expansion. They papered over problems (Bruiter et al., 1998). During the negotiations, the United Kingdom obtained a clause (opt-out), exempting it from the third stage of the EMU, in the form of a protocol annexed to the Treaty, stipulating that it is not required to introduce the single currency even if it fulfils the convergence criteria. The protocol was necessary in order to secure the agreement of the United Kingdom on the treaty. It is for the UK Government to decide whether or not the country will move to the third stage of the EMU. In Denmark, the Treaty was rejected in a referendum held in June 1992. Denmark subsequently obtained clauses exempting it from several provisions of the treaty, including transition to the third stage of the EMU. During the process of ratifying the Treaty, the speculation sparked off by the negative result of the first Danish referendum (June 1992) and the uncertainty surrounding the French referendum (September 1992) resulted in speculative monetary turbulence, forcing the Italian and UK authorities to withdraw their currencies from the European exchange-rate mechanism. During the summer of 1993, the French franc also came under strong pressure. On 2 August 1993, the fluctuation margins of the exchange-rate mechanism were widened to 15%. Doubt was once again cast on the feasibility of the EMU, both by economic and financial

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operators and by public opinion as well, who were sensitive to the unacceptable rise in unemployment and the difficulties caused by the economic recession. In Box 6.1, we group the reasons behind the ERM crisis in 1992/93:

Box 6.1  The main reasons behind the ERM crisis in 1992/93 • Large deficit in Germany due to reunification, high inflation and unemployment (in other words, an increase of interest rates so as to manage inflation). • Increase of interest rates in 1992 by Germany, making the mark more attractive. In that way, the domino effect was apparent, where increases in interest rates appeared in other countries, in order to avoid the high supply of their currencies for the purchase of the mark. • Direct intervention led to crisis while indirect intervention appeared with the increase of interest rates. • The United Kingdom joined the ERM in October 1990, left in September 1992. Italy left the same period, too. Therefore, Great Britain and Italy no longer invested in Germany due to the currency exchange risk. • Irish unemployment was 17%. There were high interest rates, and 1/3 of Irish exports went to the United Kingdom. Devaluation of British currency and undervaluation of Irish currency of 15% occurred. As a result, there is a decrease of Irish exports to the United Kingdom, a crisis in Ireland, and the devaluation of Irish currency for keeping competitiveness high. • Sweden left the ERM. • Devaluation of currencies of the Netherlands, Finland and Sweden existed. • No reaction from Denmark, which in turn made it less competitive since it had strong trade relationships with the above three mentioned countries. • Danish rejection of the Maastricht Treaty on 2 June, 1992 and the crisis started in September 1992. The Danish rejection was viewed as a blow to the prospects for a single currency in the foreseeable future. The abandonment of the agreed-upon timetable to monetary union would loosen the tight discipline that the Maastricht treaty had implied to European inflation rates and budget deficits, and thus doubts arose about the likelihood of continued convergence of European fiscal and monetary policies. • By 16 September we had the suspension of the sterling’s participation in the ERM, as well as the UK announcement on 19 September that it would not return the sterling to the ERM until the mechanism was reformed. • Stage Two of the ERM crisis served to reinforce the view that fundamentals are more important than market phenomena. For Belgium, Denmark, France and the Netherlands’ superficially successful efforts to preserve their ERM parities in late 1992 and through the turbulent first seven months of 1993 led the ERMII to widen +/- 15% in the exchange rate band. In January 1993, Ireland finally chose to devalue the Irish pound within the ERM, as unemployment rose. • Rising unemployment in Spain and Portugal led to further devaluations of their currencies in May of 1993. Unemployment also rose in Denmark and France. The German economy was finally cooling down. The Bundesbank had embarked on a course of reducing interest rates, but the reductions were considered inadequate to address in a timely manner the deteriorating economic conditions of some of Germany’s partners. • Political uncertainty played a major role in the crisis – for example, in Denmark, France, Italy, and Spain. • Fiscal policy, particularly in Germany, was faulted as one of the principal causes of the crisis. Fiscal policies were tightened both during and/or in the wake of the crisis. For instance, in Italy, Sweden, Finland, Portugal and even Germany. Monetary policies were tightened by all of the central banks whose currencies came under downward pressure. In several cases (Sweden, Spain, Portugal and Norway, for example), monetary policies were employed to limit subsequent currency depreciation.

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Box 6.1  continued • The fixed (pegged) exchange rate regime constrained national monetary policies. It also contributed to excessive borrowing abroad at ‘cheaper’ interest rates by domestic residents and to excessive cross-border investments seeking higher yields. Both borrowers and lenders ignored the potential exchange rate risk. Given that most of the European countries ultimately abandoned the rigidly fixed exchange rate regime, through the adoption of floating or the 15 per cent band, the ex post critics argued that the fixed regime should have been abandoned or modified earlier in order to avoid the damage to the real economy. • The Exchange market intervention, the official assistance on an unprecedented scale, and the net sales of the Deutsche mark by European central banks between June and December 1992 were estimated at DM284 billion, approximately $200 billion. A portion of those sales came from owned reserves, but an even larger portion reflected the extension of bilateral and multilateral credit. Mutual support eventually included an $11.2 billion EU loan to Italy and an array of new loan programs by the European Investment Bank. Although the official financing during and following the crisis did not involve the Bretton Woods institutions, there was an unprecedented volume of international financial assistance. • Black Wednesday refers to 16 September 1992 when the British government was forced by currency speculators to withdraw the British Pound from the European Exchange Rate Mechanism (ERM) – most notably George Soros who earned over US$1 billion in doing so. In 1997, the UK Treasury estimated the cost of Black Wednesday at £3.3 billion. ‘The trading losses in August and September were estimated at £800 million, but the main loss to taxpayers arose because the devaluation could have made them a profit. If the government had maintained $24 billion foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4 billion profit on sterling's devaluation’ (Financial Times, 10 February, 2005).

Source: Truman, 2002, author’s modifications.

6.4.1 The Exchange Rate Mechanism (ERM II) The Amsterdam European Council meeting in June 1997 adopted the fundamental principles and elements of a new exchange-rate mechanism (ERM II), which regulated the relationships between the single currency and the currencies of those Member States of the European Union not participating in the monetary union. The exchange-rate mechanism operation system was put in operation on 1 January 1999, the starting date of the third stage of the EMU. Unlike the EMS, under which all the currencies established central parities amongst themselves (central rates) and fluctuation margins around themselves, the parities and margins of the new exchange-rate mechanism are now fixed exclusively in respect to the euro. It was only after this crisis that a new exchange rate mechanism (ERM II) replaced the original ERM of the European Monetary System (EMS) on 1 January 1999. ERM II helped enable Member States not participating in the euro area or mechanism, to orient their policies towards stability. It fostered convergence and thereby helped them in their efforts to adopt the euro. The ERM II also linked the non-participating currencies to the euro. The currencies of the participating ‘preins’ have a central rate against the euro. By pursuing stability-oriented policies, these central rates are the focus of economic management in the participating ‘preins’ Member States. Around each central rate, there are relatively wide standard

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fluctuation margins of +/- 15%. However, narrower margins between the euro and the participating ‘pre-in’ currencies are possible. In the event that a central rate becomes unsustainable, realignment will take place (). The following conversion rates were apparent from the beginning of the ERM II (Table 6.3):

Table 6.3  Conversion rates of EMU currencies Number of countries

1 euro =

Exchange rate

1 2 3 4 5 6 7 8 9 10 11 12 13

40.3399 1.95583 340.750 166.386 6.55957 0.787564 1936.27 40.3399 2.20371 13.7603 200.482 5.94573 239.640

Belgian francs German marks Greek drachmas Spanish pesetas French francs Irish pounds Italian lire Luxembourg francs Dutch guilders Austrian schillings Portuguese escudos Finnish marks Slovenian tolars

Source: European Union, .

After the enlargement of the EU from 15 to 25 countries, most of the new members entered the ERM II with the following conversion rates (Table 6.4):

Table 6.4  ERM II bands, central rates (conversion rates of future EMU members – not finalized rates), and dates of entrance Country (national currency) Cyprus (pound) Denmark (krone) Estonia (kroon) Latvia (lat) Lithuania (lita) Malta (lira) Slovakia (koruna) Slovenia (tolar)

Central rate (for 1 euro)

Fluctuation band

Date of entrance

0.585274 7.46038 15.6466 0.702804 3.45280 0.429300 38.4550 239.640

+/- 15% +/- 2.25% +/- 15% +/- 15% +/- 15% +/- 15% +/- 15% +/- 15%

2/5/2005 1/1/1999 28/6/2004 2/5/2005 28/6/2004 2/5/2005 28/11/2005 28/6/2004

Source: European Union, .

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6.5 Economic and Monetary Union (EMU) and the Stages of its Creation; The European Central Bank (ECB) During the negotiations of the Maastricht Treaty in 1990–1991, both economists and politicians alike considered the EMS a success. The precariousness of the exchange rate between the European currencies was significantly reduced: between 1979 and 1985, it was half of what it had been in 1975–1979, and it was halved again between 1986 and 1989. The drop in, and the junction of, both inflation rates and long-term interest rates further contributed to the success of the EMS. Consequently, in 1988, the European Council of Hanover established the Delors Committee to put forward proposals to achieve European monetary union. Interestingly, the committee was not asked to discuss whether the Economic and Monetary Union (EMU) was a good idea. ERM was not the perfect instrument to deliver stability in the money market. Accordingly, small, extremely integrated European economies needed to evade large exchange rate fluctuations and since ERM members had already relinquished monetary sovereignty by letting Germany set the single interest rate in the ERM, formal authorization of a monetary union did not seem such a big step (Jabko, 1999). The practical activation periods foreseen in the Delors Report were resumed and fixed by the Maastricht Treaty on 7 February 1992. This marked the end of the Intergovernmental Conferences that had begun in 1990. The Maastricht Treaty came into force on 1 November 1993 and underlined the pledges of the member countries to prepare a path to European Unification and established the relative times and principles. Delors recommended a three-stage plan (see Table 6.5), which presented ways of achieving greater coordination of economic and monetary policies, leading to the foundation of a European currency and a European Central Bank. The European Central Bank (ECB) sets monetary policy for all European Union countries adopting the single currency. It is the successor to the European Monetary Institute (EMI). The ECB works with national central banks within the European System of Central Banks (ESCB). Its key tasks are to: • • • • •

Define and implement monetary policy, such as setting interest rates. Maintain price stability. Support economic policies of member states as long as they do not affect price stability. Conduct foreign exchange operations and look after the official foreign reserves of the member states. Promote the smooth operation of payment systems that link banks.

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Table 6.5  Stages of the Maastricht Treaty Stage 1 (July 1990–Dec 1993)

Stage 2 (as of 1 January 1994)

Stage 3 (from 1 January 1999)

• Free circulation of capital among union countries. • It is forbidden to grant public loans to firms at favourable conditions. • Independence and autonomy of the central bank. • It is forbidden to finance public deficit. • Increased co-operation between central banks. • Free use of the ECU. • Improvement of economic convergence.

• States adopt economic and monetary policies in convergence. • Exchange level based on credibility of economic policies of member states. • Creation of the EMI (European Monetary Institute). • Ban on the granting of central bank credit to the public sector. • Increased co-ordination of monetary policies. • Strengthening of economic convergence. • Process leading to the independence of the national central banks, to be completed at the latest by the date of establishment of the European System of Central banks. • Preparatory work for Stage 3.

• Irrevocable fixing of conversion rates. • Introduction of the Euro. • Conduct of the single monetary policy by the European System of Central Banks (ESCB). • Entry into effect of the intra-EU exchange rate mechanism. • Entry into force of the Stability and Growth Pact (SGP).

Source: Bitzenis and Andronikidis, 2006, 31–33.

Europe’s new central bank has exclusive rights to authorise the issue of banknotes within the Community but it will share this actual role with national central banks. Member states taking part in the monetary union are only allowed to issue coins. The ECB has to approve the volume of money issued. The ECB is regarded by many in the banking profession as a duplicate of Germany’s Bundesbank – being based in Frankfurt, Germany’s financial capital. Like the Bundesbank, one of its main aims is to keep inflation under control (Wynne, 1999). Based on the Delors report, the European Council of Madrid in 1989 decided that the first stage of the EMU would begin in July 1990. The European Council of Maastricht in December 1991 decided that Europe would have a single currency by the year 2002. The establishment of the European Monetary Institute (EMI) on 1 January 1994 marked the beginning of the second stage of the EMU and with this the Committee of Governors ceased to exist. The EMI prepared the ground-work for

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the EMU. Its transitory existence also mirrored the state of monetary integration within the Community. The EMI had no responsibility for the conduct of monetary policy in the European Union nor had it any competence for carrying out foreign exchange intervention. Although, it worked hard to discourage budget deficits, its role to ban them altogether failed. The two main tasks of the EMI are: • •

to strengthen central bank cooperation and monetary policy co-ordination; to make the preparations required for (a) the establishment of the European System of Central Banks (ESCB); (b) the conduct of the single monetary policy; and (c) the creation of a single currency in the third stage.

To this end, the EMI provided a forum for consultation and for an exchange of views and information on policy issues. Moreover, it specified the regulatory, organizational and logistical framework necessary for the ESCB to perform its tasks in Stage 3. It was decided that Stage 3, would start in 1997 if a majority of the potential entrants fulfilled the ‘Maastricht criteria’. In Stage 3, swap rates were fixed. Otherwise, the EMU was to begin in January 1999 with whatever number of countries met the criteria (this has happened with eleven member countries). The objectives of the Maastricht Treaty, the so-called three pillars, can be summarized as: •

• •

the continuous development of a single market and transformation into an economic, political, monetary union with its own European single currency by 1999; the introduction and development of a common foreign and security policy; the introduction and development of co-operation in terms of law and order.

Furthermore, the Maastricht Treaty intends to: • • •

define new rights for European citizens (institution of European citizenship); include other matters concerning community competence (consumer protection, public health, etc.); allot additional powers to the European Parliament and extend European citizenship.

6.5.1 Maastricht or Convergence Criteria The four Maastricht convergence criteria (or five if we considered separately the budgetary discipline thus the annual government deficit over GDP ratio and the ratio of gross government debt to GDP) are presented in Article 121(1) of the Treaty establishing the European Community (EC Treaty). They are set out in the Protocol on the convergence criteria referred to in Article 121 of the EC Treaty

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and reflect the degree of economic convergence that Member States must achieve. Each Member State must satisfy all the criteria in order to be able to participate in the third stage of economic and monetary union (EMU). The Treaty stipulates that the inflation rate of a given Member State must not exceed by more than 1½ percentage points that of the average of the three best-performing Member States in terms of price stability during the year preceding the examination of the situation in that Member State. Moreover, the nominal long-term interest rate must not exceed by more than 2 percentage points the average of the three best-performing Member States in terms of price stability. The period taken into consideration is the year preceding the examination of the situation in the Member State concerned. Regarding the ratio of the annual government deficit to gross domestic product (GDP), this must not exceed 3% at the end of the preceding financial year. If this is not the case, the ratio must have declined substantially and continuously and reached a level close to 3% (interpretation in trend terms according to Article 104(2)) or, alternatively, must remain close to 3% while representing only an exceptional and temporary excess). Regarding the ratio of gross government debt to GDP, this must not exceed 60% at the end of the preceding financial year. If this is not the case, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace (interpretation in trend terms according to Article 104(2)). The Member State must have participated in the exchange-rate mechanism (ERM) of the European monetary system (EMS) without any break during the two years preceding the examination of the situation and without severe tensions. Last but not least, each of the member countries should ensure compatibility of their national legislation with that of the Articles 108 and 109 of the Treaty and the Statute of the ESCB (). 6.5.2 Special Case Studies Regarding Entry into the EMU: The Cases of Greece and Sweden The membership of Greece into the EU is a special case and worthy of mention. Greece entered the ERM I on 16th March 1998. At that time, the central parity was 357 GRD against the ECU and the fluctuation band +/- 15%. However, the ERM II replaced the ERM I in January 1999 and the euro replaced the ECU. After the conversion rate of the euro had been determined, the Greek drachma (GRD or GDR) resulted in a central rate of 353.109 against the euro. On 17 January 2000, the central rate of the Greek drachma was revalued at 340.75 GRD against the euro. The fluctuations during the two-year period before the Greek entrance to the EMU had been limited to the band of +/- 15%. For example, between April and August 1998 there was an appreciation of 6% of the GRD (or GDR) against the Euro (tightening the monetary policy to reduce inflation). In late January/early February 1999, it reached the highest level against the euro (321 GDR [or GRD] to 1 Euro). Then a gradual depreciation started and the Greek drachma reached

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334.7 GRDs (or GDRs) against the Euro on 31 March 2000. Thus, Greece, the ECB and the other member states agreed to a further depreciation of the Greek drachma against the euro in order to reach the final official central rate of Greek drachma against the euro, which is 340.75, an appreciated rate compared to the initial central rate of 353.109 but a depreciated rate compared to the rate at the time of decision (see Table 6.6).

Table 6.6  Greek exchange rate during 2000 (Drachma against Euro) Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

331,06 333,17 333,91 335,22 336,59 336,85 336,87 337,29 338,6 339,46 340,16 340,71

Greece is a special case study because it is the only country that failed for two consecutive years to enter the EMU. All other countries except for Sweden (only at the beginning), remained out of the EMU on their own free will. Up until 1995, Greece recorded very high deficits, for some years above 10% of GDP. Then they miraculously diminished. In 2000, given a deficit below 3% of GDP, Greece was accepted as the 12th member of the European Monetary Union. In March 2002, Eurostat refused to validate data transmitted by the Greek government. In reaction to this, the National Statistical Service of Greece (NSSG) revised the debt level by several percentage points. In September 2002, Eurostat again refused to validate the data. The debt was revised upwards once again and the government balance, which the Greek government had presented as a surplus, became a deficit. In March 2004, Eurostat refused once more to validate the Greek numbers. This was shortly before Greek elections and a new government (‘New Democracy’, a conservative party) was to be inaugurated. When New Democracy won the March 7 elections in 2004, it claimed it would make the financial audit of the government accounts a key objective. Thus, the government produced new estimates after investigating the years 1997–2003, and the resulting data was given to Eurostat, which in turn published a report of their findings. It appeared that the Greek government accounts had been falsified (Eurostat diplomatically avoids this word), mostly by having ‘postponed’ accounting for huge military expenses, from 1997 onwards. It was reported that if the true deficit figures were known, Greece would have not joined the European Monetary Union. This argument was based on calculations of the corrected deficits employed by the newer ESA95 methodology. However, when calculated with the ESA79 methodology, in force at the time of the Greek application and even according to the revised numbers, Greece had met the deficit criterion for its reference year of 1999. Thus, since the remaining criteria had also been met, Greece was properly accepted

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into the Eurozone (ESA79 was also the methodology employed to calculate the deficits of all other Eurozone members at the time of their applications). Greece, in common with other Eurozone members, benefited from cheaper interest rates than it would have received otherwise. Some commentators found it surprising that the Greek public prosecutor did not launch an investigation into the crime of falsification of documents. Others, though, held a completely different viewpoint. ‘Irregularities’ (the word falsification is never officially used) in deficit reporting were also practised by other Eurozone members. Most notably, by Italy and Portugal. Additionally, there were allegations of widespread ‘creative accounting’ employed by many countries in order to meet the deficit criterion for entry into the Eurozone. Even the practice of one-off measures by so many states has been criticized, since in several cases, their deficits rose back over 3% soon after the reference year, whilst large economies such as Germany and France seem to have defied the rules ever since. Last but not least, changes in the accounting method often seriously affected the deficit numbers (Spain and Portugal had, like Greece, marginally exceeded 3% in their reference year of entry, when their deficit was revised according to ESA95). It was argued that the New Democracy government had simply miscalculated the consequences of its actions, which brought about a strong reaction by Eurostat (stronger than that for other violators, ). Thus, Greece is a special case study because of its manipulation of the figures before and after its entrance into the EMU. As mentioned above, on September 2004, Greece revised its economic figures regarding its deficit and its government debt. The revised deficit figures for the period 1997–2003 are of the following magnitude: 1997: 6.6% of GDP instead of 4.0% 1998: 4.3% of GDP instead of 2.5% 1999: 3.4% of GDP instead of 1.8% 2000: 4.1% of GDP instead of 2.0% 2001: 3.7% of GDP instead of 1.4% 2002: 3.7% of GDP instead of 1.4% 2003: 4.6% of GDP instead of 1.7% In 2004, the finalized general government deficit in Greece stood at 7.9% of GDP. This ratio was revised several times starting from less than 3%, then moving to 4%, reached 5% and then on to 6.6% and 6.9% when it was revised again to the very final time to reach 7.9%. The general government deficit was reduced from 7.9 % of GDP in 2004 to 2.6 % of GDP in 2006, which is below the 3% of GDP deficit reference value. This is identical to the target set in the December 2005 update of the stability programme (see 2007/465/EC: Council Decision of 5 June 2007 abrogating Decision 2004/917/EC on the existence of an excessive deficit in Greece).

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On the other hand, the revised debt figures for the period 1997–2003 are of the following magnitude: 1997: 114.0 % of GDP instead of 108.2 % 1998: 112.4 % of GDP instead of 105.8 % 1999: 112.3 % of GDP instead of 105.2 % 2000: 114% of GDP instead of 106.1% 2001: 114.7% of GDP instead of 106.6% 2002: 112.5% of GDP instead of 104.6% 2003: 109.9% of GDP instead of 102.6% Greek government debt declined from 108.5% of GDP in 2004 to 104.5% in 2006. According to the spring 2007 forecast, the debt ratio is projected to fall further, to around 97.5% by the end of 2008, still well above the 60% of GDP reference value. The debt ratio can be considered as sufficiently diminishing towards the 60% of GDP reference value (see 2007/465/EC: Council Decision of 5 June 2007 abrogating Decision 2004/917/EC on the existence of an excessive deficit in Greece). According to Eurostat (Government Finance Statistics, EDP Notification Tables 2008.07) the Greek GDP at current market prices was for 2002: 143482 million euros; in 2003: 155543; in 2004: 168417; in 2005: 181088, and in 2006 (planned) 194458 million euros. Moreover, according to Eurostat, the Greek general government consolidated gross debt level at nominal value outstanding at the end of each year was: in 2002: 158887 million euros; in 2003: 167723; in 2004: 182702; in 2005 (estimated): 194666, and in 2006 (planned): 202770. Thus, we can create the following Table (Table 6.7) based on the above statistics: Table 6.7  Greek GDP and Greek deficit in 2002–2006 Greece

GDP

Debt

Ratio (per cent)

2002 2003 2004 2005 2006

143482 155543 168417 181088 194458

158887 167723 182702 194666 202770

110.74 107.83 108.48 107.50 104.27

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The Greek general government deficit (according to Eurostat) was in 2002: -7465; in 2003: -9554; in 2004: -13110; in 2005: -9495, and in 2006 (planned): -5010 million euros. Thus, we can create the following table (Table 6.8) based on the above statistics: Table 6.8  Revised Greek GDP and revised Greek deficit in 2002–2006 Year

GDP

Deficit

Ratio (per cent)

2002 2003 2004 2005 2006

143482 155543 168417 181088 194458

-7074 -8965 -11681 -8222 -5010

-4.93 -5.76 -6.94 -4.54 -2.58

The Greek budgetary statistics have undergone a major revision. Such substantial increases mentioned above resulted from earlier actions undertaken by Eurostat as well as initiatives taken by the incoming Greek government in the spring of 2004 to launch a thorough fiscal audit. Revisions in statistics, and in particular in government deficit data, are not unusual. Since the publication of the first outcomes in March by the national statistical institutes, data is often revised in light of new information becoming available, or because errors are easily detected. However, the 2004 revision of the Greek budgetary data is exceptional. The reasons why these figures differ from the ones provided in previous notifications are essentially as follows: • •

An increase in the recording of military expenditures on equipment goods. Correct recording of capital injections and EU grants. It is important to underline, however, that in the case of Greece most capital injections in state-owned enterprises were mainly financed by EU grants earmarked for specific purposes. Consequently, they should be treated as capital transfers (impacting the deficit) and not as share capital increases (financial transaction without impact on the deficit).

For the deficit: •

Military expenditures (military durables [e.g. battleships, tanks, missiles, fighters, etc.]): data as provided by the Greek authorities was on a cash basis in the absence of data on deliveries. Eurostat demanded that Greek authorities provide figures according to the method of deliveries. The Greek authorities responded that such data was not available. The discrepancies occurred because military equipment should be recorded as

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government expenditure at the moment of their delivery, irrespective of effective payments, which can take place when the equipment is ordered, during construction, upon delivery or even at a later stage. However, data on deliveries of military equipment is confidential or not used in national accounts, and national statistical institutes have difficulties in obtaining the necessary information to draw government accounts fully in-line with the accounting rules. Although the method for recording expenditures was based on deliveries, in fact no information on deliveries has been given since 1997. Therefore, most military expenditures covered by borrowing have not been recorded in the last seven years. As information on deliveries cannot be obtained now, the Greek authorities have decided to record these amounts on a cash basis. Thus, additional expenditure imputed in government accounts after revisions took place in September 2004: 0.2% of GDP burden of deficit in 1997 0.1% of GDP burden of deficit in 1998 0.9% of GDP burden of deficit in 1999 1.9% of GDP burden of deficit in 2000 1.2% of GDP burden of deficit in 2001 1.7% of GDP burden of deficit in 2002 0.7% of GDP burden of deficit in 2003 •

Debt assumptions: Figures on previously notified debt assumptions were incomplete. Data available at the IMF were higher than the amounts reported to Eurostat. The Greek authorities explained that differences are partly due to different coverage of the notion of public sector. Although the accounting rules on the recording of debt assumptions have been well established since at least 1995, they were one of the most frequently discussed issues between Eurostat and the Greek statistical authorities from 1996 to 2002. Although Eurostat has made clear the rules to be followed, such rules were not applied in a consistent way and data has frequently changed. It can be suggested that Eurostat’s recommendations were not followed. The Greek authorities acknowledged that 217 millions (mio) of € of debt assumptions had taken place in 2000, and 494 mio € in 2001, against the previously reported figures of 38 mio € in 2000 and nil in 2001. Most recent reporting includes debt assumptions of 277 mio € for 2002 and 168 mio € for 2003. Most recently, Greece informed Eurostat that the 1997, 1998 and 1999 accounts need to be corrected to include 124, 140, and 97 bio (billions of) € of debt assumptions, respectively.

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•

Capitalized or capital interest: Again figures on previously notified capitalized or capital interest were incomplete. Eurostat had explicitly made it clear during the years 1996 to 1998 that capitalized interest should be properly recorded and accrued over time, deteriorating the deficit/surplus of government in those years in which the amounts had to be recorded. However, this does not seem to have been done by the Greek authorities, or it was it has only been done for partial amounts. Despite explicit assurances given by the Greek authorities to the contrary, the rules on the recording of capitalized interest were not applied. The Greek authorities have now informed Eurostat that capitalized interest for the years 1995 to 2000 were as follows: 1995: 1964 mio € 1996: 1765 mio € 1997: 990 mio € 1998: 282 mio € 1999: 108 mio € 2000: 340 mio € It should be remembered that in the first notification (before the revision), the amount of capitalized interest was 33 bio GDR for 1997 (106 mio €), 27 bio GDR for 1998 (82 mio €), and nil for 1999. It should also be added that in 2004 the Greek authorities stated that in 2000 unrecorded capitalized interest amounted to 340 mio €, an amount much larger than the one recorded in 1999. However, still the impact should be limited.

•

Capital injections: Data once again has been found to be incomplete. Greece argued that all capital injections had been registered as financial transactions below the line without any impact on the government deficit because the beneficiaries of capital injections were ‘all quasi-corporations’, ‘therefore, the amount received by them in order to finance infrastructure could be treated as a financial transaction. This, of course, would not have been possible in the case of corporations’. The units receiving capital injections, such as the Greek Electricity and Greek Telecommunication Company, did have the legal status of corporation and therefore could not be considered by accountants as quasi corporations, and some of the capital injections covered mainly past and consistent losses of state-owned enterprises that were highly indebted. Eurostat believes that capital injections from 2000 to 2003 have been correctly recorded in the Greek government accounts. This is at present also the case for the years 1997 to 1999, as a correction has been imputed according to the rules for the treatment of capital injections.

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Greece agreed that several capital injections had not been properly recorded. The deficit for 2000 and 2001 was therefore revised upwards by 0.8% of GDP for 2000 and 0.9% for 2001. The reclassification of capital injections concerned a number of companies, notably the railways (OSE), the Athens Metro, and EGNATIA, a motorway company. The Greek authorities seem to have correctly registered capital injections from 2000 onwards. However, the revision in the accounts of October 2002 was not extended back into the years before 2000. The Greek authorities informed Eurostat that capital injections amounted to 1233 mio € (1.27% of GDP) in 1997 and 1415 mio € (1.34% of GDP) in 1998, none of which had been registered as deficit increasing. Concerning 1999, Greece claimed capital injections amounting to 1820 mio € (1.61 % of GDP) of which only 411 mio € (or 0.36 % of GDP) were imputed as capital transfers. Accordingly, they increased the deficit. •

DEKA: In 1997, the Greek government created a state-owned holding known as DEKA. The government moved several enterprises to be privatized to the DEKA balance sheet. DEKA injected capital in some of the enterprises it controlled, sold some of them and paid dividends to the government. When the Greek government founded DEKA, the Greek authorities suggested that it should be classified outside the government and that the dividends it paid to the government could be recorded as deficit-reducing property income. Eurostat brought to the attention of the Greek statistical authorities the need to correct the sector classification of DEKA and/or the accounting treatment of its transaction immediately after DEKA’s establishment in 1997. Eurostat recommended that DEKA be reclassified as inside the government in 1999. However, the Greek authorities only moved to do so in 2002. When Eurostat questioned whether the impact of the reclassification of DEKA has been properly assessed by the Greek authorities, for the period from 1997 to 2001, the Greek authorities, in a letter dated 27.10.04 confirmed that this had not been the case. As a result, amounts previously classified as share capital increases equal to 211 mio € both in 1997 and 1998, and of 113 mio € in 1999, have been reclassified as capital transfers, increasing the deficit. Data is now complete.

•

Interest on convertible bonds: Eurostat requested form Greece that convertible bonds be included in the reported government debt. Shareconvertible bonds were finally included into government debt in September 2002 with a retroactive correction since 1998. The interest paid by the

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government was considered as government expenditure. As a consequence, the deficit of government increased by 46 mio € in 2000 and 82 mio € in 2001. However, deficit figures before the year 2000 were not corrected at that time. Now, Eurostat believes that share-convertible bonds have been correctly recorded in the accounts. •

EU (structural funds) grants: data is as provided by the Greek authorities during a meeting on 10 November 2004. The amounts correspond to projects co-financed by the European Union. On the basis of the information provided by the Greek statistical authorities, the figures for 1997–1999 have now been corrected to the following amounts: 1997: 202 mio € 1998: 179 mio € 1999: -272 mio € The negative amount of the correction for the year 1999 is explained by the fact that the amounts to be added have been recorded under the item ‘capital injections’ due to national accounts classification practices in Greece. Finally, in relation to structural funds, the deficit figure of 2003 was increased in the notification of September 2004 by an amount of 475 mio € (equal to 0.3% of GDP), compared to the figure reported in the March 2003 notification. This was due to an error in public accounting relative to the effective payments by EU institutions in 2003.

•

Interest: The Greek authorities confirmed on 19 November 2004 that interest due to an increase in debt should not be added to government expenditures as it was already previously incorporated in the Social Security Funds survey.

For the Debt: Between 2000 and 2003, amounts of approximately 5 bio € per year failed to be included in the government debt due to incorrect consolidation at general government level of government debt. Eurostat asked the Greek authorities to communicate the amounts to be added for this reason to government debt between 1997 and 1998. The Greek authorities confirmed on 19 November 2004 that the amount of debt that should be added to the general government debt for this issue was equal to 949 mio € in 1997 and 1972 mio € in 1998. The debt of share exchangeable bonds which had been wrongly classified outside the government by the Greek authorities was added to the government debt in 1999. In order to correct the figure Eurostat used information which it

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had already received on previous occasions by the Greek authorities. Between March and September 2002 the government debt increased due to the inclusion of share convertible bonds previously excluded from government debt; between September and November 2002 the government debt increased again due to the inclusion of share exchangeable bonds into government debt. These bonds had been issued by a Luxembourg-based special purpose vehicle (SPV). The proceeds were used to buy shares of companies owned by the government. Conversely, dividends proceeds from these state-owned companies were used to pay the coupon of the bonds. The Greek government was fully guaranteed the payments of both interest and principal. Following Eurostat’s decision about securitization of operations undertaken by the general government, the securities issued by the SPVs were included under the liabilities of the Greek government (and within the Maastricht debt of general government). A correction was imputed for the years 2000 and 2001. Nevertheless, the data for the year 1999 (the first year in which one emission of share exchangeable bonds was issued) has yet to be corrected. Finally, between March and September 2004, when debt increased due to the decision to capitalize interest payments, due to an incorrect consolidation inside general government of social security assets (due apparently to the difficulty of obtaining reliable historical information), and due to the non-inclusion of the debt of particular mutual funds inside social security. The Greek authorities have explained that from 1997 onwards, the government asked particular state-owned banks to postpone the payment of interest due. According to the Maastricht definition of debt, these amounts should have been recorded in government debt, but this did not happen. The impact on debt of general government due to capitalized interest equalled 4.5% of GDP in 2000, 4.2% in 2001, 3.9% in 2002 and 3.4% in 2003. As for the debt for the years 1997– 1999, the Greek authorities informed Eurostat that the increase of debt due to the non-inclusion of the stock of capitalized interest in government debt is as follows: 4.719 bio € (1997), 5.001 bio € (1998), and 5.109 bio € (1999). The Greek authorities informed Eurostat in September 2004 that government debt was wrongly consolidated inside general government (consolidating assets of social security), and that the debt of mutual funds was wrongly classified outside the government in the period 2000–2003. Eurostat therefore asked the Greek authorities to investigate whether debt figures for 1997–1999 should also be increased for the same reasons. As a result of the Greek authorities investigation, amounts of around 1 bio € for 1997 and 2 bio € for 1998 and 1999 have now been added to the debt of the general government. To conclude, Greece is a special case not only because of its manipulation of its economic figures before and after entrance to the EU, but also because it remained out of the EMU as it failed for two consecutive years to satisfy the Maastricht Criteria. However, in 2000, Greece finally became part of the EMU. Sweden is also another unique case study because it originally (in 1999) failed to meet the Maastricht Criteria also. Although some months later it met the criteria, Sweden had a change of heart. As a result, it left unfulfilled its legal obligations to

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the EMU. Sweden’s national legislation failed, on purpose, to comply with Articles 108 and 109 of the Maastricht Treaty, as well as with the Statute of the European System of Central Bank and the Statute of the European Central Bank. For this reason in the convergence reports of 1998, 2000, 2002, 2004, and 2006, Sweden has been entered. In reality, Sweden’s economic performance is excellent as it has not only the lowest annual inflation rate among the 25 EU members (0.9%), but the lowest interest rate (3.3%), as well. On the other hand, in the convergence report published on May 2007 only Cyprus and Malta have been included as these two countries will be the new EMU members from 1/1/2008 (15 countries make up the EMU membership). In the following tables (6.9–6.16), as an example, the reference prices for the convergence report of 2000 are presented for Greece and Sweden.

Table 6.9  Greece: Long-term interest rates (per cent)

Long-term interest rates Reference value Euro area average

1998

1999

2000 Jan

2000 Feb

2000 Mar

Apr 1999 to Mar 2000

8.5 6.6 4.7

6.3 6.8 4.6

6.6 – 5.7

6.5 – 5.7

6.2 – 5.5

6.4 7.2 5.0

Note: The reference value is based on the best-performing Member States in terms of price (Austria, France and Sweden for the period from April 1999 to March 2000) plus 2 percentage points. Source: European Central Bank, 2000.

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Table 6.10  Greece: Exchange rate stability Membership of the Exchange Rate Mechanism (ERM/ERM II) Membership since Devaluation of bilateral central rate on country’s own initiative Maximum and minimum upward deviations from central rates in %*

Yes March 1998 No Maximum Minimum upward upward deviations deviations

1 April 1998 to 31 December 1998 (ERM currencies)* Belgian Franc Danish Krone Deutsche Mark Spanish Peseta French Franc Irish Pound Italian Lira Dutch Guilder Austrian Schilling Portuguese Escudo Finnish Markka

8.0 7.9 8.0 7.8 8.0 7.0 7.7 8.1 8.0 7.9 8.0

3.2 3.2 3.2 3.0 3.2 1.8 2.9 3.1 3.2 3.1 3.1

9.0 2.8

5.9 1.9

8.7 2.6

4.4 1.7

4 January 1999 to 31 March 2000 (ERM II currencies) Euro (4 January 1999 to 16 January 2000) Euro (17 January 1999 to 31 March 2000) For information only Danish Krone (4 January 1999 to 16 January 2000) Danish Krone (17 January 1999 to 31 March 2000)

Note: ERM II replaced the ERM from the beginning of 1999. With affect from 17 January 2000 the central parity for Greece; * Daily data at business frequency; ten-day moving average. Source: BIS and European Central Bank, 2000.

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Table 6.11  Greece: General government financial position (as a percentage of GDP)

General government surplus (+)/deficit (-) Reference value Surplus (+)/deficit (-) net of public investment expenditure** General government debt Reference value

1998

1999

2000*

-3.1 -3 0.6 105.4 60

-1.6 -3 2.7 104.4 60

-1.3 -3 2.9 103.7 60

Note: * European Commission forecast; ** A negative sign indicates that the government deficit is higher than investment expenditure. Source: European Commission (spring 2000 forecasts) and European Central Bank, 2000.

Table 6.12  Greece: HICP inflation (annual percentage changes) 1996 1997 1998 1999 HICP inflation* Reference value** Euro area average***

7.9 2.5 2.2

5.4 2.7 1.6

4.5 2.2 1.1

2.1 2.1 1.1

2000 2000 2000 Jan Feb Mar 2.4 – 1.9

2.6 – 2.0

2.8 – -2.1

Apr 1999 to Mar 2000 2.0 2.4 1.4

Note: * Note that from January 2000 the coverage of the HICP has been extended and further harmonized; ** Calculation for the April 1999 to March 2000 period is based on the unweighted arithmetic average of annual percentage changes of Sweden, Austria and France plus 1.5 percentage points; *** The euro area average is included for information only. Source: European Central Bank, 2000.

Moving to the case of Sweden we can clearly see that Sweden meets the economic criteria of Maastricht:

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Table 6.13  Sweden: Long-term interest rates (per cent) 1998

1999

2000 Jan

2000 Feb

2000 Mar

Apr 1999 to Mar 2000

5.0 6.6 4.7

5.0 6.8 4.6

6.0 – 5.7

5.9 – 5.7

5.5 – 5.5

5.4 7.2 5.0

Long-term interest rates Reference value Euro area average

Note: The reference value is based on the best-performing Member States in terms of price (Austria, France and Sweden for the period from April 1999 to March 2000) plus 2 percentage points. The euro is included for information only. Source: European Central Bank, 2000.

Table 6.14  Sweden: HICP inflation (annual percentage changes) 1996 1997 1998 1999 HICP inflation* Reference value** Euro area average***

0.8 2.5 2.2

1.8 2.7 1.6

1.0 2.2 1.1

0.6 2.1 1.1

2000 2000 2000 Jan Feb Mar 1.0 – 1.9

1.4 – 2.1

Apr 1999 to Mar 2000

1.4 – 2.1

0.8 2.4 1.4

Note: * Note that from January 2000 the coverage of the HICP has been extended and further harmonized; ** Calculation for the April 1999 to March 2000 period is based on the unweighted arithmetic average of annual percentage; *** The euro area average is included for information only. Source: European Central Bank, 2000.

Table 6.15  Sweden: General government financial position (as a percentage of GDP)

General government surplus (+)/deficit (-) Reference value Surplus (+)/deficit (-) net of public investment expenditure** General government debt Reference value

1998

1999

2000*

1.9 -3 4.6 72.4 60

1.9 -3 4.6 65.5 60

2.4 -3 4.9 61.3 60

Note: * European Commission forecast; ** A negative sign indicates that the government deficit is higher than investment expenditure. Source: European Commission (spring 2000 forecasts) and European Central Bank, 2000.

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Table 6.16  Sweden: Exchange rate stability Membership of the exchange rate mechanism (ERM) Devaluation of bilateral central rate on country’s own initiative

No No Maximum upward deviations

Minimum upward deviations

1 April 1998 to 31 December 1998 (ERM currencies)**

0.4

-12.6

Belgian Franc Deutsche Mark Spanish Peseta French Franc Irish Pound Italian Lira Dutch Guilder Austrian Schilling Portuguese Escudo Finnish Markka Non-ERM currencies Greek Drachma Pound Sterling

0.4 0.4 0.5 0.4 0.4 0.5 0.4 0.4 0.4 0.4

-12.9 -12.6 -12.5 -12.6 -11.5 -12.4 -12.4 -12.6 -12.5 -12.3

0.5 4.2

-16.8 -3.2

8.3

-1.5

8.3 11.2 0.9

-1.4 -1.1 -9.0

Maximum and minimum upward deviations*

4 January 1999 to 31 March 2000 (ERM II currencies)*** Euro For information only Danish Krone Greek Drachma Pound Sterling

Note: ERM II replaced the ERM from the beginning of 1999; * Daily data at business frequency; ten-day moving average; ** Maximum upward (+) and downward (-) deviations from April 1998 in bilateral exchange rates against the currencies shown (in %); *** Maximum upward (+) and downward (-) deviations from January 1999 in bilateral exchange rates against the currencies shown (in %). Source: BIS and European Central Bank, 2000.

6.6. Costs and Benefits from the Introduction of the Euro and being a Member of the EMU As mentioned in Bitzenis and Andronikidis (2006), the benefits of the EMU to member countries are mainly connected with the five Maastricht criteria (low interest rates, low inflation, a stable monetary policy, a stable exchange rate

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policy when we have one common monetary policy and one currency, and a strict budgetary policy – limited debt/GDP and deficit/GDP ratios). Furthermore, membership into the EMU allows member states to make savings in three areas: reduced costs due to the elimination of currency exchange; lower costs created by healthy competition in the eurozone; and a more favourable trading and investment environment for local businesses (European Commission, 1990). The implications for the three main areas are as follows: (a) Currency exchange: The elimination of costs associated with currency exchange within the euro area produce estimated savings of up to one percentage point of annual European Union GDP each year; (b) A single currency: The use of a single currency allows easier price comparison across the participating member states which in turn stimulates competition. The ultimate winners are Europe’s citizens and consumers; and (c) Trade and investment: By eliminating the exchange rate risk, the Economic and Monetary Union (EMU) brings increased business and trading potential to commercial companies, especially small and medium-sized enterprises (Masson et al., 1992). By creating a single market and more efficient markets for goods and services, the euro raises the competitiveness of the participating economies. Amongst other things, it encourages a more rapid development of new product lines, a faster implementation of new techniques in the production process, and more investment in human capital. Therefore, it stimulates growth of production, income and employment, and restrains inflation. Countries that have adopted the euro benefit from such advantages as: elimination of transaction costs; removal of exchange rate risk from trade with other members of the euro area; improved efficiency of financial and monetary markets; transparency of prices for goods and services in euro area countries, which promotes competition; improved distribution of resources; and, generally, better economic integration (Melitz, 2000). The introduction of the euro reinforces competition between the Member States adopting the new currency. As prices in all participating countries are expressed in euro, transparency will be enhanced which in turn strengthens competition and certainly has an impact on price convergence, i.e. very large price differences are no longer sustainable. However, just as prices for goods and services currently diverge on a regional basis within member states, some differences in prices are also likely to persist. For example, it should be recognized that levels of indirect taxation may diverge between member states, thus resulting in different price levels. Nevertheless, price differences are more difficult to sustain and tend to be limited by variations in the level of transaction costs (Pain, 2002). Given the size of the euro area, the euro plays an important role as an international currency. It is quite likely to be used extensively in trade outside the euro area and should be seen as an attractive alternative to the dollar. It is already used extensively as a borrowing currency in corporate bond markets. Solidly based on the stability-oriented policies of the European Central Bank and sound

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fiscal policies of the member States, the euro will eventually play a significant role in financial portfolios worldwide, and as a major reserve currency. Therefore, the euro has the potential to stabilize the international economic environment and to promote international trade. International investors now have broader opportunities to diversify their portfolios and to control their risks (Pratti and Schinasi, 1999). Table 6.17 presents the advantages of the EMU as discussed in the literature (Salvatore, 2002a; Salvatore, 2002b; Endey, 1998; Leblond, 2004).

Table 6.17  Advantages from being an EMU member and from the introduction of a common currency (EURO) Advantages of the EMU for participating member states Exit from exchange rate crisis Fiscal policy and fiscal interventions conducted by national governments Low restrained inflation

Advantages of the EMU for enterprises

Advantages of the EMU for consumers

Effectiveness in a larger market Reduced travel costs Reduction of operation costs Easier and less expensive transfer of funds to other countries Windfall advantages and Faster growth of purchasing opportunities in many export power (due to lower inflation). markets CEE consumer purchasing power grows Reduced costs due to the end of Strategic opportunities Increased competition which currency exchange will lead to lower prices Elimination of exchange rate Lower costs created by healthy Lower charges for foreign competition in the eurozone exchanges risks in the EMU area Favourable trading Enhanced profitability Lower interest rates Investment environment for More investment opportunities Secured purchasing power local businesses Prevention of counterfeiting, Merger and acquisition Job security adoption and implementation of opportunities company law Stimulation of competition Lower production cost Price convergence Improved competitiveness of Repackaging of products Easier price comparison participating economies Rapid development of new Review of new marketing Elimination of time for product lines strategies changing currencies Implementation of new More choices and business Economic stability production process techniques opportunities for SMEs More investment in human Disappearance of exchange rate Reduction or removal of capital risk in the EMU differences in prices Encouragement of growth of Increased competition in the Saving the costs of changing production banking system and lower currencies interest rates (lower lending/ borrowing cost) Removal of exchange risk from The euro area is treated as one Removal of risks of exchange trade with other members of the domestic market rate fluctuations euro area

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Table 6.17  continued Advantages of the EMU for participating member states Improved efficiency of financial and monetary markets Improved distribution/ allocation of resources Better economic integration/ stability Opportunities for portfolio diversification Stabilization of international economic environment Euro is an attractive alternative to the dollar. Price convergence, stronger competition Transparency of prices for goods and services Improved employment rules Higher GDP/income Confidence in Europe’s economy

Advantages of the EMU for enterprises Economies of scale

Advantages of the EMU for consumers More choices and better prices

Incorporation of innovation

New basis for supporting growth and employment Investment and growth and thus Reduction in many costs, especially for large companies job creation Influence in employment Structural reforms that lead to policies job creation Lower prices for importing raw Protection of salaries materials Economic stability (better Movement of labour business environment) Removal of risks of exchange Improved price transparency, rate fluctuations in trade Greater price transparency Elimination of exchange rate risks in the EMU area

Apart from the benefits derived from the EMU participation of EU member countries, many benefits also exist for companies. Firstly, as previously mentioned, the use of the euro as a single currency stimulates competition and leads to new product development, new production methods and a larger number of potential customers. Secondly, many companies are able to export using the euro. In that way, they reduce operating costs (European Commission, 1990). In addition to this, the Economic and Monetary Union (EMU) will bring small and medium-sized enterprises (SMEs) more choices and business opportunities. Many SMEs will become stronger and more competitive with the disappearance of the exchange rate risk in most of the European Union’s largest markets, the increased competition in the banking industry and lower interest rates. Moreover, SMEs will be able to sell their products and services across a far wider area (economies of scale) to more potential customers. In other words, cumbersome exporting turns into a more straightforward domestic business exercise (Leblond, 2004). Finally, large companies operating across Europe will enjoy a reduction in many of their costs, due to the elimination of foreign exchange risk, notably in the areas of treasury management and foreign exchange transactions. However, the impact of the euro will be much wider and will affect employment policies, pricing and marketing, and decisions on the location of production and distribution centres. Competition in some sectors will undoubtedly be stronger

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and with much greater price transparency. Furthermore, the cost to consumers of certain goods in certain markets may even be expected to fall (Rose, 2000). The benefits of the Economic and Monetary Union (EMU) for consumers are also numerous. To mention a few: reduced costs for travelling to other countries; easier and less expensive transfer of funds to other countries; greater cost transparency and increased competition leading to lower prices; the elimination of exchange rate risks among the participating countries; low interest rates that reduce the cost of borrowing; secured purchasing power through lower inflation; and more sustainable economic growth, which will increase job security. On the other hand, EMU participation also has costs for member countries. The main disadvantages to member countries of the EMU are summarized in Table 6.18.

Table 6.18  Costs of participation in the EMU EMU Disadvantages The risk of losing the monetary policy instruments. For example, the exchange rate policy, or the monetary policy – interest rate policy at national level. Τhe inconsistency of the euro area economy or as often expressed the economic divergences between economies within the euro area could challenge the viability of the EMU. Currency zones should be compact and homogenous enough to show little regional variation in business cycles, otherwise a one-size-fits-all monetary policy will leave some regions lingering in recession, while others grow so fast that they overheat the zone. The European Central Bank (ECB) has been trying to chart a middle course between slow- and fastgrowing countries while establishing its credibility as an inflation-fighter but the result has been a monetary policy that is too ‘hot’ for some, too ‘cold’ for others, and ‘just right’ for almost no one. Reduced autonomy in decision making process, as countries have different backgrounds and needs. The critics consider the ‘centralized blocks’ as an outdated concept in a world where globalization and localism are the main competitive philosophies. Consumers and businesses will have to convert their bills accounts. Some costs will occur as banks and businesses need to update computer software for accounting purposes, update price lists, and so on. Europe may not constitute an ‘optimum currency area’ because the business cycles across the various countries do not move in synchronicity. In a recession, a country can no longer stimulate its economy by devaluing its currency and increasing exports. Previously, the anchor of the European Monetary System had been the independence of the German Bundesbank and its strong focus on price stability. Even though the European Central Bank (ECB) is independent, it will have to prove its independence in the future. This will, at the very least, incur temporary costs as it will have to be extra-tough on inflation. When other governments exert pressure on a government to reduce borrowing, or even pay fines if the budget deficit exceeds a reference value, this may have the perverse effect of increasing an existing economic imbalance or deepening a recession. The costs of adoption of all EMU norms and standards by enterprises.

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Angelov (2002) assumes that there are three types of expenses: costs for improvement of legislation, costs of compliance with European principles, and costs for total modernisation of the industrial potential. Ramos and Surinach (2004) argue that the main cost of joining a currency area is the risk of losing monetary policy instruments. For instance, the exchange rates at the national level as stabilization mechanisms against macroeconomic disturbances affect only one country in an area or affect countries in different manners. Their arguments are based on the fact that as the macroeconomic disturbances known as ‘asymmetric shocks ‘cannot be dealt with a common monetary policy, the achievement of macroeconomic stabilization would need alternative adjustment mechanisms. 6.7 The Stability and Growth Pact The Stability and Growth Pact (SGP) is the concrete EU answer to concerns on the continuation of budgetary discipline in the Economic and Monetary Union (EMU). Political agreement on the pact was reached at the Dublin European Council in December 1996. During initial negotiations leading up to the establishment of the pact, ironically enough, Germany was the main driving force pushing for rigid rules and strict regulations. The European Council called on the Council of Ministers to draw up a resolution to the Stability and Growth Pact, which was adopted by the Amsterdam European Council on 17 June. The SGP strengthened the European Community Treaty provisions on fiscal discipline in the EMU foreseen by Articles 99 and 104 (with the amendments adopted in 1993 in Maastricht). The full provisions took effect when the euro was launched in the third stage of the Economic and Monetary Union on 1 January 1999 (Beetsma and Uhlig, 1997). The SGP was built on the convergence criteria, which member states have to fulfil in order to join the single Euro currency. In more detail, the Stability and Growth Pact is comprised of: • • •

the Resolution of the Amsterdam European Council on the Stability and Growth Pact of 17 June 1997; Regulation (EC) No. 1466/97 on the surveillance of budgetary positions and the coordination of economic policies (prevention aspect); Regulation (EC) No. 1467/97 on the implementation of the excessive deficit procedure whenever a Member State exceeds the reference value, i.e. a deficit of more than 3% of gross domestic product (GDP) (punitive aspect).

The SGP established a system for the coordination and surveillance of national budgetary policies. The countries adopting the single currency were required to submit an annual stability programme. All public deficits (budgetary, social and those deriving from local authority deficits) could not exceed the 3% of GDP

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threshold. There was supposed to be a relatively broad margin that would allow a member state to adjust its budgetary policy in accordance with its economic climate. The member states undertake to abide to the medium-term budgetary objective of positions close to balance or in surplus. In addition the member states: • •

•

• •

are invited to make public, on their own initiative, the Amsterdam European Council recommendations made to them; commit themselves to take the corrective budgetary action they deem necessary to meet the objectives of their stability or convergence programmes; will launch the corrective budgetary adjustments they deem necessary without delay on receiving information indicating the risk of an excessive deficit; will correct excessive deficits as quickly as possible after their emergence; will undertake not to invoke the exceptional nature of a deficit linked to an annual fall in the GDP of less than 2%, unless they are in severe recession (annual fall in real GDP of at least 0.75%).

The Council is: •

•

•

committed to rigorous and timely implementation of all elements of the Stability and Growth Pact in its competence. In addition, it is urged to regard the deadlines for the application of the excessive deficit procedure (EDP) as upper limits; invited to impose sanctions if a participating member state fails to take the necessary steps to bring the excessive deficit situation to an end and to apply rigorously the whole range of sanctions provided for; invited to state in writing the reasons which justify a decision not to be acted on.

6.7.1 Procedure of Sanctions According to the SGP (Excessive Deficit Procedure [EDP]) The Maastricht Treaty (Article 104) obliges member states to avoid excessive budgetary deficits. In particular member states shall comply with budgetary discipline by respecting two criteria: a deficit to GDP ratio and a debt to the GDP ratio not exceeding a reference value of 3% and 60% respectively, as defined in the Protocol of the Excessive Deficit Procedure (EDP). The EDP is responsible identifying and countering such excessive deficits, including the possibility of financial sanctions. To make this a more effective deterrent, the Stability and Growth Pact (SGP) clarified and speeded up the excessive deficit procedure, in particular with Council Regulation 1467/97.

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Until March 2005 (after that date decisive revisions to the SGP took place), the Commission was responsible for the surveillance procedure; it asked the Member States to provide it with the necessary information, analysed it and then submitted a report to the Economic and Financial Committee, which delivered its opinion. The Commission addressed a recommendation to the Ecofin Council, which then took a decision by a qualified majority vote. If a member state exceeded the 3% threshold, the Ecofin Council would address a recommendation to the Member State in breach of the EDP procedure. If this proved insufficient, sanctions adjusted to the State’s national economy would be imposed. A recession of more than 2% of GDP would be recognized as an exceptional case, and sanctions would not be imposed. The Ecofin Council would carry out an assessment for recessions of between 0.75% and 2%. In the case of recessions of less than 0.75% the member state at fault would not be able to invoke exceptional circumstances, and non-pecuniary sanctions would be imposed. The Ecofin Council may require the member state in question to publish additional information before issuing bonds and securities, ask the European Investment Bank to reconsider its lending policy towards the member state concerned, require the member state concerned to make a non-interest-bearing deposit until the excessive deficit has been corrected, and, finally, may impose fines of an appropriate size (Le Figaro, 14.12.1996). When the Council decides that an excessive deficit does exist, it makes recommendations to the member state concerned and establishes a deadline of four months for effective corrective action to be taken. In the absence of special circumstances, such action is that which ensures completion of the correction of the excessive deficit in the year following its identification. If, after a progressive notice procedure, the member state fails to comply with the Council’s decisions, the Council normally decides to impose sanctions, at the latest, ten months after reporting of the data indicating that an excessive deficit exists. Sanctions first take the form of a non-interest-bearing deposit in the Commission. The amount of this deposit comprises a fixed component equal to 0.2% of the GDP and a variable component linked to the size of the deficit. Each following year the Council may decide to increase the sanctions by requiring an additional deposit, though the annual amount of deposits may not exceed the upper limit of 0.5% of the GDP. A deposit is a rule converted into a fine if, in the view of the Council, the excessive deficit has not been corrected after two years. The council may decide to abrogate some or all of the sanctions, depending on the significance of the progress made by the participating Member State to correct the excessive deficit. The council will abrogate all outstanding sanctions if the decision on the existence of an excessive deficit is itself abrogated. However, any fines already imposed are not reimbursable. Interest on the deposits lodged with the Commission, and the yield from fines is distributed among those Member States without an excessive deficit, in proportion to their share in the total GDP of eligible member states.

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6.7.2 Criticisms of the SGP A critical aspect of the implementation of the Maastricht Treaty and the Stability and Growth Pact is the rather unbalanced emphasis on the budget deficit. The term Excessive Deficit Procedure in fact illustrates that the second reference value, keeping public debt below the limit of 60% of GDP, has been left completely in the shadow (Buti et al., 2003). One reason for having omitted the debt criteria may have been that certain Member States (notably Belgium and Italy in 1998/9 and Greece in 2000/1) at that time had public debt levels far above the 60% threshold (see Table 6.33). The Commission and the Council possibly considered that any discussion what-so-ever about the enormous divergence of the debt levels among member states and any attempts to find valid arguments to admit Belgium and Italy into the EMU, despite this debt level, would simply be too complicated for the political establishment to cope with. Consequently the focus was put on the deficit and it was argued, somewhat against the spirit of the Treaty provisions, that those countries were ‘on track’ to reduce the level of their debt.

Table 6.19  Debt over GDP (per cent) Countries

1992

1993

1994

1995

Eurozone EU(15) Belgium Denmark Germany Greece Spain France Ireland Italy Lux. Netherlands Austria Portugal Finland Sweden UK

60.4 66.3 69.0 73.7 75.2 74.9 74.1 72.8 70.4 69.4 69.2 70.4 – – 66.3 70.7 72.6 71.0 68.8 67.9 64.0 63.2 62.5 64.0 132.2 137.9 135.9 134.0 130.2 124.8 119.6 114.8 109.1 108.1 105.8 100.5 66.3 78.0 73.5 69.3 66.9 63.2 59.2 55.8 50.1 47.8 47.2 45.0 42.9 46.9 49.3 57.0 59.8 61.0 60.9 61.2 60.2 59.4 60.8 64.2 87.8 110.1 107.9 108.7 111.3 108.1 105.8 105.2 106.2 106.9 104.7 102.4 46.8 58.4 61.1 63.9 68.1 66.6 64.6 63.1 61.2 57.5 54.6 50.8 39.6 45.3 48.4 54.6 57.1 59.3 59.5 58.5 57.2 56.8 58.6 63.0 92.5 95.1 89.6 81.8 73.3 64.5 53.8 48.6 38.4 36.1 32.3 32.0 108.1 118.7 124.8 124.3 123.1 120.5 116.7 115.5 111.2 110.6 108.0 106.2 5.5 6.8 6.3 6.7 7.2 6.8 6.3 5.9 5.5 5.5 5.7 4.9 77.9 79.3 76.4 77.2 75.2 69.9 66.8 63.1 55.9 52.9 52.6 54.8 57.2 61.8 64.7 69.2 69.1 64.7 63.7 67.5 67.0 67.1 66.6 65.0 54.4 59.1 62.1 64.3 62.9 59.1 55.0 54.3 53.3 55.6 58.1 59.4 40.5 55.9 58.0 57.1 57.1 54.1 48.6 47.0 44.6 43.9 42.6 45.3 – – 73.9 73.7 73.5 70.6 68.1 62.7 52.8 54.4 52.6 51.8 39.2 45.4 48.5 51.8 52.2 50.8 47.6 45.0 42.1 38.9 38.5 39.8

Source: European Commission, 2004.

1996

1997

1998

1999

2000

2001

2002

2003

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Admittedly, while deficits are difficult to forecast and final data comes only with a considerable delay, forecasts for debt are even less reliable and subject to even more controversy. They are revised several times even after publication, to some extent due to revaluation of items of public debt which are not directly influenced by the budget balance (Tamborini and Targetti, 2005). More emphasis on the debt criteria would also make it possible to take a more explicit account of cross-country differences with respect to the potential rate of growth. Countries with a higher potential rate of growth (notably low-income countries with a potential for reducing a productivity gap vis-à-vis the highincome countries) could be allowed to run a higher budget deficit and yet respect the debt limit. For high-income countries with a lower potential rate of growth of productivity and low growth of the labor force (notably, Germany) respecting the debt limit would involve keeping the budget deficit well below the limit of 3% fixed in the Maastricht protocol (Eichengreen et al., 1998). The SGP treats all states the same without regard to their underlying fiscal institutions. The pact should recognize explicitly that the debt-to-GDP ratio is more important than the deficit-to-GDP ratio and that the appropriate budgetary position will vary from country to country. Highly indebted countries should be required to balance their budgets or even to run surpluses to reduce their debt ratios at a satisfactory pace. In determining the appropriate path for public debt, it is necessary for policy-makers to take account of the need for higher public investment in some countries (especially in many of the new member states), as well as future liabilities (in particular, as a result of aging populations). France and Germany may have breached the rules of the pact, but fiscal policy has not been conducted irresponsibly. The rise in the euro area’s budget deficit in the past years (2003–2006) has been largely due to the effects of the economic cycle. By allowing the automatic stabilizers to work to their fullest capacity, governments have helped cushion the downturn in economic activity rather than exacerbate it. Unlike the United States, France and Germany do not have ‘twin deficit’ (fiscal and current account) problems. If the deficit limit of 3% of the GDP had been strictly enforced, a much greater burden would have been placed on the European Central Bank to use monetary policy to support the economy. This would hardly have been sensible, given that interest rates are already at historic low levels. By requiring each country to achieve cyclically adjusted budgets ‘close to balance or in surplus’, the pact treats each country the same despite very different ratios of government debt to GDP across the euro area. The balanced budget rule implies a decline in debt ratios toward zero. This makes little economic sense and even less political sense. The rule takes no account of the fact that public investment can add to a country’s assets as well as its debts. The pact is asymmetric: it does not make proper allowance for cyclical effects. Once the deficit breaches 3% of the GDP, member states are expected to eliminate the ‘excessive deficit’ the year after it is identified, with little regard to the stage of the economic cycle. Conversely, the pact is not forceful enough in requiring fiscal consolidation during good times.

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It was recognized that the loss of the exchange rate instrument in the EMU would imply a greater role for automatic fiscal stabilizers at the national level to help economies adjust to asymmetric shocks, and would make it ‘necessary to ensure that national budgetary policies support stability oriented monetary policies’. This is the rationale behind the core commitment of the SGP, i.e. to set the ‘… medium-term objective of budgetary positions close to balance or in surplus …’ which ‘… will allow all member states to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP’ (Papademos, 2003). The SGP has been as widely criticized as it has been acclaimed. Commission President Romano Prodi has called it ‘stupid, because it is rigid’, while others believe that it is ‘one of the most remarkable pieces of policy coordination in world history’. Most probably, the truth lies somewhere in between. For if each country kept its budget in equilibrium, the aggregate budget position of the Economic and Monetary Union (more specifically Euroland) would also be balanced. Automatic stabilizers could contribute to smooth down the business cycle and the ECB has sufficient margins for the fine-tuning of monetary policy. Calculations by the European Commission have shown that under normal conditions the 3% margin of avoiding excessive deficits was sufficient to ensure the unconstrained functioning of automatic stabilizers, provided that the structural budget objective was adhered to. But in reality, Euroland’s structural budget has never been in balance. With the exception of 1999 and 2000 (when it was lower), it has remained at an average deficit around 2.3–2.8%. Countries such as Germany and France argued that the deterioration in the business climate after 2001 prevented them from fully implementing the consolidation of their budget positions and therefore the swings of automatic stabilizers should have allowed them to go above the required 3% limit. As a consequence, the aggregated fiscal stance should also adjust more flexibly to the business climate. This is a request for vertical budget flexibility. However, the argument is confused. The business cycle should only affect the cyclical component of deficits, not their structural part. Theoretically, it would be possible to reduce structural deficits and at the same time increase cyclical deficits, if demand is insufficient. However, in reality, both Germany and France implemented tax reforms, which increased the structural deficits. Germany’s structural deficit was below 1.9% of GDP between 1998 and 2000, but stayed above 3.2% in every year since 2001. In France it rose from below 2.3 % to more than 3.6%. In Germany, the deficits reflected a desperate attempt to redistribute the burden of transfers related to German unification, despite this being 15 years previous. In France, it was a direct consequence of the policy shift after the 2002 elections. Either way, the problem was less the business climate after a series of exogenous shocks (end of the Clinton-boom, 9/11 terrorism attack, Iraq war), but more the management of domestic policy objectives. The economic issue was exactly what the pact was intended to deal with – the difficulty of implementation was political. On the other hand, it has been argued that even if an overall balanced

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budget position for Euroland might be desirable, ‘one rule fits all’, it would be too restrictive. Horizontal flexibility is required. Why should some countries not be allowed to spread public investment over a period of several years? Especially if a country’s debt/GDP ratio is low, higher deficits could be affordable. Yet, in the context of a balanced or at least stable budget for the aggregate fiscal stance this argument implies that some countries should be saving for others to be able to borrow. Otherwise the deficits by one country would increase interest rates for all. This idea of horizontal flexibility may be economically reasonable, but it crudely lacks political legitimacy. Who should decide who saves and how much and who is allowed to borrow? 6.7.3 Early Warnings for Countries Based on SGP Almost all countries failed to follow the 3% rule: Portugal, Germany, France, Greece, Italy, the Netherlands, and the UK. Accordingly, since 2002, half of the member states have been subject to an ‘early warning’ (Ireland, Italy) or called on to take necessary steps to alleviate excessive government deficits (Portugal, the Netherlands, Greece, Italy, and six of the ten new Member States), some of which have now been repealed or suspended, in light of efforts made by the countries in question to control budgetary deficits (Table 6.20). Table 6.20  Surplus/deficit over GDP (per cent) Countries

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Eurozone – – EU(15) – – Belgium -8.0 -7.3 Denmark -2.2 -2.9 Germany -2.5 -3.1 Greece -11.1 -13.4 Spain – – France -4.2 -6.0 Ireland -3.0 -2.7 Italy -10.7 -10.3 Lux. 0.2 1.5 Netherlands -4.2 -2.8 Austria -2.0 -4.2 Portugal -6.0 -8.9 Finland -5.6 -7.3 Sweden – -11.6 UK -6.5 -8.0

– – -5.0 -2.4 -2.4 -9.4 – -5.5 -2.0 -9.3 2.7 -3.5 -5.0 -6.6 -5.7 -9.3 -6.7

– – -4.3 -2.3 -3.3 -10.2 – -5.5 -2.2 -7.6 2.1 -4.2 -5.2 -4.5 -3.7 -7.0 -5.7

Source: European Commission, 2004.

-4.3 -4.2 -3.8 -1.0 -3.4 -7.4 -4.9 -4.1 -0.2 -7.1 1.9 -1.8 -3.8 -4.0 -3.2 -2.7 -4.3

-2.6 -2.4 -2.0 0.3 -2.7 -4.0 -3.2 -3.0 1.2 -2.7 3.2 -1.1 -1.9 -3.0 -1.5 -0.9 -2.0

-2.2 -1.6 -0.7 1.1 -2.2 -2.5 -2.7 -2.7 2.4 -2.8 3.1 -0.8 -2.4 -2.6 1.5 1.8 0.2

-1.3 -0.7 -0.4 3.2 -1.5 -1.8 -1.2 -1.8 2.4 -1.7 3.5 0.7 -2.3 -2.8 2.2 2.5 1.0

-.01 -1.0 -0.2 2.6 1.3 -2.1 -0.9 -1.4 4.4 -0.6 6.3 2.2 -1.5 -2.8 7.1 5.1 3.8

-1.6 -1.0 -0.5 3.1 -2.8 -1.4 -0.4 -1.5 1.1 -2.6 6.3 -0.0 0.2 -4.4 5.2 2.8 0.7

-2.3 -2.0 -0.1 1.7 -3.5 -1.4 -0.0 -3.2 -0.2 -2.3 2.7 -1.9 -0.2 -2.7 4.3 -0.0 -1.6

-2.7 -2.6 -0.2 1.5 -3.9 -1.7 0.3 -4.1 0.2 -2.4 -0.1 -3.0 -1.1 -2.8 2.3 0.7 -3.2

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Following the audit carried out by the new Portuguese Government in 2002, the budgetary deficit for 2001 was revised upwards to 4.1% of the GDP, making Portugal the first member state to exceed the reference value. After assisting the situation, in October 2002, the Commission initiated the excessive deficit procedure in accordance with the Treaty. The public deficit in Portugal fell back in 2002 and 2003 to below 3% of the GDP. The Commission recommended that the Council terminate the excessive deficit procedure against Portugal. On 22 June 2005 the Commission adopted a report on the budgetary situation in Portugal and assessed the updated stability programme. In its report, the Commission observed that Portugal’s deficit was well above 3% of the GDP. In 2004, Portugal announced a deficit of 2.9% of the GDP. For 2005, it was expected to record a government deficit of 6.2% of GDP. While acknowledging that Portugal had launched a programme of structural reforms, the Commission considered it was difficult to see what impact this would have on Portugal’s budgetary situation. In 2003, Germany and France were subject to procedures for excessive government deficit (due to 2002–2003 excessive deficits for both countries – see the above Table 6.20). For example Germany recorded a deficit of at least 3.7% for 2004 and may well be in breach of the Stability and Growth Pact in the years 2005–2007. If so, it would make it four years running. Germany is currently in an excessive deficit procedure. However, these procedures have been suspended. In November 2003, the Council refused to follow the recommendations issued by the Commission that Germany and France return to deficit levels below the 3% reference value. The Commission filed a petition against this decision with the Court of Justice, which recognized in July 2003 that the Council was not required to follow the Commission’s recommendations. Since that time, the Commission has not started any new procedures. In December 2004, it declared that ‘no further steps are necessary at this point’. In addition to the institutional dispute it caused, this matter stressed the need to modernize the Stability and Growth Pact, in particular with a view to looking into the economic situation more seriously. The Commission recommended that the Council address a warning to Italy in view of the risk that its budget deficit would exceed the 3% threshold in 2004. At a meeting of finance ministers on 5 July 2004, the Council decided not to issue an early warning because of the additional budgetary commitments presented by Italy. In June 2005 the Commission adopted a report on Italian public finances which found that the exceeding of the 3% threshold could be considered temporary. On the strength of this report, the Commission recommended that an excessive deficit procedure be initiated against Italy. Acting on the recommendation, the Council officially launched the procedure on 28 July 2005. In June 2004, the Commission initiated the excessive deficit procedure in respect of the Netherlands. Following the reduction of the Dutch deficit from 3.2% in 2003 to less than 2.3% in 2004, the Commission recommended on 18 May 2005 that the procedure be suspended in view of the fact that the Netherlands was firmly back on the path of healthy fiscal consolidation.

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As for Greece, the Council decided to initiate the excessive deficit procedure at a meeting of finance ministers on 5 July 2004. It called on the Greek Government to put an end to its excessive deficit situation by 2005, at the latest. In April 2005, the Commission assessed the Greek stability programme and came to the conclusion that, despite the Greek Government’s efforts, the outlook for 2005 and beyond was uncertain. It called on Greece to implement the necessary permanent measures to correct the excessive deficit. The Council’s recommendation provides the UK (although not being a member of the EMU) with six months to present corrective action, and requires the excessive deficit to be brought to an end by the 2006–2007 financial year at the latest. It calls for an improvement of 0.5% of GDP in the structural balance between the 2005–2006 and 2006–2007 financial years. In 2003–2004 and in 2004–2005, the UK deficit was 3.2% of GDP. The Commission’s latest forecasts estimate that it will rise above the 3% ceiling in 2006–2007. In reality, member states can only recommend that the UK reduces its deficit below the 3% ceiling because, not being a member of the eurozone, the country is not subject to fines. 6.7.4 Solutions for the SGP: The Three Proposals As a result of the persistent pressure exerted by weak growth in 2003 and 2004 on member states’ government finance, the Commission started a debate in the summer of 2004, with a view to revising the Stability and Growth Pact more profoundly. After more than six months of negotiations between those in favour of minimal reform and parties such as France and Germany, which support a pact that is more concerned with growth and employment, the Spring European Council (22–23 March 2005) adopted a reformed Stability and Growth Pact that, because of its increased flexibility, should help to stimulate the economic growth of the Union. While maintaining stability-related acquis, the reform should allow for economic cycles, future reforms (investments, structural reforms) and the specificities of each Member State to be better taken into consideration. Accordingly, the preventive component of the pact will now take the specificities of each Member State into better consideration in defining the return to budget balance, while reinforcing budgetary discipline during favourable periods. As of spring of 2003, on the Commission’s initiative, the European Council adopted a more flexible interpretation of the SGP, emphasizing the need to take into consideration structural – and not merely nominal – deficit. Through a better understanding of economic fluctuations, this approach should, to a certain extent, make counter-cyclical policies possible. Thus, in September 2004, the Commission took action on the debate surrounding the Stability and Growth Pact by issuing a communication among countries on strengthening economic governance and clarifying the implementation of the Stability and Growth Pact. It proposed a series of improvements. The Commission focused particularly on the trend in economic factors in the Member States and the long-term sustainability of public finances.

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In March 2005, the EU Council relaxed the rules to respond to these criticisms and to make the pact more enforceable. To external observers of the pact in countries where there is a movement to join the eurozone, such as in the UK, the failure of the pact to enforce its provisions on France and Germany was believed to have provided ammunition against joining the eurozone. This is cited as another major example of Franco-German ‘bullying off’ other member states when it suits them. More eurosceptic commentators assert that the pact promotes neither stability nor growth, and remark (correctly) that it has been applied inconsistently, after the Council of Ministers failed to apply sanctions against France and Germany. Three different proposals regarding the future of the SGP were made. The first referred to ‘refrigeration’, ‘hospitalisation’ and ‘death’ of the SGP. These were the adjectives the press used to describe the Stability and Growth Pact on the eve of the historical ECOFIN decision not to impose sanctions on the delinquent French and German fiscal stances. For example, when the Ecofin Council in November 2003 voted against proceeding with the Excessive Deficit Procedure (EDP) regarding Germany and France, many observers concluded that the SGP was dead or at least ‘suspended’. No doubt the decision violated the spirit of the SGP. The fate of the SGP was settled in the early hours of 25 November 2003 in what was a true institutional crisis between the European Commission and the ECB on the one side, demanding for the rules to be enforced, and the intergovernmentalist ensemble of the eurozone finance ministers rejecting the application of sanctions to the leading EU member states on the other side. The positions were clear: Romano Prodi, European Commission president and Jean-Claude Trichet, European Central Bank president, led demands for the rules to be enforced on France and Germany. Smaller countries, led by Gerrit Zalm, Dutch finance minister, claimed Germany was exporting its excessive budget deficit to other countries through higher interest rates. Hans Eichel, the German finance minister refused to accept the Commission recommendation, backed by the threat of sanctions, to make a further €6bn ($7bn, £4.2bn) of budget cuts in 2004. France, overshooting the 3% deficit of the GDP rule for the second time in a row, supported Germany as did Italy, holder of the rotating EU presidency. The Italian EU presidency pushed through a political declaration asking France and Germany to bring their deficits within the 3% limit by 2005, but would lift the threat of fines if they failed. Eventually, the Italian compromise proposal, put forward by Giulio Tremonti, chair of the meeting, was approved by the ECOFIN. Only Austria, the Netherlands, Finland, and Spain voted against this political declaration to suspend the operations of the Stability and Growth Pact for Germany and France. Spain was expected to back France and Germany, and linked its change of position in the ECOFIN

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meeting to the opposition to the new voting rules enshrined in the new constitution increasing the weight of big countries, especially Germany and France. Gerrit Zalm, the Dutch finance minister, who, along with his Austrian, Finnish and Spanish counterparts, voted for the commission proposals and protested that some small countries had been intimidated by France and Germany. He predicted that all 12 members of the eurozone would now pay the price of French and German fiscal incontinence. Actually, there was no qualified majority at the Ecofin Council meeting of 25 November 2003 on the Commission recommendations under Articles 104(8) and 104(9) of the Treaty in respect of either France or Germany. Even so, most economists consider that the euro area still needs a way of persuading countries to control their budget deficits and debts. The problem can only get more acute as most EU countries face mounting fiscal burdens, as their populations’ age and both pension and health-care obligations increase. The fear is that without some common rules countries that make painful reforms may be faced with higher interest rates caused by others’ irresponsibility. The second solution, which was the implementation and enforcement of SGP, failed: actually the SGP failed when applied for the case of Portugal. Many economists have long argued that it would make no sense to force countries such as Germany and France, already struggling to come out of recession, to cut public spending at this point in the economic cycle. The consequences of such a policy were already on display in Portugal, which breached the 3% limit in 2001. Under heavy pressure from the EU, the Portuguese government slashed public spending and came up with a series of accounting tricks to bring their deficit back under the 3% limit in 2002. But since then the economy has fallen into deep recession, tax revenues have fallen and the budget deficit has, once again, soared out of control. However, few observers doubt that if Germany had been within the rules and a smaller country had violated them, it would have been the Germans leading the chorus demanding the rules be enforced (‘The death of the stability pact’, 27 November 2003, The Economist, print edition). The SGP came under attack when it became clear that if the excessive deficit procedure (EDP) were to be applied it would require that governments, of France and Germany for example, pursue ‘counter-cyclical’ policies; they would have to tax more and spend less in an economic downturn. An economic adviser would recommend that governments do exactly the opposite. This phenomenon then drew criticism towards the SGP. The clashing point came when France and Germany managed to hold the Pact in abeyance when the Ecofin Council of 25 November 2003 decided not to move to the next stage of the excessive deficit procedure (there was no ‘qualified majority’ to carry through that decision). At this point most newspapers declared the SGP dead.   ‘EUROPE: France and Germany may escape EU fines’, George Parker in Brussels and Bertrand Benoit in Berlin, Financial Times, 25 November 2003; ‘EUROPE’S STABILITY PACT: EU may yet feel the bite of the paper tiger’, Ed Crooks, Economics Editor of London Financial Times, 26 November 2003.

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The third proposal was the SGP be revised or reformed. Noises are being made about making the SGP more productive and respectful, possibly by examining the golden rule of finance or the question of whether deficits are being used to pay for investment rather than consumptive expenditures. All these suggestions of reform have not been settled, but various options are being considered. ‘The Golden Rule’ of public finances is a solution that should be seriously considered but the parameters by which it would be made effective would have to be carefully agreed. Literally, the golden rule of public finances implies that the government can only borrow to finance investments and not the current expenditures. In other words, by allowing a State to borrow in order to fund public capital formation, we have on one hand the public capital formation (the so called ‘good deficit’) and on the other hand investments to finance public consumption (‘bad deficit’). The opponents of ‘the Golden Rule’, however criticize it because it might foster over investment, in the sense that investment decisions are usually taken by politicians who are only concerned with the electoral cycle and often do not take into account the productivity effects of the investment, but rather its short term impact on voters. Accordingly, politicians are tempted to consider all investment as public capital formation investment and to have a rather expansionist use of fiscal policy, which ultimately could be damaging in the case of the EMU, as it would create inflation and a rise of interest rates. This, in turn, would result in lower investment, employment and consequently lower economic growth. The main advantage of ‘the Golden Rule’ is that it spreads the burden of capital projects over the different generations of taxpayers benefiting from them and avoids the efficiency loss caused by distortionary taxation if the tax rate fluctuates over time. The lack of this possibility may negatively affect capital spending. The problem is particularly relevant with the initial transition period; in which current generations have to tax-finance new projects while also pay interest on past debts. The Commission has already taken an important step by taking into account the structural deficit rather than the nominal one which takes into account the effects of the business cycle. The reform of the SGP should also include other variables, such as a better definition of public spending, namely a distinction between investment expenditure, current expenditure and revenues, and national debt levels. The current SGP does not take into account the causes that lead to a given deficit. A country that has a deficit caused by higher investment expenditure, for example due to increased investment in infrastructures and/or R&D, will under the current framework, be regarded in the same way as a country that breached the threshold due to a rise in current expenditure and/or due to the use of pro-cyclical policies during an economic boom without the respective cuts in expenditure. Therefore, it is essential to distinguish ‘productive’ from ‘non productive’ spending. The sanctions mechanism has lost its credibility and needs to be strengthened. This strengthening can only be obtained through the reinforcement of the decision

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making procedure, which inevitably implies more powers for the European Commission rather than via the reduction of sanctions. However, the best solution for improving the sanctions mechanism would be the improvement in the coordination of economic policies which would necessarily imply that Member States would be less likely to be subject to any sanctions. Nevertheless, the problem with the current design of the SGP is that sanctions arrive late in the process and that the Council may not be able to take the political responsibility to impose fines on one of their own peers. It would therefore be desirable to increase the political cost of not complying with the SGP, although it is far from evident how this could be done in practice. An even better option might be to introduce a higher degree of automatic application of sanctions in the excessive deficit procedure (Hagen et al., 2001). One other option could, for example, be to request a deposit of 0.2% of the GDP at the moment when the Council decides that an excessive deficit exists and to release this deposit when the appropriate corrective measures have been taken. This would allow the Council to avoid making difficult decisions and to make more positive ones when governments have complied. Additionally, it would be desirable to strengthen the early warning mechanism. The Commission and the Council could start putting pressure on the countries sooner. This would at least impose a political cost on the governments so early that they can take a gradual approach to reducing the deficit. If the warning is made too late, the government is left with drastic and unpopular options to regain sustainability and the costs of complying become much higher than the costs of being criticized by the Commission and the Council. Again this would require more resources for long-term budgetary analysis by the Directorate-General for Economic and Financial Affairs or by an external specialized body (Gros and Hozba, 2001). To sum up, the euro areas’ Stability and Growth Pact has been under growing pressure from both European politicians and opinion-makers who maintain that the limitations imposed on budget deficits make it impossible for governments to pursue so called ‘expansionist’ fiscal policies that would allegedly be appropriate for the current economic downturn (Beetsma, 1999). As the pressure increases and several euro area governments (including the influential French and German executives) lobby more or less explicitly for a ‘relaxation’ of the commitments to limit and progressively reduce budget deficits, it is now easier than ever to understand the rationale behind the constraints currently imposed by the Pact (Butti and Franco, 2005). To put it in a nutshell, the debate concerning the Stability and Growth Pact gathered momentum following a ruling on 13 July 2004 by the Court of Justice of the European Communities concerning the excessive deficit procedures initiated against Germany and France. In November 2003, the Commission had sent to the Council recommendations for speeding up the excessive deficit procedure in both cases. However, the Council did not act on those recommendations and suspended the excessive deficit procedures. The pact has proved to be inapplicable against

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big countries such as France and Germany, which, ironically, were the biggest promoters of it when it was created. Indeed, these countries have run ‘excessive’ deficits under the pact definition for some years now, yet the EU Council has not applied sanctions against them. 6.7.5 SGP Finally Revised: The Third Proposal was Promoted On 3 September 2004, the European Commission adopted this communication among countries in order to strengthen economic governance and clarify the implementation of the Stability and Growth Pact. Sound management of public finances is essential for sustainable economic growth. The Treaty provisions which lay down the reference values for the government deficit and public debt (3% and 60% of GDP respectively) remain the centrepiece of the system in providing the budgetary framework with the necessary underpinning. Excessive deficits should be avoided and quickly corrected. In an enlarged European Union of 25 Member States (27 members in 1.1.2007), a common framework may make the existing provisions more effective by taking into account the differences between the economic situations of the Member States. The Commission has put forward three suggestions for revising the Stability and Growth Pact: clarifying and rendering operational the debt criterion, identifying country-specific medium-term budgetary objectives, and defining the adjustment path in the excessive deficit procedure, taking into account issues related to the sustainability of public finances. As regards the debt criterion, the revised Stability and Growth Pact could clarify the basis for assessing the ‘satisfactory pace’ of debt reduction provided for in Article 104(2)(b) of the Treaty. In defining this ‘satisfactory pace’, the need to bring debt levels back down to prudent levels before demographic ageing has an impact on economic and social developments in member states should be taken into account. Member states’ initial debt levels and their potential growth levels should also be considered. Annual assessments could be made relative to this reference pace of reduction, taking into account country-specific growth conditions. For instance, if a given member states’ growth is lower than its potential growth, the pact would allow for a slower rate of debt reduction. Conversely, if that member states’ growth is higher than forecast, then the pact would not allow for a slower rate of debt reduction. Medium-term objectives are intended, on the one hand, to provide for sufficient room for manoeuvre to ensure that the government deficit does not exceed 3% of GDP during an economic slowdown without recourse to pro-cyclical fiscal policy. On the other hand, medium-term objectives allow member states to reduce debt and to prepare for the budgetary impact of ageing populations. The current Stability and Growth Pact does not give an operational definition of the medium-term budgetary objective. Member states are currently supposed to present an annually balanced budget position throughout the economic cycle. Uniform objectives in an EU of 25 member states do not appear appropriate from

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an economic point of view. The Commission states that a medium-term objective can be based on current debt levels, taking into account their development over time. Furthermore, factors such as potential economic growth, inflation, the existing implicit liabilities related to ageing populations, the impact of structural reforms or the need for additional net investment should also be considered. The reference value for government deficit is 3% of Gross Domestic Product (GDP). A deficit exceeding this value is considered exceptional (Amending Act – Regulation (EC) No. 1056/2005 on 27.07.2005) when: •

•

It results from an unusual event outside the control of the Member State concerned and has a major impact on the financial position of the general government. It results from a severe economic downturn (if the excess over 3% of the GDP is the result of negative annual GDP growth or a cumulative fall in production over a prolonged period of very low annual growth).

The scenario of slow but positive economic growth is not considered in the current regulatory framework. The Commission envisages a rethinking of the adjustment path once a country breaches the 3% deficit threshold and/or a redefinition of the ‘exceptional circumstances clause’. A period of zero growth, bringing about deficits greater than 3%, would not at present trigger this clause so that the member state would avoid to be placed in an excessive deficit situation. Regulation (EC) No. 1467/97 sets out the exceptions to this. No excessive deficit procedure (EDP) will be launched against a member state experiencing negative growth or a prolonged period of low growth. Previously, the exception was for countries in a recession defined as 2% negative growth, something which has been virtually unheard of among EU member states. Member states recording a ‘temporary’ deficit or one close to the 3% reference value will be able to refer to a series of ‘relevant factors’ to avoid an excessive deficit procedure. Factors will include potential growth, the economic cycle, structural reforms (pensions, social security), policies supporting R&D plus medium-term budgetary efforts (consolidating during good economic times, debt levels, public investment). Countries will have two years (previously one) to correct an excessive deficit. This may be extended in cases of ‘unexpected and adverse economic events with major unfavourable budgetary effects occurring during the procedure’. To benefit from these, countries must provide evidence that they have adopted the correction measures recommended to them. Member states have committed to using unexpected fiscal receipts during periods of strong growth to reduce their deficits and debt. Medium-term objectives will be tailored to individual member states based on their current debt ratio and potential growth. This will vary from -1% of GDP for low debt/high potential growth countries to balance or surplus for high debt/low growth countries. The Council wants to strengthen Eurostat’s resources, powers, independence and accountability. As a reaction to the Greek

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under-reporting of statistics, it suggests that imposing sanctions on a member state ‘should be considered’ when there is infringement of the obligations to duly report government data. Finally, the excess over the reference value is considered temporary if the Commission’s budget forecasts state that the deficit will fall below the reference value when the unusual circumstance or serious downturn is terminated. 6.8 Prospects of Countries in Order to become New EMU Members 6.8.1 The Special Cases of Sweden, the United Kingdom and Denmark As for Sweden, it too is technically obliged to introduce the euro in its economy. However, it has remained out of the ERM II and has made no efforts to fulfil the criteria for a stable exchange rate. Moreover, in 1997 it made the decision not to introduce the euro currency. In the first referendum for the entrance of Sweden into the EU held on 13 November 1994, 53% of the voters were in favour of joining the EU and of the future adoption of euro. However, the consultative national referendum held on 14 September 2003, resulted in a rejection of the proposal to adopt the euro, with 56.1% of the population voting against the euro and 41.8% voting in favour, on a turnout of 81.2%. Consequently, for the time being, the decision to adopt the euro has been postponed as all political parties have pledged to uphold the latest results. Prime Minister Göran Persson said in September 2004 that Swedish membership will definitely not take place before the 2010 General Election. The decision of Sweden not to adopt the euro in the near future has generally been well accepted within the European Union. Sweden joined the EU in 1995. In 1995, however, the euro did not exist, neither physically (2002) nor legally (1999), and therefore it is worthy to note that the suggestion that the Swedes voted for euro adoption in their first referendum on EU entry in 1994 cannot be taken seriously. The United Kingdom and Denmark have neither joined the EMU, nor have they adopted the euro. The British government under Prime Minister Tony Blair committed itself to a triple-approval procedure before adopting the euro, which involves approval by the Cabinet, Parliament, and the British electorate in a referendum. The then Chancellor Brown stated in June 2003 that the best exchange rate acceptable for the UK to adopt the single currency would be around 73 pence per euro. This rate, however, has not been formalized as an official condition of entry. Opinion polls in the UK show a consistent majority of the British people to be against adopting the euro. Some argue that they perceive a loss of their political and economic sovereignty. Others are unconvinced of the case for a change from their familiar currency. However, a graver reason for hostility to the euro is the euro’s perceived failure in Euroland economies; the UK has enjoyed superior economic performance over major Euroland economies throughout the

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euro era. Furthermore, the large future unfunded pension liabilities of the greying populations of Europe (unlike in the UK where pension liabilities are generally well funded, and the UK’s population is not likely decline) are often cited as a major economic argument against adoption of the euro. A referendum in the near future has been ruled out. If the United Kingdom were to adopt the euro, it is unclear what would happen to its overseas territories which use the British Pound Sterling. It is conceivable that the euro would only become the official currency in those regions which technically use the currency identified by the code GBP (i.e., Great Britain and Northern Ireland, South Georgia and the South Sandwich Islands), while the regions using their own currencies with a fixed exchange rate of 1:1 to the Pound Sterling might keep their currencies with a fixed rate to the euro. These regions would be the Falkland Islands (Falkland Islands Pound – FKP), the Isle of Man (Isle of Man Pound), Jersey (Jersey Pound), Guernsey (Guernsey Pound – GGP), and Saint Helena (Saint Helenian Pound – SHP). A referendum on adopting the euro was held on 28 September 2000 in Denmark, resulting in a 53.2% vote against adoption. If Denmark ever adopts the euro, Greenland, which is a part of Denmark but not of the EU, would need to hold a separate referendum to decide whether it wants to switch to the euro or not. The outcome of this possibility is uncertain, as current trends seem to favour its independence from Denmark. 6.8.2 Prospects of the EU Member Countries for their Entrance into the EMU The Economic and Monetary Union (EMU) is a single currency area within the European Union single market where people, goods, services and capital move without restrictions. The EMU is the natural complement of the single market. This market will work more efficiently and deliver its benefits more fully with the removal of high transaction costs brought about by currency conversions and the uncertainties linked to the exchange rate instability. The necessity of the EMU was apparent since it creates the framework for economic growth and stability. The rules, institutions and objectives of the EMU were set down in the Maastricht Treaty. The creation of the EMU had been a project of the European Union since the late 1960s. In 1969, the European summit at Hague made the EMU an official objective. The realization of the need for European monetary integration re-emerged in June 1988. The European Council in Hannover, Germany, headed by Jacques Delors, proposed concrete stages leading to the creation of the Economic and Monetary Union (EMU). In order for the EMU to operate properly, the European Central Bank and the European System of Central Banks (ESCB) were established in June 1998, with the primary objective to create the framework leading to economic growth and price stability. The creation of a single monetary policy was one of the European Council’s primary tasks.

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Since 1 January 1999, the European Central Bank (ECB) has been responsible for conducting the monetary policy for the euro area; the world’s largest economy after that of the United States. Greece joined as the 12th member two years later. The creation of the euro area and the new supranational institution, the ECB, was a milestone in the long and complex process of European integration. The legal basis for the single monetary policy is the Treaty that created the European Community and on 1 June 1998, both the Statute of the European System of Central Banks (ESCB) and the Statute of the European Central Bank (ECB). The ECB was established as the core of the Eurosystem and the ESCB. The ECB together with the national central banks perform the tasks they have been entrusted with. The ECB is a legal entity under public international law. The ESCB comprises the ECB and the national central banks (NCBs) of all EU Member States (Article 107.1 of the Treaty) whether they have adopted the euro or not. The Eurosystem comprises the ECB and the NCBs of those countries that have adopted the euro. The Eurosystem and the ESCB will co-exist as long as there are EU Member States outside the euro area (the euro area consists of the EU countries that have adopted the euro). As for the ERM II, it appeared to be the most suitable constituent of the EMU. In particular, after the establishment of ERM II all currencies were back within their previous narrow margins, and as originally planned by the EMU the currencies of 11 EU members were locked on 1 January 1999. Furthermore, Greece adopted the euro after two years, making the dream of a monetary union a reality (Williamson, 2000). Although membership in the ERM II is voluntary, Member States with derogation which ultimately wish to join the euro area will be expected to participate in the ERM II. An additional source of stability is the full participation of all Member States in the close coordination of the economic policies of the Economy and Finance Ministers Council. The main differences between the EMS and the EMU are: (a) that the latter is built on a single currency created by the Treaty, replacing the currencies of all participating states; (b) a European Central Bank is responsible for the single monetary policy; and (c) there is a much closer convergence of economic and fiscal policies. In the EMS, Member States retained their currencies and control of national monetary policies. Nevertheless, at the time of its creation, the EMS represented an unprecedented transfer of monetary autonomy because parities between exchange rates could be changed only by ‘mutual agreement’. Following the introduction of the euro on 1 January 1999 in 11 Member States and on 1 January 2001 in Greece, and the enlargement of the European Union (EU) with ten new Member States on 1 May 2004, 13 Member States are not yet full members in Economic and Monetary Union (EMU). Two of these Member States, Denmark and the United Kingdom, enjoy a special status. In accordance with the terms of the relevant protocols, annexed to the Treaty, these countries gave notification that they would not participate in Stage Three of EMU on 1 January 1999. As a consequence, convergence reports for them only have to be provided

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if they request so. Since no such request has been made, the 2004 Convergence Report excludes these two countries. According to the assessment of Monetary Affairs Commissioner, Joaquín Almunia, the new member states are a ‘very heterogeneous group’, and yet ‘some common features and policy challenges can be identified’: •

•

•

•

•

While income levels vary widely among the new member states, their aggregate per-capita GDP is still only about half the euro area average. The gap is gradually closing as actual and potential growth rates are generally higher than those in the euro area. However, fostering real convergence will remain a key policy theme for many years to come. Most of the new member states have also undergone a momentous transition from planned to market economies over the last 15 years. While the transition process has found its ‘official’ completion with EU accession, some post-transition features still shape the policy environment in some countries. These include the need to complete the price liberalization process and the need to upgrade an outdated capital stock. Structural change in the financial sector, for example, is still rapid and ongoing and needs to be managed effectively. As they seek to increase their scarce productive capital through high public and private investment, most new member states also run sizeable current account deficits as the process is not fully matched by domestic savings. Current account sustainability is not a major concern, given the generally high degree of macroeconomic stability, the significant share of FDI in current account financing and the ongoing integration into the EU economy. Still, vigilance is needed to ensure that these imbalances do not become unsustainable or make the economies vulnerable to shocks. A major achievement of the new member states has been the successful pursuit of disinflation. Monetary policy frameworks have been strengthened, and central banks are overall credible in their mandates to pursue price stability.

In the following Table (6.21) data for 13 countries is shown. As previously mentioned, Slovenia entered into the EMU at 1.1.2007, and Malta and Cyprus entered at 1.1.2008. Also, Slovakia will join the eurozone at 1.1.2009. The remaining 9 countries are still applicants. Focusing on the performance of individual countries over the reference period in 2008, only three of the 9 applicant States (the Czech Republic, 3%, Poland, 2.6%, and Sweden, 1.7%) examined had average HICP inflation rates below the reference value. HICP inflation in Romania (4.9%) and Lithuania (5.8%) was just above and equal to the reference value, respectively, while it was considerably above the reference value in Bulgaria (7.6%), Latvia (10.1%), Hungary (7.9%) and Estonia (6.7%) (see Table 6.21).

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Table 6.21  Progress towards Maastricht – an overview of economic indicators of convergence (excluding the exchange rate criterion)* HICP Long-term inflation interest rate

General government surplus (+) or deficit (-)

General government gross debt

Cyprus

2004 2005 2006 2007

1.9 2.0 2.2 2.0

5.8 5.2 4.1 4.2

-4.1 -2.3 -1.5 -1.4

70.3 69.2 65.3 61.5

Czech Republic

2004 2005 2006 2007

2.6 1.6 2.1 3.0

4.8 3.5 3.8 4.3

-2.9 -3.6 -2.7 -1.6

30.7 30.4 29.4 28.7

Estonia

2005 2006 2007

4.1 4.4 6.7

– – –

2.3 3.4 2.8

4.5 4.2 3.4

Latvia

2004 2005 2006 2007

6.2 6.9 6.6 10.1

4.9 3.9 4.1 5.3

-0.9 0.1 -0.2 0.0

14.5 12.1 10.7 9.7

Hungary

2004 2005 2006 2007

6.8 3.5 4.0 7.9

8.2 6.6 7.1 6.7

-6.5 -7.8 -9.2 -5.5

59.4 61.7 65.6 66.0

Malta

2004 2005 2006 2007

2.7 2.5 2.6 2.0

4.7 4.6 4.3 4.3

-5.0 -3.2 -2.6 -2.1

74.9 74.2 66.5 65.9

Poland

2004 2005 2006 2007

3.6 2.2 1.3 2.6

6.9 5.2 5.2 5.5

-3.9 -2.5 -3.8 -2.0

41.8 42.0 47.6 45.2

Slovakia

2004 2005 2006 2007

7.5 2.8 4.3 1.9

5.0 3.5 4.4 4.5

-3.0 -3.1 -3.6 -2.2

41.6 34.5 30.4 29.4

Bulgaria

2006 2007

7.4 7.6

4.2 4.5

3.0 3.4

22.7 18.2

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Table 6.21  continued HICP Long-term inflation interest rate

General government surplus (+) or deficit (-)

General government gross debt

Romania

2006 2007

6.6 4.9

7.2 7.1

-2.2 -2.5

12.4 13.0

Slovenia

2005 2006

2.5 2.4

3.8 3.8

-1.7 -1.7

29.0 29.6

Sweden

2004 2005 2006 2007

1.0 0.8 1.5 1.7

4.4 3.4 3.7 4.2

1.8 3.0 2.3 3.5

50.5 50.4 45.9 40.6

Lithuania

2006 2007

3.8 5.8

4.1 4.5

-0.5 -1.2

18.2 17.3

Reference Nov 2005–Oct 2006 (year 2005) value

2.8%

6.2%

-3%

60%

Reference Apr 2006–Mar value 2007 (year 2006)

3%

6.4%

-3%

60%

Reference Apr 2007–Mar value 2008 (year 2007)

3.2%

6.5%

-3%

60%

Note: * In 2008, Bulgaria, Czech Republic, Hungary, Poland, Romania, and Sweden do not participate in the ERM II. On the other hand, in 2008, Slovakia, Lithuania, Latvia, Estonia participate in the ERM II. Source: European Central Bank Convergence Reports (2005–2008) .

On 2 May 2005, Cyprus, Latvia and Malta were included in the Exchange Rate Mechanism II (ERM II). They followed Estonia, Lithuania and Slovenia, which had become members of the ERM II on 28 June 2004, as well as Denmark, a longstanding member (it has entered in January 1999 and had an agreed fluctuation band of +/- 2.25%, instead of +- 15% which is valid for the other members). On 28 November 2005, Slovakia entered the ERM II. Regarding, Cyprus, the high deficit figure and public debt exceeding the Stability and Growth Pact criteria forced Cyprus to postpone its application for ERM II membership in the summer of 2004. Cyprus’s average inflation rate in 2004 was 1.9%. The general government deficit was 2.3% of GDP in 2005 and 4.1% in 2004. Government debt figures: 69.2% of GDP (2005), and 70.3% (2004). The introduction of the euro for the case of Cyprus took place at 1st January 2008. Malta joined ERM II on 2 May 2005. Malta’s average inflation rate was 2.7% in 2004. The general government deficit was 3.2% of GDP in 2005 and 5.0% of

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GDP in 2004. Government debt figures were 74.2% of GDP (2005), and 74.9% (2004). The introduction of the euro for the case of Malta took place at 1st January 2008. As regards government debt, Cyprus and Malta exhibited debt ratios above the 60% of GDP reference value in the time period 2003–2005. Regarding Slovakia, the average inflation rate was 7.5% in 2004. The general government deficit was 3.1% of GDP in 2005 and 3.0% of GDP in 2004. Government debt figures: 34.5% of GDP (2005), and 41.6% (2004). Slovakia joined the ERM II in late November 2005, and the country will adopt the euro in January 2009. Looking back at the period from 1996 to 2003, debt levels increased substantially in most countries. The highest increases in the debt ratio were recorded in Malta, the Czech Republic and Slovakia. Only in Estonia, Hungary and Sweden was the 2003 debt ratio below the ratio of the starting year. None of the countries examined in the 2004 Convergence Report participated in ERM II for the full reference period from October 2002 to September 2004. Consequently, they did not participate for at least two years before the convergence examination as laid down in Article 121 of the Treaty. With the exception of Sweden, the countries examined in this report acceded to the European Union only on 1 May 2004 as members with a derogation. Since then each non euro area member state has treated exchange rate policy as a matter of common interest and has had the option to apply at any time for participation in ERM II. Eight countries have kept their currencies outside the exchange rate mechanism during this period, namely the Czech Republic, Cyprus, Hungary, Latvia, Malta, Poland, Slovakia and Sweden (Cyprus, Latvia, Malta and Slovakia entered in 2005). Cyprus and Malta entered the EMU on 1.1.2008 after their participation in the ERM II for the two years of the reference period. The three currencies participating in ERM II, namely the Estonian Kroon, the Lithuanian Litas and the Slovenian Tolar, have traded continuously at or close to their central rates since joining the mechanism. Following a careful assessment of the appropriateness and sustainability of Estonia’s and Lithuania’s currency boards, it was accepted that both countries would join ERM II with their existing currency board arrangement in place, as a unilateral commitment, thus placing no additional obligation on the ECB. Slovenia adopted the euro on 1 January 2007. According to the European Commission and Austrian Finance Minister Karl-Heinz Grasser, only Slovenia appeared on the right track to adopt the euro as of this date (this finally took place at 1.1.2007). Cyprus and Malta adopted the euro on 1 January 2008. Slovenia’s average inflation rate was 2.5% in 2005. In December 2006, the rate fell to 2.4%. The country’s general government deficit was 1.7% of GDP in 2005 and also 1.7% of GDP in 2006. Government debt was 29.0% of GDP in 2005, and 29.6% of GDP of in 2006. There are still a number European countries such as the Czech Republic, Hungary, and Poland, that have not joined the ERM II yet. Since joining the EU in 2004, the Czech Republic has adopted a fiscal and monetary policy that aims to

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align its macroeconomic conditions with those of the rest of the European Union. Currently, the most pressing issue is the large Czech fiscal deficit. The Czech Republic aims for entry into the ERM II in 2008, although economic forecasts indicate that it may not be ready until 2009. Additionally, the Czech government has declared its commitment to adopting the euro by 2010. However, high national debt may delay eurozone membership. The Czech deficit reached 3.6% of GDP in 2005 from 2.9% in 2004. In 2004, the average inflation rate stood at 2.6%. The general government debt was 30.4% of GDP in 2005, and 30.7% of GDP in 2004. Poland is obliged to join the eurozone as euro adoption is ‘part of the EUpackage’. Accordingly Polish President Lech Kaczyński plans to organize a referendum concerning euro adoption. Strictly speaking, 77% of the Polish population have already voted in favour of euro adoption at the referendum on their entry into the EU, which in turn implicated their EMU entry. EU commissioner, Joaquin Almunia, has politely reminded Poland that it does not have an EMU opt-out as did the UK and Denmark. As for Poland, the average inflation in 2004 was 3.6%. The general government deficit was 2.5% of GDP in 2005, and 3.9% in 2004. Government debt figures: 42.0% of GDP in 2005, and 41.8% of GDP in 2004. The conservatives who won the elections in September 2005 have refused to make binding decisions on the adoption of the euro. Warsaw has yet to set a target date for euro adoption. Hungary plans to adopt the euro as its official currency on 1 January 2010, although unofficial assessments suggest that this will not happen until 2012 or even 2014. Hungary has overshot its deficit target of 4.6% of GDP for 2004. In 2004, the average inflation rate was 6.8%. The general government deficit stood at 6.5% of GDP in 2004 and 7.8% in 2005. Government debt figures show 61.7% of GDP (2005), and 59.4% (2004). Due to the slow pace of deficit reduction, the original 2010 target date for the adoption of the euro is likely to be shifted to sometime in or after 2012. Estonia hopes to adopt the euro on 1 January 2010. Doubts over its entry at that point are however growing among EU leaders and banks. Austrian Finance Minister Karl-Heinz Grasser has joined the European Commission in expressing doubts about the feasibility of this date. Although Lithuania aims to adopt the euro on 1 January 2010, doubts over this are also growing among EU leaders and banks. In the meantime, the German Bundesbank, a major and arguably the most important national bank in the ESCB, is critical of the bloc’s rush to enlarge the single currency zone. Estonia, Lithuania and Slovenia joined the Exchange Rate Mechanism (ERM II) in June 2004. A central exchange rate for the three currencies (the Estonian Kroon, the Lithuanian Lita and the Slovenian Tolar) against the euro and a fluctuation band within the ERM II were established on 27 June 2004. The rates were fixed at one euro against 15.6466 Estonian Kroons, 3.45280 Lithuanian Litas and 239.640 Slovenian Tolars, respectively. Under ERM II, the currencies of the three countries must not deviate by more than 15% up or down from the agreed rates against the

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euro. Estonia had an average inflation rate of 3.0% in 2004, and in December 2005 the rate of inflation reached 4.1% (see Table 6.21). The general government surplus was 2.3% of GDP in 2005 and 2.3% in 2004, and gross government debt was 4.5% of GDP in 2005 and 5.2% in 2004. In Lithuania, the average inflation rate in 2006 was 3.8%. The general government deficit was 0.5% of GDP in 2006. The government debt figures are 18.2% of GDP (2006). Lithuania formally applied to join the eurozone on 16 March 2006, following earlier announcements by its Prime Minister and its central bank chairman that it will stick to its target of adopting the euro January 2009. Monetary Affairs Commissioner Joaquín Almunia and ECB President Jean-Claude Trichet have warned Lithuania that the country is at risk of being rejected on the grounds that its inflation rate exceeds 3%. The threshold for euro applicants’ inflation rate was 1.5% above the average of the EU’s three lowest inflation rates. But Lithuanian authorities suggest its inflation, which is the lowest among Baltic countries, will be balanced out by the country’s enormous economic growth of more than 8% per annum and by stable consumer prices. Despite their remarkable economic growth, the Baltic states of Estonia, Latvia and Lithuania may have to wait for their membership of the eurozone until 2010 due to their above-the-limit inflation rates.

6.9 The Copenhagen Criteria and EU Membership Ten member countries entered the EU in May 2004 after the satisfactory fulfilment of the Copenhagen criteria. However, referendums were held in 1998 in 5 countries, and in another four of the remaining five in 2000. Only Cyprus did not hold a referendum (Table 6.22).

Table 6.22  Membership referendum results Slovakia Lithuania Slovenia Hungary Czech Republic Poland Estonia Latvia Malta Cyprus Source: European Parliament.

92% in favour of EU entrance 90% in favour of EU entrance 90% in favour of EU entrance 84% in favour of EU entrance 77% in favour of EU entrance 77% in favour of EU entrance 67% in favour of EU entrance 67% in favour of EU entrance 54% in favour of EU entrance No referendum held

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The 5th enlargement of the EU along with its new members, Bulgaria and Romania, was completed on 1 January 2007. The European Parliament will then be comprised of 786 seats (Table 6.23).

Table 6.23  The enlargement of the European parliament 626 seats until June 2004 732 seats after June 2004 786 seats after the entrance of Bulgaria and Romania (1/1/2007) 736 seats after 2009 election

In the previous sections, the most important treaties of the European Union were mentioned while the major goals of the union were clarified. In order for the process of enlargement to be completed successfully, some additional criteria for countries to become members have been established. The Copenhagen criteria that each candidate country has to abide by before becoming an EU member are political, social, legal as well as economic. •

‘stability of institutions guaranteeing democracy, the rule of law, human rights and the respect for and protection of minorities’. This criterion is classified as political and social.

The main areas that were taken into serious consideration are: independence and coordination of government, public administration, the judicial system, corruption, sexual equality, protection of the Roma society and some other minorities, and the development of childcare institutions. Every presently negotiating country (continuously) has to meet the Copenhagen criteria. •

‘the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union’. This criterion is classified as economic.

These criteria are established by the economic principles and policies, recognized in the EC Treaty by the Maastricht Treaty that came into force on 1 November 1993. •

‘ability to take in the obligations of membership, including adherence to the aims of political, economic and monetary union’. This is the socalled acquis criterion, which refers to the implementation of the Union’s legislation, known as the acquis communautaire. The significance of the acquis was emphasized at the Madrid European Council in 1995.

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Apart from membership in the European Union, additional criteria have been established for countries entering the European Monetary Union. The Economic and Monetary Union (EMU) is a solitary currency region within the European Union single market where people, goods, services and capital move without restrictions. Thus, the framework for economic growth and stability is created. Furthermore, it is buttressed by an autonomous central bank and the legal obligations of the participants are to pursue sound economic policies and to coordinate these policies very closely. 6.9.1 Costs and Benefits of Integration in the European Union The acquis communautaire is the basic literature to start research into the costs and benefits of the enlargement process. It consists of an entire framework of European Community legislation, accumulated and systematically amended over the last 45 years where its adoption is the basic criterion for EU accession. The chapters of acquis were 31 for the 10 countries that entered in May 2004 as well as for Bulgaria and Romania, but they will become 35 for the future applicants such as Croatia, FYROM, Turkey, etc. The 35 chapters of acquis entail the foundation for negotiations between the EU and the candidate member states (Table 6.24). Table 6.24, also presents the correspondence among the 31 chapters of the 5th Enlargement and the 35 chapters of the 6th Enlargement.

Table 6.24  Chapters of acquis correspondence 5th Enlargement 1. Free movement of goods 2. Free movement of persons

3. Freedom to provide services

4. Free movement of capital 5. Company law 6. Competition policy 7. Agriculture

8. Fisheries 9. Transport policy 10. Taxation 11. Economic and Monetary Union

6th Enlargement 1. Free movement of goods 7. Intellectual property law 2. Freedom of movement for workers 3. Right of establishment and freedom to provide services 3. Right of establishment and freedom to provide services 9. Financial services 4. Free movement of capital 6. Company law 8. Competition policy 5. Public procurement 11. Agriculture and rural development 12. Food safety, veterinary and phytosanitary policy 13. Fisheries 14. Transport policy 21. Trans-European networks (one half of it) 16. Taxation 17. Economic and monetary policy

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Table 6.24  continued 5th Enlargement 12. Statistics 13. Social policy and employment

14. Energy 15. Industrial policy 16. Small and medium-sized enterprises 17. Science and research 18. Education and training 19. Telecommunication and information technologies 20. Culture and audio-visual policy 21. Regional policy and coordination of structural instruments 22. Environment 23. Consumer and health protection 24. Cooperation in the field of Justice and Home Affairs 25. Customs union 26. External relations 27. Common Foreign and Security Policy (CFSP) 28. Financial control 29. Financial and budgetary provisions 30. Institutions 31. Other issues

6th Enlargement 18. Statistics 19. Social policy and employment (including anti-discrimination and equal opportunities for women and men) 15. Energy 21. Trans-European networks (one half of it) 20. Enterprise and industrial policy 25. Science and research 26. Education and culture 10. Information society and media

22. Regional policy and coordination of structural instruments 27. Environment 28. Consumer and health protection 23. Judiciary and fundamental rights 24. Justice, freedom and security 29. Customs union 30. External relations 31. Foreign, security and defence policy 32. Financial control 33. Financial and budgetary provisions 34. Institutions 35. Other issues

Source: Bitzenis and Andronikidis, 2006.

For the negotiations with Croatia and Turkey, the acquis was split up into 35 chapters for the purpose of creating a better balance among the chapters: dividing the most difficult ones into separate chapters for easier negotiations, uniting some easier chapters, moving some policies between chapters, as well as renaming a few of them in the process. The 6th Enlargement Policy includes Turkey, Croatia and FYROM at the moment and will include Serbia & Montenegro, Albania, and Bosnia & Herzegovina in the near future. From the acquis it is obvious that the benefits from integration are multidimensional: political, economic and cultural for the EU country members, the accession countries and those potentially acceding. The EU integration is not confined simply to economic benefits from the establishment of a single market, but it consists of the overall progress in both legal, institutional regulations and standards to increase the freedom and scope of choice for consumers and producers as well as for savers, enterprises and employees. This is crucial for achieving

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comparable living standards across countries. Realized benefits of EU accession are closely related to benefits from the adoption of acquis communautaire. Table 6.25 summarizes the advantages and disadvantages from becoming a member of the EU as discussed in the literature (Nuti, 2002; Harrisson et al., 1996; Baldwin et al., 1997; Messerlin, 2001).

Table 6.25  Advantages and disadvantages from being an EU member Advantages from being an EU member Enhancement of market opportunities (increased market size) Reduction of trade barriers or even removal of either tariff or non-tariff barriers Reduction of business cost Reduction of costs of new market entry Free movement of employers/employees across borders to find and take up employment Strengthening of international accounting standards Transparency in business operations and business performance Facilitation of business operations by increasing the intensity of competition. High growth rates Peace and stability

Costs from being an EU member The costs of adoption of all EU norms and standards by enterprises Migration issues – in particular the impact of the movement of the highly skilled and unskilled from accession countries to the EU(15) Fear that the wages would be depressed in the EU(15) Fear that the unemployment would rise in the EU(15) Perceived compromise of identity, struggle for political independence, and social welfare diversity. Challenges for the poorest of the EU member states due to Structural Funds adjustments Possible negative impact on weak EU(15) economies from trade, FDI and migration Costs for improvement of legislature

Costs of compliance with European principles Costs for modernisation of the industrial potential More FDI and trade flows through EU Deterioration in security and EU resources enlargement (Sergi, 1999; 2004) (vast resources requited to coordinate policies, bridge gaps in economic development, alleviate structural discrepancies etc.) A larger and more diverse European Union is likely to be a weaker union Fears for losing economic advantages, and Faster growth of consumer incomes compromising cultural standards, religion and (due to GDP growth) tradition Stabilization and strengthening of institutions Threats to domestic producers’ market position Increased administration capabilities and respect High transition costs for weak countries with for the rule of law bad economies and environments Exploitation of the wage cost advantages in Producers from weak economies will need to central and eastern European countries (CEECs) import new equipment and technologies from advanced countries such as Germany and France. This extra cost may lead to a decrease of the producer surplus

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Table 6.25  continued Advantages from being an EU member

Costs from being an EU member

Greater international integration and policy cooperation

Many of the EU businesses attach higher risks to invest in the accession countries due to weaknesses in the business infrastructure both the ‘hard’ infrastructure and, especially, the ‘soft’ business environment Improvement of investment climate and business Reluctance to compromise independence and environment resistance to the integration of countries not considered ‘European’ Better start-up regulations, more predictable EU benefits are already achieved for the EU investment and business operations, avoidance applicant countries before their entrance of bureaucratic and selective licensing

Easier technology transfer New markets will provide new ideas for CEEC entrepreneurs Strengthened company management and capital markets Streamlined trade and custom regulations Structural and Fund eligibility for the new EU members

According to Viner (1950) and Meade (1955), the major benefits from entering the EU are: • • • • • •

Increase in trade and capital flows. Improvements on hard and soft infrastructure by the structural funds given to country-members. Decrease of the business risk by fostering macroeconomic, legal and political stability. Improvement in the quality of life and standards of living. Use of efficient methods of production, by the integration of new technologies, the cost of which is subsidized partially by the EU. Reduction in prices of goods, due to the existence of free market.

Brown et al. (1997) refer to welfare increases as important benefits related to EU membership. Research carried out in Eastern European countries by the use of the Michigan Model of World Production and Trade, has shown that a welfare increase of 3.8 to 7.3% is expected for countries entering the EU. At the same time, Keuschnigg et al. (2001) highlight trade liberalization as a significant benefit from EU membership. As cuts in trade and agricultural tariffs occur due to European

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agreements, real trade costs decrease and country-members improve their trade equilibrium. At the macroeconomic level, the enlargement is expected to have an impact on the growth rate of the EU GDP, which in turn will be linked to the faster growth of consumer incomes and purchasing power (due to changes in population structure and preferences). This in turn will enhance market opportunities. The easier physical movement of goods across borders within the EU countries helps avoid delays to shipments of inputs or final products, while the introduction of common product standards will reduce the costs of new market entry (Cecchini Report, 1998). The prevention of counterfeiting, the adoption and implementation of the company law and the strengthening of international accounting standards will increase transparency in business operations and business performance. At the same time, the enhanced ability to move expatriate managers due to free movement legislation will enable the EU to profit from the creativity and enthusiasm of talented and skilled managers from other country-members and will enable inward investors to develop their business and overcome shortages of skilled managers (Nuti, 2002). On the other hand, EU entrance is not considered to be without costs for country-members. Strapec et al. (1999) mention the costs inherent from adoption of EU norms and standards by enterprises, as well as threats to domestic producers’ market position as the most serious costs for countries entering the EU. Another cost refers to reduced autonomy in the decision making process, a really important factor, as countries have different backgrounds and needs. The transition costs can be very high for countries with weak economies and environments. A study by Matsaganis et al., 2003, suggested that the producer surplus of Greece and Italy will decrease significantly due to low prices, because a free market zone drives down prices on goods. In addition, Greek and Italian producers will need to import new equipment and technologies from Germany and France. This extra cost may lead to a decrease of producer surplus. Richter (1998) suggests that many of the European members are not concerned with accession costs, since membership was mostly a political decision. In other words, countries decided to join the EU primarily because of the security benefits, as their political situation was actually negative. From this point of view, costs did not truly matter. To sum up, entrance to the EU benefits country-members in different ways. Trade liberalization, increase in FDI, EU funds for improvements in infrastructure and improvements in financial indices are some indicative benefits. On the other hand, countries face additional costs also. Some of the most serious of these relate to transactional costs, changes in financial and monetary policies as well as large investments in technology and other sectors.

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6.10 Real or Nominal Integration Convergence in the Context of the EMU and the EU Real convergence is the term used to describe the process or the tendency of the countries involved towards greater similarity or equality of real variables of the national economies. Nominal convergence is about meeting certain criteria that refer to the nominal variables reflecting macroeconomic stability (Kim, 1997; Razin and Yuen, 1995). As regards nominal convergence in the context of European Union integration, we mean the 35 chapters of Acquis. In regard to the nominal convergence in the context of Economic and Monetary Union integration, we refer to the five Maastricht Criteria. In other words, the exchange rate stability, low deficits/GDP ratios, low debt/GDP ratios, low inflation, and low interest rates. On the other hand, with regard to real convergence we make reference to the narrowing of productivity and price level differentials across countries. To be more specific, reference is made to low unemployment rates, significantly high GDP per capita in PPP prices, high growth rates for all levels of income spread to all the people of a country, high real personal incomes and salaries, high productivity rates, high country competitiveness, significant FDI inflows, and high FDI/GDP ratios, improved infrastructure, improved business environment, low bureaucracy, low corruption rates, limited black economy, low criminal rates, low environmental pollution, high technology, improved and better living standards, high levels of education and health, high and dispersed social policy, advanced structural reforms, and low taxation rates likley to attract FDI flows and to become more competitive. Furthermore, significant incentives are offered by the governments in order for investments, production, employment, wages, and living standards to be increased. Thus, real convergence requires economic growth, low unemployment rates, high wages, an increase of GDP per capita in PPP prices and improved living standards. Real convergence does not only refer to financial matters. Jorge Braga de Macedo (2000) considers that the protection of property rights, the judicial system and civil rights plays a key role in real convergence. In order for a company to be put onto a converging path, the promotion of property rights and an open market are necessary. In this way, the country-member will be able to keep domestic capital within the country and at the same time achieve a high level of FDI and convergence in financial figures. Sachs and Warner (1995) showed that countries with appropriate relevant policies manage to display a better convergence, in contrast with countries showing poor policies related to property rights. The importance of institutions is highlighted by Agh (1999) who considers them as a prerequisite for avoidance of social costs. Furthermore, Tharakan (1999) reasons that real convergence is related to well-functioned government institutions and at the same time macroeconomic stability. Hochreiter (1997) mentions the credibility, the reputation and the independence of institutions (e.g. the Central Bank) as crucial issues for monetary convergence.

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As mentioned above, there are six levels of economic integration, namely: (1) the preferential trade area; (2) the free trade area; (3) the customs union; (4) the common market union; (5) the economic and monetary union; and (6) the political and economic union. A preferential trading area refers to a region that becomes a block trade of countries with less taxes and tariffs. A free trade area encourages trade among its members by eliminating trade barriers (tariffs, quotas, and other NTBs) among them. An example of such an arrangement is the North American Free Trade Agreement (NAFTA), which reduces tariff and non-tariff barriers to trade among Canada, Mexico and the United States. A customs union combines the elimination of internal trade barriers among its members with the adoption of common external trade policies toward nonmembers. Because of the uniform treatment of products from non-member countries, a customs union avoids the trade deflection problem (Krueger, 1997). A common market union is another step along the path to total economic integration. As in a customs union, members of a common market eliminate internal trade barriers among themselves and adopt a common external trade policy toward non-members. A common market goes a step further by eliminating barriers that inhibit the movement of factors of production-labour, capital and technology-among its members. An economic union represents full integration of the economies of two or more countries. In addition to eliminating internal trade barriers, adopting common external trade policies, and abolishing restrictions on the mobility of factors of production among members, an economic union requires its members to coordinate their economic policies in order to blend their economies into a single entity. Finally, a political and economic union is the complete political as well as economic integration of two or more countries, thereby effectively becoming one country. An example of a political union is the integration of the thirteen separate colonies operating under the Articles of Confederation as a new country, as with the United States of America. A discussion regarding nominal and real convergence among country-members of European Monetary Union is will follow. In particular, nominal convergence relative to Maastricht criteria will be examined with the assistance of a country case study of Greece in order to identify nominal convergence. At the same time, real convergence will be investigated through four different axes: (1) GDP growth; (2) minimum wages; (3) HDI development; and (4) unemployment. The Economic and Monetary Union (EMU) has brought a common monetary policy to the twelve countries of the euro area, a policy which is formulated to address the needs of the euro area as a whole. The suitability of this policy to individual countries will inevitably vary as member economies will from time to time experience differing rates of growth and inflation. For example, Ireland is experiencing much higher growth and higher inflation rates than Germany. If the entire euro area were to resemble Ireland, monetary policy would be tighter than if the entire euro area looked like Germany (De Grauwe, 2002). Such ‘divergences’ across euro area countries are made up of two components: (i) cyclical components,

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resulting from economies being at different points on the business cycle; and (ii) structural components, resulting from underlying differences in the economies. Real economic convergence relates to the latter and specifically to a gradual elimination of differences in economic development across euro area countries. This is desirable and probably inevitable in the long run; total welfare will increase, and the European economy will emerge stronger and more vibrant than before. Nevertheless, the process may also entail a destabilizing element for EMU macroeconomic policy, because the larger the developmental differences across the euro area economies, the greater the structural divergences in trend inflation rates will be. When economies integrate closely enough, developmental differences begin to diminish by means of a real convergence process, whereby poorer countries ‘catch up’ to richer countries in terms of per capita incomes (Guisso et al., 2004). Differences in economic measures observable among EU members can be justified by the different cultural, historical and political experiences of the individual countries. Participation in the EU requires relevant changes which due to their unique character, take place in different periods. In this way, real convergence is difficult to occasion in a short period (Baldwin, 1997). As far as participation in EU is concerned, member states may have fulfilled the 31 chapters of acquis, but real economic convergence is not possible as those chapters do not refer to economic factors. In this way, it cannot be considered that members of EU have achieved nominal economic convergence. The changes that have been made refer to institutions, political and social infrastructure and legislation. At the same time, the impact of these changes differs in a high degree amongst members. This suggests that not even in these sectors has real convergence been achieved. Barro and Sala i Martin (1992) have found in their research work a slow rate of convergence among EU members. The research of Neven and Gouyette (1995) showed the same findings; as absolute convergence among EU members was found to be extremely weak. Only 0.5% per year. It should also be noted that the greatest convergence appeared mainly among the northern regions. Other research carried out by Canova and Marcet (1995) found that EU regions converged on their own steady state, at a rate of 23% on average. Moreover, they noted that France, the Netherlands and the United Kingdom display lower convergence rates, while Portugal and Greece show higher rates. In general, results from research reveal a slow level of convergence but this differs according to the method used to examine convergence. It can be concluded that countries becoming members of EMU have all aimed to fulfil the Maastricht criteria, but this is not sufficient for real convergence. In particular, economic indicators apart from those referred to in the criteria are not the same or even similar amongst members. Furthermore, other aspects of real convergence such as institutional, political, social and environmental matters do not appear to be parallel in the EMU.

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Until 2008, only five convergence reports required by Article 109j of the Maastricht Treaty, establishing the European Community have been created (in 1998, 2000, 2002, 2006 and 2008). In these convergence reports all the reference prices for the Maastricht criteria are presented. In Table 6.26, the reference prices for the convergence report of 1998 appear (the year when 11 countries entered the EMU).

Table 6.26  Economic indicators and the Maastricht Treaty convergence criteria (excluding the exchange rate criterion) HICP Long-term General government General government inflationa interest ratesb surplus (+) or deficit (-)c gross debtc Belgium

Denmark(4)

Germany

Greece

Spain

France

Ireland

Italy

Luxembourg

Netherlands

Austria

Portugal

1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d 1996 1997 1998d

1.8 1.5 1.4 2.1 1.9 1.9 1.2 1.5 1.4 7.9 5.4 5.2 3.6 1.9 1.8 2.1 1.3 1.2(2) 2.2 1.2(3) 1.2(3) 4.0 1.9 1.8 1.2(3) 1.4 1.4 1.4 1.9 1.8 1.8 1.2(1) 1.1(1) 2.9 1.9 1.8

6.5 5.8 5.7 7.2 6.3 6.2 6.2 5.6 5.6 14.4 9.9 9.8 8.7 6.4 6.3 6.3 5.6 5.5(2) 7.3 6.3(3) 6.2(3) 9.4 6.9 6.7 6.3(3) 5.6 5.6 6.2 5.6 5.5 6.3 5.7(1) 5.6(1) 8.6 6.4 6.2

-3.2 -2.1(4) -1.7(4) -0.7(4) 0.7(4) 1.1(4) -3.4 -2.7(4) -2.5(4) -7.5 -4.0 -2.2(4) -4.6 -2.6(4) -2.2(4) -4.1 -3.0(4) -2.9(4) -0.4(4) 0.9(4) 1.1(4) -6.7 -2.7(4) -2.5(4) 2.5(4) 1.7(4) 1.0(4) -2.3(4) -1.4(4) -1.6(4) -4.0 -2.5(4) -2.3(4) -3.2 -2.5(4) -2.2(4)

126.9 122.2 118.1 70.6 65.1 59.5(4) 60.4 61.3 61.2 111.6 108.7 107.7 70.1 68.8 67.4 55.7(4) 58.0(4) 58.1(4) 72.7 66.3 59.5(4) 124.0 121.6 118.1 6.6(4) 6.7(4) 7.1(4) 77.2 72.1 70.0 69.5 66.1 64.7 65.0 62.0 60.0(4)

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Table 6.26  continued HICP Long-term General government General government inflationa interest ratesb surplus (+) or deficit (-)c gross debtc Finland

Sweden

United Kingdom

1996 1997 1998d 1996 1997 1998d 1996 1997 1998d

1.1(2) 1.2(2) 1.3 0.8(1) 1.8 1.9 2.5 1.8 1.8

7.1(2) 6.0(2) 5.9 8.0(1) 6.6 6.5 7.9 7.1 7.0

-3.3 -0.9(4) 0.3(4) -3.5 -0.8(4) 0.5(4) -4.8 -1.9(4) -0.6(4)

57.6(4) 55.8(4) 53.6(4) 76.7 76.6 74.1 54.7(4) 53.4(4) 52.3(4)

Note: (1), (2), (3) = first, second and third best performer in terms of price stability; (4) = General government deficit not exceeding 3% of GDP; general government gross debt not exceeding 60% of GDP; a) Annual percentage changes; b) In percentages. For further explanation of the Greek data, see next tables; c) As a percentage of GDP; d) Twelve-month period ending January 1998 for HICP and long-term interest rate; European Commission (spring 1998 forecasts) projections for general government surplus or deficit and general government gross debt. Source: European Commission, .

In the following Table (6.27) the reference prices for the convergence report of 2004 are presented (for the newcomers in the EU and for Sweden = 11 countries in total):

Table 6.27  Economic indicators of convergence (excluding the exchange rate criterion) HICP Long-term General government General government inflation(1) interest rates(2) surplus (+) or deficit (-)(3) gross debt(4) Czech Republic Estonia

Cyprus

Latvia

2002 2003 2004 2002 2003 2004 2002 2003 2004 2002 2003 2004

1.4 -0.1 1.8 3.6 1.4 2.0 2.8 4.0 2.1 2.0 2.9 4.9

4.9 4.1 4.7 – – – 5.7 4.7 5.2 5.4 4.9 5.0

-6.8 -12.6 -5.0 1.4 3.1 0.3 -4.6 -6.4 -5.2 -2.7 -1.5 -2.0

28.8 37.8 37.9 5.3 5.3 4.8 67.4 70.9 72.6 14.1 14.4 14.7

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Table 6.27  continued HICP Long-term General government General government inflation(1) interest rates(2) surplus (+) or deficit (-)(3) gross debt(4) Lithuania

2002 2003 2004 2002 2003 2004 2002 2003 2004 2002 2003 2004 2002 2003 2004 2002 2003 2004 2002 2003 2004

0.4 -1.1 -0.2 5.2 4.7 6.5 2.6 1.9 2.6 1.9 0.7 2.5 7.5 5.7 4.1 3.5 8.5 8.4 2.0 2.3 1.3

6.1 5.3 4.7 7.1 6.8 8.1 5.8 5.0 4.7 7.4 5.8 6.9 – 6.4 5.2 6.9 5.0 5.1 5.3 4.6 4.7

-1.5 -1.9 -2.6 -9.2 -6.2 -5.5 -5.9 -9.7 -5.2 -3.6 -3.9 -5.6 -2.4 -2.0 -2.3 -5.7 -3.7 -3.9 -0.0 0.3 0.6

22.4 21.4 21.4 57.2 59.1 59.9 62.7 71.1 73.8 41.1 45.4 47.2 29.5 29.4 30.8 43.3 42.6 44.5 52.6 52.0 51.6

Reference values(4)

2.4%

6.4%

-3%

60%

Hungary

Malta

Poland

Slovenia

Slovakia

Sweden

Note: (1) Annual percentage change. 2004 data refers to the period from September 2003 to August 2004; (2) In percentages, annual average. 2004 data refer to the period from September 2003 to August 2004; (3) As a percentage of GDP. European Commission Services projections for 2004; (4) Reference value refers to the period from September 2003 to August 2004 for HICP inflation and long-term rates and to the year 2003 for general government surplus or deficit and general government gross debt. Source: ECB, Eurostat and European Commission .

In Figure 6.2, a comparison amongst EMU members relative to the inflation rate and the interest rate is presented. With the exception of Greece, all the other countries have managed to achieve the desired inflation and interest rates.

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231

12,00% 10,00% Average inflation rate Long-term interest rate

8,00% 6,00% 4,00%

SW ED EN

F IN LAN D

PO R T U G AL

AU ST R IA

N ET H ER LAN D S

LU XEM BO U R G

IT ALY

IR ELAN D

F R AN C E

SPAIN

G R EEC E

BELG IU M

0,00%

G ER M AN Y

2,00%

Figure 6.2  Inflation rate and long-term interest rate of some EU members

It is evident from the above tables that the member states of the EMU have managed to satisfy the Maastricht criteria, although some deviations from the norm appear. Thus, it can be said that nominal convergence has been achieved in EMU. On the other hand, as already mentioned, real convergence refers to the narrowing of productivity and price level differentials across countries. Broadly speaking, this occurs as a consequence of increased economic integration between poorer and richer countries. With increased trade and technology transfer, poorer societies ‘catch up’ with richer partners over time by experiencing, on average, both higher price levels and increased productivity. Table 6.28 documents differences in per capita GDP across euro area countries.

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Table 6.28  GDP in European Union (per capita in purchasing power parity in US$) Rank Country 1 2 3 4 5 6 7 8 9 10 11 12 13 15 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34

Luxembourg Denmark Ireland Austria Belgium United Kingdom Netherlands Finland France Germany Sweden Italy European Union Spain Greece Cyprus Slovenia Malta Portugal Czech Republic Hungary Slovakia Estonia Lithuania Poland Latvia Croatia Bulgaria Romania Turkey FYROM Bosnia & Herzegovina Albania Serbia & Montenegro

Identity EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) Average EU(15) EU(15) EU(25) EU(25) EU(25) EU(15) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) APPLICANT EU(27) EU(27) APPLICANT APPLICANT APPLICANT APPLICANT APPLICANT

GDP – per capita Date of information $62,700 $33,500 $34,100 $32,900 $31,800 $30,900 $30,500 $30,300 $29,900 $29,700 $29,600 $28,300 $28,100 $25,100 $22,800 $21,600 $20,900 $18.800 $18,400 $18,100 $15,900 $15,700 $16,400 $13,700 $12,700 $12,800 $11,600 $9,000 $8,300 $7.900 $7,400 $6,800 $4,900 $2,600

2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est.

Source: .

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233

Two main observations require discussion and attention. Firstly, there are large differences in per capita GDP in PPP prices across the member states of the euro area and the EU(27). Secondly, on 1 May 2005, ten new member states entered the European Union (EU). To date, this is the biggest EU enlargement. Amongst the new member countries, eight out of ten (that entered into the EU on May 2004) are Central and Eastern European (CEE) economies which underwent major changes in their economic and political system during the transition to market economies in the 90s. On January 2007 another 2 countries from CEE, Bulgaria and Romania entered the EU, so 10/12 are CEECs. Although, the transition countries have somewhat caught up with the member states, large economic differences still exist. For instance, per capita GDP in CEE countries is substantially lower than the EU member state average. However, economic integration of the new member countries is integral to the functioning of the EU. Consequently, economic convergence based on this figure between the EU(15) and the new members of the EU(27) in the long run will be of major importance. For instance, comparable levels of economic activity are necessary for successfully enlarging the Euro currency area. As the economic and monetary union (EMU) enlarges, there will be a greater dispersion of per capita income levels across the euro area. Regarding the predicted speed of convergence, the available estimates range from 2% per year to over 10% in economic figures such as the GDP. When studying the EU accession countries, it must be kept in mind that many of them are still in various stages of systemic and institutional transformation to market economies. Until this process has progressed further, the macroeconomics will remain fragile and rapid sustained growth will be difficult to accommodate. This will slow down the average pace of real convergence during the immediate years to come. Real convergence may thus take place with full force at about the time when the accession countries are expected to join the euro area, and become subject to the common monetary policy (Honohan and Lane, 2003). Positively speaking, the fact that accession countries are adopting EU institutions is almost certainly a facilitating factor towards a real convergence of living standards. Current popular conventional wisdom holds that without the presence of the EU, the central European transition economies would not have progressed nearly as far as they did in the past decade, and would not be nearly so clear on the direction in which they are developing. Looking back on Table 6.28, one can see the significant GDP growth rate of the Greek economy which has been around 4% each year in the last five years (based on the European structural funds for the agriculture, tourism and services sector, the organization and preparation of the Olympic games, the participation of millions of low-cost emigrants, the completion of the infrastructure projects based on European funds). This calls for some optimism for real economic convergence of the economy in the future.

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It should also be noted that the significant growth rate of the Irish economy, which has been around 10% per year on average for the last 10 years, cannot be ‘duplicated’ easily by any other European economy. Furthermore, the low growth rates of the advanced countries such as Germany, France and the UK can be attributed to the maturity of their economies. However, it can be said that the less advanced countries such as the new EU(25) members and the applicants for the EU must display very high growth rates in the following ten years in order to have a chance of real economic real convergence. Table 6.29  GDP growth rate (per cent) Country Euro-zone EU(15) Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Austria Portugal Finland Sweden UK Cyprus EU(27) Czech Republic EU(27) Estonia EU(27) Hungary EU(27) Latvia EU(27) Lithuania EU(27) Malta EU(27) Poland EU(27) Slovakia EU(27) Slovenia EU(27) S.E. Europe Albania Boznia & Herzegovina

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2.5 2.7 3.2 5.5 2.3 2.0 2.5 2.1 5.8 2.2 3.8 2.9 2.6 1.0 3.9 5.2 5.5 5.9

2.2 2.5 2.5 2.8 1.7 2.1 2.8 1.7 9.9 2.9 1.5 3.0 1.6 5.3 3.5 5.1 2.8 6.1

1.5 1.6 1.2 2.5 0.8 2.5 2.5 1.1 8.1 1.1 3.3 3.0 2.0 3.5 3.9 1.3 2.7 1.8

2.3 2.5 3.5 3.0 1.5 3.6 5.0 1.9 11.1 2.0 8.3 3.8 1.6 5.0 6.3 2.5 3.3 2.3

2.9 2.9 2.0 2.5 2.0 3.5 5.3 3.5 8.6 1.8 6.9 5.3 3.9 5.6 5.0 3.6 3.1 5.0

2.8 2.9 3.2 2.6 2.0 3.5 5.2 3.2 11.3 1.7 7.8 5.0 2.7 3.8 3.5 5.6 2.8 4.8

3.5 3.5 3.8 2.8 2.9 5.5 5.2 3.8 10.1 3.0 9.1 3.5 3.5 3.5 5.1 5.3 3.8 5.0

1.6 1.6 0.6 1.6 0.8 5.0 2.8 2.1 6.2 1.8 1.2 1.2 0.8 1.7 1.1 0.9 2.1 4.1

0.9 1.0 0.7 1.0 0.2 3.9 2.0 1.2 6.9 0.5 1.3 0.2 1.5 0.5 2.3 2.1 1.6 2.1

0.5 0.7 0.8 0.0 -0.1 5.7 2.5 0.1 1.6 0.3 1.2 -0.9 0.7 -0.8 1.9 1.6 2.2 2.0

1.8 1.9 1.8 2.0 1.6 5.2 2.9 1.7 3.7 1.5 1.9 0.6 1.9 1.0 2.5 2.2 2.8 3.8

2.2

5.9

4.2

-0.7

-1.1

1.2

3.9

2.6

1.5

3.2

4.4

-1.6 2.9 2.2 -9.8 5.7 5.2 6.2 5.3 -1.6 8.3

4.5 1.5 -0.9 5.2 6.2 7.0 5.8 4.1 7.4 13.3

4.4 1.3 3.8 4.7 4.0 6.0 6.1 3.6 5.2 9.1

11.1 4.6 8.3 7.0 4.9 6.8 4.6 4.8 3.3 -10.2

4.4 4.9 4.7 7.3 3.4 4.8 4.2 3.6 1.7 12.7

0.3 4.2 3.3 -1.7 4.1 4.1 1.5 5.8 -3.5 10.1

7.9 5.2 6.9 3.9 6.4 4.0 2.0 3.9 5.7 7.3

6.5 3.8 8.0 6.4 -0.4 1.0 3.8 2.7 -2.4 7.0

7.2 3.5 6.4 6.8 1.0 1.4 4.6 3.3 6.5 2.9

6.7 2.9 7.5 9.7 -1.9 3.8 4.5 2.5 5.2 5.7

7.8 4.2 8.5 6.7 1.0 5.3 5.5 4.6 8.0 5.9

–

–

54.2

36.6

16.6

9.5

5.4

4.5

3.7

3.2

4.0

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Table 6.29  continued Country

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Bulgaria EU(27) Croatia Romania EU(27) Serbia & Monterego FYROM Turkey

1.8 5.9 3.9

2.9 6.8 7.1

-9.4 5.9 3.9

-5.6 6.8 -6.1

4.0 2.5 -4.8

2.3 -0.9 -1.2

5.4 2.9 2.1

4.1 4.4 5.7

4.9 5.2 5.1

4.5 4.3 5.2

5.6 3.8 8.3

2.5

6.1

5.9

7.4

2.5

-17.7

5.2

5.3

3.8

2.1

8.0

-1.8 -5.5

-1.1 7.2

1.2 7.0

1.4 7.5

3.4 3.1

4.3 -4.7

4.5 7.4

-4.5 -7.5

0.9 7.9

2.8 5.8

2.9 8.9

Source: UNECE, 2005, author’s modifications.

Another indicator of convergence amongst EU and EMU countries is minimum wages. Table 6.30 presents minimum wages in euros per month for EU member states and candidate countries that have statutory minimum wages. Table 6.30  Minimum wages in euros per month in EU member states, candidate countries, January 2003, 2004, 2005, 2006 Rank

Country

Identity

2003

2004

2005

2006

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Luxembourg Ireland Belgium United Kingdom Netherlands France Spain Greece Slovenia Malta Portugal Czech Republic Hungary Slovakia Estonia Lithuania Poland Latvia Bulgaria Romania

EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(25) EU(25) EU(15) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) EU(27) EU(27)

1369 1073 1163 1105 1249 1154 526 605 451 535 416 199 212 118 138 125 201 116 56 73

1403 1073 1186 1083 1265 1173 537 605 471 543 426 207 191 148 159 125 177 121 61 69

1467 1183 1210 1197 1265 1197 599 668 490 557 437 235 232 167 172 145 205 116 77 72

1503 1218 1269 1273 1293 1234 580 668 512 631 437 261 247 192 183 159 234 129 90 82

Source: European Union (eurostat), author’s modifications.

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Compared with the ranking of countries based on minimum wages in euros per month in Table 6.30, the ranking of the countries is almost unaffected when minimum monthly wages are expressed in purchasing power standards (PPS) rather than euros (Table 6.31). Table 6.31 compares the minimum wages of EU member states and candidate countries after eliminating the effect of price level differences by applying Purchasing Power Parities (PPPs) for households’ final consumption expenditure. Differences in the levels of the minimum monthly wages are remarkably reduced when expressed in purchasing power standards (PPS). In particular, eliminating differences in price levels between the countries shows the purchasing power of the minimum wage to be higher in all new Member States of the European Union (MS), as well as in Spain and Greece. In the MS, the minimum wage in euros (Table 6.30) ranged from 116 (Latvia) to 1467 (Luxembourg) euros in January 2005. This represents a ratio of about 1:13. In contrast, the minimum wage in PPS (Table 6.31) extended between 283 and 1293, a ratio of about 1:5 (Eurostat 2005). From Table 6.31 we distinguish three groups of countries with distinct levels of minimum wages. The first group includes Turkey and 9 of the 12 new EU Member States (Latvia, Lithuania, Slovakia, Estonia, Poland, Hungary, Bulgaria, Romania, and the Czech Republic). Minimum wages varied between 72 euros (Romania) and 250 euros (Czech Republic) on 1 January 2005. The second group with minimum wages between 437 euros (Portugal) and 668 euros (Greece) on 1 January 2005 includes two new Member States, Slovenia and Malta, as well as Portugal, Spain and Greece. The third group, with minimum wages in excess of 1,000 euros, includes Ireland, France, the United Kingdom, Belgium, the Netherlands and Luxembourg. In Greece, the increase in the years 1999–2005 in PPS and euros is similar (Greek nominal minimum wages are only at 55% of the average of the western advanced European countries – Greek minimum wages in PPS are at 65%) to that of Germany, France, Luxembourg, the Netherlands, Ireland, and UK. In France, the minimum wage in euros increased by 16%, while in PPS the increase was 21%. For Spain, Luxembourg, the Netherlands and Portugal, the increase in euros is higher. In Luxembourg, for example, the minimum wage in euros increased by 26% while in PPS the increase was 9% (Eurostat 2005).

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Table 6.31  Minimum wages in PPS per month in some EU member states, candidate countries, 2004, 2005, 2006 Rank

Country

Identity

2004

2005

2006

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Luxembourg Ireland Belgium United Kingdom Netherlands France Spain Greece Slovenia Malta Portugal Czech Republic Hungary Slovakia Estonia Lithuania Poland Latvia Bulgaria Romania

EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(15) EU(25) EU(25) EU(15) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) EU(25) EU(27) EU(27)

1237 929 1187 1084 1202 1170 625 821 667 774 663 439 364 320 304 283 398 281 186 219

1293 1024 1211 1186 1202 1194 696 855 703 848 582 470 415 343 330 327 410 283 232 219

1417 1050 1184 1202 1210 1128 722 785 676 776 517 431 401 314 305 292 379 240 191 189

Note: Minimum wages are gross amounts, that is, before the deduction of income tax and social security contributions. Differences among countries have been considered: For Ireland: 39 hours x 52 weeks divided by 12, Spain and Greece where salary is paid for 14 months a year, United States: 40 hours x 52 weeks divided by 12, United Kingdom: 39.4 hours x 52 weeks divided by 12, France: 35 hours x 52 weeks divided by 12. Source: European Union (eurostat).

The human development index is another indicator of convergence among different members of the EU. As presented in Table 6.32, all European Union members display a high human development index, while candidates for the EU show mainly a medium human development index. In particular, the Balkan countries have the lowest index even among the EU(25) members and are far behind the advanced western European countries such as Sweden, Ireland, Belgium, the Netherlands, the UK, France and Germany. As for the ten countries that have recently entered the EU, their rank is lower than the older EU members, while it is higher than EU candidates. At the same time, differences appear even among the EMU members and a real convergence is not immediately likely. Greece, Spain, and Portugal are the lowest ranked among EU(15) and the EMU. Furthermore, new EU member countries that

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are not members of the EMU such as Slovenia, Cyprus and the Czech Republic, display a better or similar level rank in the Human Development Index.

Table 6.32  Human development index High human development

Medium human development

4 6 8

Luxembourg EU(15) Sweden EU(15) Ireland EU(15)

59 64 68

9 10 12 13 14 15

Belgium EU(15) United States Netherlands EU(15) Finland EU(15) Denmark EU(15) United Kingdom EU(15) France EU(15) Austria EU(15) Italy EU(15) Germany EU(15) Spain EU(15) Greece EU(15) Slovenia EU(25) Portugal EU(15) Cyprus EU(25) Czech Republic EU(25) Malta EU(25) Hungary EU(25) Poland EU(25) Estonia EU(25) Lithuania EU(25) Slovakia EU(25) Croatia (applicant) Latvia EU(25) Bulgaria EU(27)

72 94

16 17 18 20 21 24 26 27 29 31 32 35 36 38 39 42 45 48 55

FYROM (applicant) Romania EU(27) Bosnia & Herzegovina (applicant) Albania (applicant) Turkey (applicant)

Low human development 146 147 148

Madagascar Swaziland Cameroon

149

Lesotho

Note: The Human Development Index (HDI) measures achievements in terms of life expectancy, educational attainment and adjusted real income. Source: United Nations Development Programme.

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239

Notable is the absence of Serbia & Montenegro from the list. While Serbia & Montenegro is either unwilling or unable to provide data, it is generally considered a country of medium to low human development. The human development index aims to investigate the degree to which people in different countries have made progress in terms of education, health and poverty. To be more specific, citizens in a country are ranked according to the level of education they achieve, to their health condition, to the estimation of their life expectancy and of course, to their economic situation. Furthermore, the possibility of citizens to live under a democratic rule of government is also taken into account. It could be suggested that countries in the EU(25) and the EMU show a nominal but not a real convergence since significant differences exist in terms of human development. For example, in their life expectancy and educational attainment.

Table 6.33  Standardized unemployment rates in Europe (per cent of Civilian Labour Force) Country

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Euro-zone EU(15) Belgium Denmark Germany Greece Spain France Ireland Italy Lux. Netherlands Austria Portugal Finland Sweden UK Cyprus EU(25) Czech Republic EU(25) Estonia EU(25) Hungary EU(25)

8.5 8.7 7.1 8.6 6.5 7.9 15.9 9.9 15.5 8.7 2.1 5.3 3.6 5.3 11.7 5.6 9.8

10.1 10.0 8.6 9.6 7.7 8.6 18.6 11.1 15.6 10.1 2.6 6.2 5.0 5.6 16.3 9.1 10.0

10.8 10.5 9.8 7.7 8.2 8.9 19.8 11.7 15.3 10.6 3.2 6.8 3.8 6.9 16.6 9.5 9.3

10.5 10.1 9.7 6.7 8.0 9.2 18.8 11.1 12.3 11.2 2.9 6.6 3.9 7.3 15.5 8.8 8.5

10.7 10.2 9.5 6.3 8.7 9.6 18.1 11.6 11.7 11.2 2.9 6.0 5.5 7.3 15.6 9.6 8.0

10.8 10.0 9.2 5.2 9.7 9.8 17.0 11.5 9.9 11.3 2.7 5.9 5.5 6.8 12.7 9.9 6.9

10.2 9.5 9.3 5.9 9.1 10.9 15.2 11.1 7.5 11.3 2.7 3.8 5.5 5.1 11.5 8.2 6.2

9.5 8.5 8.0 8.3 8.7 8.8 8.5 7.7 7.2 7.6 8.0 8.0 8.6 6.9 6.7 7.3 8.0 7.8 5.8 5.5 5.3 5.6 5.6 5.5 8.5 7.2 7.5 8.2 9.0 9.5 12.0 11.3 10.8 10.3 9.7 10.5 12.8 11.3 10.6 11.3 11.3 10.8 10.5 9.1 8.5 8.9 9.5 9.7 5.6 5.3 3.9 5.3 5.6 5.5 10.9 10.1 9.1 8.6 8.5 8.0 2.5 2.3 2.1 2.8 3.7 5.2 3.2 2.8 2.2 2.8 3.7 5.6 3.9 3.7 3.6 5.2 5.3 5.5 5.5 5.1 5.0 5.0 6.3 6.7 10.2 9.8 9.1 9.1 9.0 8.8 6.7 5.6 5.9 5.9 5.6 6.3 5.9 5.5 5.0 5.1 5.9 5.7

1.8

2.6

4.1

4.0

4.7

5.2

5.2

5.5

5.2

4.4

3.9

4.5

5.0

–

4.4

4.4

4.1

3.9

4.8

6.4

8.6

8.7

8.0

7.3

7.8

8.3

–

–

–

–

–

9.6

9.2

11.3 12.5 11.8

9.5

10.2

9.2

7.4

6.8

6.1

5.6

9.6

9.0

8.4

6.9

5.6

5.8

5.9

6.3

5.6

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Table 6.33  continued Country Latvia EU(25) Lithuania EU(25) Malta EU(25) Poland EU(25) Slovakia EU(25) Slovenia EU(25) South-East Europe Albania Boznia & Herzegovina Bulgaria EU(27) Croatia Romania EU(27) Serbia & Monterego FYROM Turkey

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 –

–

–

–

–

–

14.3 14.0 13.7 12.9 12.6 10.4

–

–

–

–

–

–

13.2 13.7 16.4 16.4 13.5 12.7 10.8

6.1

7.1

6.5

5.7

6.8

7.5

–

7.6

7.9

6.8

7.7

7.7

7.3

14.0 14.4 13.3 12.3 10.9 10.2 13.4 16.4 18.5 19.8 19.2 18.8

–

–

–

–

13.7 13.1 11.3 11.9 12.6 16.7 18.7 19.4 18.7 17.5 18.0 –

–

11.0 11.4 11.3 10.1

6.9

6.9

7.4

7.2

6.6

5.8

6.1

9.3

10.5 11.1 12.3 11.8 12.4 13.4 13.1 12.6

27.0 22.0 18.0 13.1 12.4 14.9 17.7 18.4 16.8 16.4 15.8 –

8.0

9.8

–

–

–

–

6.5

15

6.0

14.4

39.0 38.7 39.0 39.4 39.9 42.7 44.0 44.9

15.3 16.4 12.8 11.1 12.5 13.7 12.2 16.0 17.9 17.9 16.3 13.5 12.2 17.8 16.6 17.3 17.6 15.9 17.6 18.1 20.4 22.3 22.8 21.3 18.7 18.5 8.2

10.4 10.9

9.5

6.6

8.8

10.3 11.5 10.5

8.8

8.4

7.4

6.2

24.6 24.0 23.9 24.7 26.1 25.6 27.2 27.4 26.6

28

26

28

28

26.2 27.7 30.0 36.6 38.8 41.7 32.3 44.0 45.1 41.8 45.3 45.3 44.6 7.9 7.6 8.1 6.9 6.1 6.4 6.8 7.6 6.5 8.3 10.3 10.5 10.3

Source: UNECE, 2005, author’s modifications.

The last indicator used to investigate real convergence among the EU and the EMU members is the registered unemployment indicator. As we can see on Table 6.33, different percentages of unemployment are apparent in each countrymember. In particular, candidate countries from the Balkan region display decisive high unemployment (between 18–45%), whilst EU country members (15) such as Austria, Luxembourg, Ireland, and the Netherlands have considerably lower unemployment rate (around 5%). To summarize, the finding that the EMU countries such as Greece, Portugal and Spain display double digit unemployment and very low minimum wages, along with the fact that these countries have 55% of the average wage level of the most advanced European countries, and at the same time have the lowest GDP per capita among the EMU countries and rank very low in HDI, are proof in support of nominal instead of real convergence for these countries. Using Greece as a country case study – a member of the EU and the EMU – we can argue that Greece lags behind most if not all the other members of the

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EU(15) and the EMU and it has a lot of catching-up to do. In more detail, at the time of its entry into the EEC in 1981, Greece was the proverbial ‘sick man of Europe’. Labour costs were extremely high – after seven years of controls under the dictatorship – and so were prices, as the result of the oil price shocks of 1973 and 1979. Inflation was above 20%, the GDP was stagnant and investment was on the decline. As late as 1998, when European finance ministers were in the process of accessing those applicant countries which qualified for the Economic and Monetary Union, Greece was still out of the mainstream, the only one of the 12 EU member states that wished to join and could not meet the necessary criteria. As of 1 January 2001, Greece entered the ‘inner circle of the EU’, the so-called euro-zone. Four of the five ‘Maastricht criteria’ had been satisfied (the state deficit, exchange rate stability, inflation and interest rates). As regards the fifth criterion, relating to national debt, Greece like other member states (e.g. Italy and Belgium), is trying hard to comply with the ‘60% of GDP’ criterion. A satisfactory decrease occurred in the years before its EU accession – the national debt was around 106% of its GDP. The goal of the Greek government is to narrow the gap to near parity by 2010 with the application of specific policies that are designed to generate sufficient growth. Nevertheless, as mentioned above, real convergence requires economic growth, low unemployment rates, high wages, increase of GDP per capita in PPP prices, and implies an ongoing improvement in living standards. Although, Greece has satisfied the Maastricht criteria and integrated into the EU, we can argue that it has reached only nominal convergence with Western European advanced countries in specific economic indicators such as lower interest rates, inflation, foreign debt, and state budget deficits. It has also succeeded in securing exchange rate stability. As for real convergence, Greece faces many obstacles and has a distance yet to travel before it reaches the level of GDP per capita in PPP prices of Western European advanced countries, or their low unemployment rates (Delhey, 2001). Also, the small yearly increases in Greek industrial output hinder the real convergence of the Greek economy, as does the fact that Greece holds (in 2005/6) only 75% of the EU(15) average GDP per capita in PPP prices; a very disappointing performance which reflects weak living standards. There are measures that can possibly mitigate this disappointing performance. These would be the decrease of the very high rate of the Greek black economy which is around 30–35% of its GDP when at the same time the EU(15) average is less than 15% (in Austria 10%, in France 15%, in the UK and the Netherlands 12%, in Germany 17%, in Ireland 16%, in Norway, and Sweden, 19%, etc). Furthermore, an indicator of better living standards in Greece is high rate of home-ownership and self consumption. In particular, home-ownership in Greece is more than 80% when the EU(15) level is around 60% (in Sweden only 38%, in the Netherlands 54%, in Finland 58%, in France 56%, in Denmark 50%, in Austria 57%, in Germany 43%) (Vaughen – Whitehead, 2003). Finally, the high acceleration of Greek GDP can be seen as a positive sign, permitting the optimistic

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speculation that Greece can narrow the existing gap in the following years and achieve real convergence in about ten years time. In summary, it can been argued that by utilizing alternative indicators, nominal convergence exists among country members of the EU(25) and the EMU, while real convergence appears to be a long-term target with many obstacles. In particular, while all countries have managed to achieve the criteria proposed by the EU (Copenhagen Criteria) and the EMU (Maastricht Criteria) for membership, different levels of unemployment, wages, and GDP, and different human development indices appear in each member.

6.11 Prospects for the Balkan Countries Entering the EU In this section, we discuss the prospects of Balkan countries entering the EU by examining the progress reports for each country. The structure of the analysis is as follows: after mentioning key events for each country relating to EU relations, we analyse elements regarding the present status of the country and its progress relevant to three areas: (1) the political criteria; (2) the economic criteria; and (3) the obligations of membership (chapters of aquis/administrative criteria). For the purposes of our analysis the countries have been categorized in four groups. Group 1 consists of Bulgaria and Romania which became members in 2007. The second group concerns Croatia because of its positive prospects to enter EU sooner than the countries in the third group and fourth group. The third group consists of Turkey, while the fourth group includes Albania, Bosnia & Herzegovina, FYROM, and Serbia & Montenegro. Group 1: Bulgaria and Romania Both Bulgaria and Romania have taken the main steps toward European integration in parallel and both finally became EU members at 1.1.2007. Romania established diplomatic ties with the European Union in 1990, and the following year a Trade and Co-operation Agreement was also signed. In 1995, the bilateral Europe Agreement was brought into force. Romania submitted its formal application for membership of the EU on 22 June 1995. However, the decision on the application came only at the Luxembourg European Council in December 1997. The Romania-EU intergovernmental conference meeting in Brussels on 15 February 2000 marked the official start of membership negotiations. In June 2004, the EU decided to set a new ‘safeguard clause’ for Romania and Bulgaria, which delayed their accession because they failed to meet their targets. Meanwhile, in May 2004, Romania became a full member of the North Atlantic Treaty Organisation (NATO). On 17 December 2004, the Brussels Council took note of Romania’s progress in its accession preparations and considered the country ‘eligible to assume all the obligations of membership at the envisaged time of its accession’, in January 2007. On 22 February 2005, the Commission gave a positive judgement on the

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scheduled 25 April 2005 signing of Romania’s Accession Treaty. Romania signed its EU Accession Treaty, and on 25 October 2005 the Commission published its monitoring report on the country’s level of preparedness. The country joined the EU as a full member on 1 January 2007. Bulgaria established diplomatic relations with the EU in 1988. In 1993, the European agreement on EU association was signed before going into force in 1995. In December 1995, Bulgaria submitted its application for EU membership, and two years later preliminary negotiations were launched. The Commission presented its first regular report on Bulgaria’s progress towards accession in November 1998. The second report, released in 1999, recommended that formal negotiations commence and so accession negotiations started on 15 February 2000 which were completed on 15 June 2004, six months ahead of schedule. The technical closure of talks on the final two negotiating chapters was completed on 14 June 2004. On 25 April 2005, Sofia signed its EU Accession Treaty, which was ratified by the parliament on 11 May of the same year. Romania completed its negotiations on the same date. On 13 April 2005, Bulgaria signed the Accession Treaty. Consequently, the country joined the EU as a full member on 1 January 2007. Group 2: Croatia Croatia declared its independence from Yugoslavia in 1991, but it actually gained its independence four years later when occupying Serb troops finally left the country. The EU established diplomatic relations with Zagreb in 1992. In 1997, the Council laid down the political and economic conditions for developing bilateral ties with Croatia. Two years later, the EU proposed a new Stabilization and Association Process (SAP) for five South-East European countries, including Croatia. In May 2000, the Commission adopted a positive feasibility report to commence negotiations in November 2000 for a Stabilization and Association Agreement (SAA). The SAA was signed in October 2001. At the end of 2001, the Commission adopted a country strategy for Croatia covering the period from 2002 to 2006. The strategy provided the framework for EC assistance via the Community Assistance to Reconstruction, Development and Stability in the Balkans (CARDS) programme. On 21 February 2003, Croatia submitted its application for EU membership. On 18 June 2004, the Brussels Council gave Croatia the ‘go-ahead’ to initiate membership negotiations. EU leaders granted Croatia official candidate status in June 2004, and accession negotiations were originally scheduled to start on 17 March 2005. However, the launch of talks was postponed on 16 March pending Zagreb’s ‘full co-operation’ with the UN war crimes tribunal. Finally, on 3 October 2005, Zagreb received the green light for accession talks to commence. Croatia has made important progress as far as the implementation of the priorities of the Partnership is concerned. However, additional improvements are judged necessary, especially in regional cooperation. Amongst other things, border issues are yet to be resolved. Furthermore, Croatia has to pay attention to refugee

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returns, where a number of deadlines have not been met. Moreover, there is a need for further efforts from Croatia in the field of housing care programmes for former tenancy rights’ holders and there is also need to create the economic and social conditions necessary for sustainable refugee return. As regards minority rights, implementation of the Constitutional Law on National Minorities has been slow and the need to improve the position of minorities, in particular the Serb minority, remains an urgent priority. Implementation of a new Roma strategy has begun, but major challenges still lie ahead. Continuous efforts for improvements are necessary in the field of the judiciary and corruption but in this case the most important factor is the achievement of coordination of the government bodies and agencies involved (SEC, 2005, 1424). In the economic sector, the most notable progress has been made in the field of land reform. However, many problems appear relevant to macroeconomic imbalances – mainly government deficit, current account deficit and external debt, as well as structural problems that may impair its capability to stay on a path of strong growth. Progress also needs to continue on structural reforms and on advancing privatization and enterprise restructuring (SEC, 2005, 1424). Finally, regarding the ability of Croatia to cope with the obligations of membership, Croatia has made a degree of progress in terms of legislative alignment with the acquis. However, with regard to Croatia’s competition policy, administrative capacity taxation system, environmental issues and with regard to the field of social policy and employment, the alignment is remains weak. The Croatian government started accession talks with the EU in 2005 and has hopes of taking part in the European Parliament elections in 2009. Group 3: Turkey Turkey established its relations with the European Commission in 1959, when it applied for associate membership in the European Economic Community. Four years later, an association agreement, known as the Ankara Agreement, was signed, aimed at bringing Turkey into a Custom Union with the European Economic Community and eventually to membership (September 1963). In 1995, after the signing of two financial protocols and the protocol amending the European Social Charter, Turkey finalized an agreement with the European Association Council, creating a customs union. It is worth noting that prior to this, in 1987; Turkey had applied for full membership to the European Economic Community. In 1999, the European Helsinki Council recognized Turkey as an EU candidate country, after its application in 1997. Turkey has presented its National Programme for the Adoption of the Acquis (2001) and started a major constitutional reform in order to meet the Copenhagen political criteria. The opening of accession negotiations has not yet been arranged, since the EU has defined particular conditions and priorities in order for negotiations

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to begin. The Accession Partnership for Turkey was first adopted by the Council in 2001. A revised Accession Partnership was adopted in May 2003. On 3 October 2005, membership negotiations were symbolically initiated with Turkey, which has been an associate member of the EU since 1963 and an official candidate since 1999. The historic decision of the 17 December 2004 by the European Council was confirmed by the European heads of state and government on 17 June 2005. On 29 June 2005, the Commission presented its negotiating framework to Ankara, and after a full day of intense negotiations, the EU(25)’s foreign ministers finalized the document on 3 October 2005. Overall, Turkey has made progress in aligning with the acquis, but further substantial efforts will be necessary in order to complete the tasks foreseen. In the political arena, Turkey has to resolve the Cyprus problem, and at the same time settle peacefully its relationship with Greece. Serious efforts need to be made in the field of Human Rights. Until now, Turkey has made substantial progress by executing decisions of the European Court of Human Rights (ECHR). Several protocols were signed, including Protocol No. 14 at the European Convention on Human Rights and the protocol amending the European Social Charter. The European Agreement relating to Persons participating in the Proceedings of the European Court of Human Rights was ratified on 6 October 2004 and went into force on 1 February 2005. The International Convention on the Protection of the Rights of All Migrant Workers and Members of Their Families went into force on 1 January 2005. However, more needs to be done in this field because of the alleged ongoing torture and illtreatment of people in Turkey. The new Penal Code, which introduced improvements in particular in relation to women’s rights, non-discrimination and the fight against torture and illtreatment, was put into force on 1 June 2005. In spite of various legal and practical initiatives, the problem of discrimination on the basis of gender still remains a cause of concern. Efforts are needed to fully enforce new legal developments in this area. Moreover, limited progress has been made in the field of freedom of expression, since many journalists, editors and writers continue to be prosecuted and convicted because they express their opinions openly. As for freedom of association and peaceful assembly, a new law was put into force in November 2004, marking a significant step forward in the development of civil society. However, a regulation adopted in March 2005 introduced some restrictions which could in practice hamper both the establishment and functioning of associations. Despite the measures taken to ease restrictions on demonstrations, there have been several cases where security forces have used disproportionate force against demonstrators. Both associations and foundations continue to encounter difficulties if they conduct work that is not considered to be in conformity with their statute, or if their statute is considered to be in contravention of the constitution.

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In the field of religion, apart from some ad hoc measures, limited progress has been made to establish legislation which addresses outstanding problems. NonMoslem religious communities continue to experience difficulties connected with legal personality, property rights, training of clergy, residence rights and work permits for Turkish and non-Turkish clergy, schools and internal management. Action taken by the authorities to challenge the property rights of the non-Moslem religious foundations by the State is another matter of concern. There has been no progress on the status of the large non-Sunni Muslim Alevi community in Turkey. The publication of a report by a state body, the Human Rights Advisor Board, on the protection of minorities and the exercise of cultural rights, sparked a lively debate. However, there has been no further broadening of the general approach and no consolidation of the relevant legal framework, especially in the area of broadcasting and education, where severe restrictions continue to apply (SEC, 2005, 1426). Significant progress, though, has been achieved in the area of the judiciary with the adoption and the enforcement of a series of new laws which will contribute to improve the judiciary’s independence and efficiency. The prison system has continued to improve although isolation in high security prisons remains a serious problem. The training of enforcement judges has, to date, been inadequate. On the other hand, the Turkish authorities have pursued a number of training programmes on human rights targeting relevant personnel in the Ministry of the Interior, Ministry of Justice, the gendarmerie and the police. Regarding economic criteria, Turkey has made great progress in macroeconomic issues while in the field of inflation and foreign direct investment serious problems still exist. Further work is necessary as regards privatization. It should be added that the priorities of 2003 have not yet been accomplished in the economic sector, meaning that Turkey has to make further improvements. Finally, as far as the ability of Turkey to assume the obligations of membership is concerned, there has been progress in meeting the short-term priorities in a number of sectors. The legal work to complete the free circulation of goods has progressed, but is not yet complete. However, as regards competition, there has been no progress in the establishment of a state aid monitoring authority. On 4 September 2006 the European Parliament voted on a report concerning Turkey’s progress on preparing for membership. The report suggests that Turkey had made insufficient progress in the areas of freedom of expression, minority rights, corruption and violence against women (; ). Group 4: Albania, Bosnia & Herzegovina, FYROM and Serbia & Montenegro Albania, Bosnia & Herzegovina, FYROM and Serbia & Montenegro began their relations with the European Commission in the 1990’s. They are all potential

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candidates after their participation in 1999 in the Stabilization and Association Process (SAP). Albania Albania signed its first agreement with the European Commission in 1992, regarding Trade and Co-operation. At the same time, it became eligible for funding under the EU Phare programme. After that, the country gained various benefits from the Autonomous Trade Preferences with the EU while in 2000 there was an extension of duty-free access to EU markets for Albanian products. In 2001, the CARDS programme was enforced to help countries that participate in SAP, including Albania. In the same year, the Commission recommended the undertaking of negotiations of the Stabilization and Association Agreement, negotiations which were completed in February 2006. European Partnership, adopted by the Council in June 2005, focuses on assisting Albanian authorities by identifying short and medium-term priorities which are pre-requisites for Albania in order to make further progress towards its EU membership. Overall, Albania has made progress in implementing the European Partnership’s short-term priorities, but has not yet begun to concertedly address those set out for the medium term. Notable progress has however been made in the adoption of new legislation and in the formulation of action plans, although these have to some degree been hindered due to lack of political will. In the political area, after the valid elections of 2005, Albania passed new legislation in important areas such as property restitution and compensation. It has amended the Electoral Code and continued the fight against organized crime. The Parliament’s new rules of procedure have the potential to make its legislative work more rational and transparent. Besides this, Albania needs to make further efforts to improve parliamentary rules and fight corruption (SEC, 2005, 1421). As regards the priorities related to the economic situation, Albania has been successful in maintaining a stable macroeconomic framework, generally achieving IMF objectives. Progress has been achieved in removing administrative barriers in investment, and Albania’s SME agency is now operational. New legislation on the restitution and compensation of property has been adopted. Public finance management has improved considerably, with better revenue estimation and budget planning. The latter is reinforced by the new Integrated Planning System, and a new EU-compatible strategy on public internal financial control. Furthermore, improvements are necessary in social cohesion and employment. Business law has to be altered in such a way that business start-up becomes an easy and profitable task. Finally, in relation to European standards, progress has been made in the field of customs, with the fulfilment of revenue targets, improved administrative capacity, lower levels of staff turnover, better co-operation with the police and the implementation of the ASYCUDA system in Tirana, Durres, Qafe Thane, Vlora, Kakavie and Kapshtice. A Competition Authority has been established, and a new law on state aid, which provides for the creation of a state aid authority by 2006,

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The Balkans: Foreign Direct Investment and EU Accession

has been adopted. As for intellectual property, a new law provides for improved copyright protection. On the other hand, the customs services, tax legislation, public procurement and the legislative field need further upgrading. Bosnia & Herzegovina After the declaration of independence of Boznia & Herzegovina in 1992, the EU established political and economic conditionality for the development of bilateral relations (June, 1998). As already mentioned, the EU had proposed the new Stabilization and Association Process in 1999 for Boznia & Herzegovina, as well as for all the other countries in group four. In 2003, the Commission produced a feasibility study assessing Bosnia & Herzegovina’s capacity to implement a future Stabilization and Association Agreement. The Commission addressed 16 priorities and in 2005, due to the fact that the country had made great progress related to those priorities, it recommended the opening of negotiations for a Stabilization and Association Agreement. Overall, Bosnia & Herzegovina has made good progress in fulfilling the European Partnership’s short-term priorities, and has also started to address some of the medium term ones. Notable steps have been taken regarding the adoption of the required laws. In political matters, Bosnia & Herzegovina successfully conducted elections in 2005, while at the same time it made substantial efforts to support refugee and minority rights. In terms of governance, new State-level Ministries and institutions have been established and, despite some disruptions, the Council of Ministers’ functioning has improved. Positive steps have also been taken in public administration where necessary funding has been provided for the Civil Service Agencies at State and Entity levels and inter-agency cooperation has been enhanced. Furthermore, in the field of the judiciary, a single High Judicial and Prosecutorial Council has been established and the overall functioning of the judicial system has been upgraded. Defence and police reforms have also seen progress (SEC, 2005, 1422). In the economic sector, the country has made substantial efforts to improve the business environment and to produce reliable statistics. At the same time, efforts have proved fruitful in enhancing fiscal sustainability, with the domestic debt however being a major problem. Serious efforts are necessary in order for the country to continue to develop its capacity for economic planning and budget preparation, to ensure the operation of a consolidated government account, to accelerate structural reform and to further improve, the business environment on the whole. Finally, the country’s progress to reach European standards is satisfactory. Progress has been made related to internal market and the fields of justice, security and freedom. Nonetheless, the 2005 European Partnership’s requirements have only been partially met and sustained efforts remain necessary in order for Bosnia & Herzegovina to move closer to EU standards.

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It is important Bosnia & Herzegovina accelerates the removal of duplicate licences, authorisations and similar barriers within the Bosnia & Herzegovina territory in order to create a real internal market. Public procurement legislation should be properly implemented. Last but not least, continued efforts are required to implement the laws on standardisation and intellectual property, and to ensure the adequate functioning of a single business register. Former Yugoslav Republic of Macedonia (FYROM) FYROM initiated its EU relations in 1996, when it became eligible for funding under the EC PHARE programme. After one year, negotiations for bilateral agreement began while the Former Yugoslav Republic of Macedonia in 1997 signed the Co-operation Agreement, the Agreement on Trade in Textile Products and the Agreement in the field of Transport. Other than the new Stabilization and Association Process in 1999, FYROM applied in 2004 for EU membership. The year 2001 was pivotal for FYROM with the CARDS programme initiated for the SAP countries (including FYROM), along with the EU-FRY Consultative Task Force. In 2003, there was an Enhanced Permanent Dialogue which replaced the format of the Consultative Task Force. FYROM has managed to make satisfactory progress as far as political criteria are concerned. In particular, the judiciary field has undergone major reforms. Progress has been achieved in the area of human rights and in the protection of minorities, too. Nonetheless, considerable and sustained efforts will be necessary to consolidate the rule of law, to fight corruption and to make additional progress in the areas of public administration reform and respect for human rights. As far as the economic criteria are concerned, FYROM has sustained macroeconomic stability and has completed a follow-up programme with the International Monetary Fund. The process of introducing market-oriented reforms has continued, leading to a further reduction of the role of the State in the economy. However, the ‘playing field’ for economic planners remains uneven in many areas, mainly due to the lack of transparent procedures. As regards measures to improve the business environment, the legal framework for company registration has been improved and some progress has been achieved in simplifying and reducing licensing procedures. However, market entry and exit procedures are still long, partly due to insufficient clarity of property rights and weaknesses in the administration and the judiciary (SEC, 2005, 1425). Finally, the progress in reference to the priorities concerning the ability to assume the obligations of membership has been unstable. In general, while FYROM has made substantial progress in the area of legal approximation of the acquis and the elaboration of strategic documents, progress has been much more limited regarding the implementation and, especially, enforcement of the approximated legislation. All institutions should devote maximum attention to bettering their enforcement record.

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Serbia & Montenegro Serbia & Montenegro as one country attempted to achieve bilateral relations with the EU in 1997, at that point the EU Council of Ministers established political and economic conditionality for the development of these relations. After the fall of the Milošević regime in 2000, the country signed an agreement with the EU in order to be provided with assistance and support. At the same time, Serbia & Montenegro derived many benefits from the Autonomous Trade Preferences from the EU. The state of Serbia & Montenegro was composed of the Republic of Serbia, Kosovo and the Republic of Montenegro. The UN has placed the province of Kosovo under an interim international civil and military administration, following the 1999 conflict. Based on a ‘twin-track’ approach (whereby the two Republics would negotiate with the EU separately in areas where they operate separately but at the same time they would aim to abide to a single Stabilization and Association Agreement), the Council has agreed to reopen talks towards the possible EU republics’ membership. In April 2005, the Council called on the Commission to start negotiations on a Stabilization and Association Agreement ‘as soon as possible’. At the same point the Commission adopted a feasibility report which stated that Serbia & Montenegro is prepared to negotiate a Stabilization and Association Agreement with the EU. In November 2005 the Commission issued an annual progress report on Serbia & Montenegro (). Finally, in the field of the European standards, Serbia & Montenegro has made good progress. More improvements are needed in the field of legislative and public administration as well as the abolition of barriers. Comprehensive reform of the customs administration has started. The administrative capacity has been strengthened in many areas while a continuous training of customs officers is under way. As regards public procurement, there are still inter-republican obstacles due to the existence of domestic preferential schemes. Concerning business registration in Serbia, a law transferring this function from the Commercial Court to an independent agency has been adopted and is being implemented. In the anti-trust area, Serbia adopted a competition law. However, Montenegro has not yet adopted the relevant legislation. Moreover, State aid co-ordination points have been appointed to each Republic and have produced initial state aid inventory reports. In the field of intellectual property rights, a set of legislative measures was adopted on the State Union level. Implementing legislation is under preparation by the Republics. Penal provisions were somewhat strengthened in both Republics; however, ex-officio proceedings are not yet possible neither in Serbia, nor in Montenegro. Enforcement remains weak and has to be improved. Last but not least, in the field of capital movement, the system of corresponding accounts in commercial banks to ensure free movement of capital between the two Republics has not yet been established.

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Based on the results of the referendum held on 21 May 2006, Montenegro declared independence on 3 June 2006. On 28 June 2006, it became the 192nd member state of the United Nations, and on 11 May 2007, the 47th member state of the Council of Europe.

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Chapter 7

Case Studies

The importance and significance of the case studies is well known. We have decided to include as many case studies regarding multinationals that are active in South East European Economies as possible and to present and critically discuss the South East European Economies themselves. Case studies are written summaries or syntheses of real-life cases based upon data and research. With the help of these case studies we can isolate and think through the key issues involved in relation to both theory and practice and incorporate these issues within the globalized and integrated business environment. Therefore, in this way we can identify appropriate strategies for resolving the ‘case’ as well as weigh the pros and cons of the alternative options and strategies. At the end, we can recommend and present a rationale for the best possible solution. Based on the material discussed and analysed in the previous six chapters we have included 22 different case studies. We are confident that this way the reader will be able to ingest the material more efficiently.

7.1 Stability Pact for the Western Balkans The Stability Pact is the first serious attempt by the international community to replace the previous, reactive crisis intervention policy in South Eastern Europe with a comprehensive, long-term conflict prevention strategy. On 10 June 1999, at the EU’s initiative, the Stability Pact for South Eastern Europe was adopted in Cologne. In the founding document, more than 40 partner countries and organizations undertook to strengthen the countries of South Eastern Europe (SEE), ‘to foster peace, democracy, respect for human rights and economic prosperity in order to achieve stability in the whole region’. Euro-Atlantic integration was promised to the countries in the region. At a summit meeting in Sarajevo on 30 July 1999, the Pact was reaffirmed. The idea for the Stability Pact arose in late 1998 and thus predates the Kosovo war. The NATO intervention acted as a catalyst for strengthening international political will for co-ordinated and preventive action in the region. The Stability Pact is based on experiences and lessons from worldwide international crisis management. Conflict prevention and peace building can be successful only if they start in parallel with three key sectors: the creation of a secure environment, the promotion of sustainable democratic systems, and the promotion of economic and social well-being. Progress in all three sectors is necessary for sustainable peace

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and democracy. The Stability Pact is neither a new international organization nor does it have any independent financial resources or implementing structures. In the founding document of the Stability Pact, the EU, which had assumed a leading role in the Pact, undertook to draw South Eastern Europe ‘closer to the perspective of full integration … into its structures’, including eventual full membership in the EU. The European Union and its member states are collectively the most significant donors in the region. Moving toward European structures includes the possibility of full membership of the EU. Countries wishing to be admitted must, however, first meet the conditions defined by the EU Council in 1993 concerning democratic, economic and institutional reforms (Copenhagen criteria). As a contribution to the Stability Pact and an interim step towards membership, the European Union set up a new generation of Stabilization and Association Agreements (SAAs). These were aimed at the five South Eastern European countries which until then had no contractual relationship with the EU, i.e. Albania, Bosnia & Herzegovina, Croatia, FYROM and Serbia & Montenegro. The EU signed the first SAA with FYROM in April 2001. A similar agreement with Croatia was signed in October 2001; negotiations with Albania started in late 2002. The intention is to increase economic, political and social co-operation between the EU and the South Eastern European countries through a tailored instrument, the aid regulation CARDS (Community Assistance for Reconstruction, Democratization and Stabilization). An amount of 4.65 billion euros has been allocated over the period 2002–2006 to accompany and support the reforms of the countries concerned. Finally, the Stability Pact is complementary to the Stabilization and Association Process (SAP) and the accession process, and provides a bridge between the Western Balkans, the candidate countries in SEE, and the Republic of Moldova. The ultimate goal is to help the member countries to become EU members. Questions: 1. What is the Stability Pact (its goal, members, year of establishment, headquarters, etc.)? 2. Has the Stability Pact been successful for South East European countries (SEECs)? 7.2. Stability and Growth Pact The Stability and Growth Pact (SGP) is the concrete EU answer to concerns about the continuation of budgetary discipline in the Economic and Monetary Union (EMU). Adopted in 1997, the SGP strengthened the Treaty provisions on fiscal discipline in EMU foreseen by Articles 99 and 104, and the full provisions took effect when the euro was launched on 1 January 1999.

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The principal concern of the SGP was to enforce fiscal discipline as a permanent feature of EMU, as well as to safeguard sound government finances as a means to strengthen the conditions for price stability and for strong and sustainable growth conducive to employment creation. However, it was recognized that the loss of the exchange rate instrument in EMU would imply a greater role for automatic fiscal stabilizers at national level to help economies adjust to asymmetric shocks, and would make it ‘necessary to ensure that national budgetary policies support stability oriented monetary policies’. This is the rationale behind the core commitment of the SGP, i.e. to set the ‘… medium-term objective of budgetary positions close to balance or in surplus …’ which ‘… will allow all member states to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP’. Europe’s poorest countries were warned in the past that they could face heavy penalties for breaking eurozone rules even though richer countries like France and Germany were allowed to escape with impunity. Joaquín Almunia, EU monetary affairs commissioner, gave his starkest warning that poor countries could have their aid cut-off if they breached deficit rules set by the EU’s Stability and Growth Pact when he stated, ‘It’s very strong, it’s never been adopted before, but it exists and it’s worth remembering’. The threat applies to countries receiving money from the EU’s cohesion fund, paid to countries with less than 90% of the Union’s average GDP, to help fund largescale transport and environmental projects. A critical aspect of the implementation of the Maastricht Treaty and the Stability and Growth Pact is perhaps the rather unbalanced emphasis on the budget deficit. The very term: Excessive Deficit Procedure (EDP), in fact illustrates that the second reference value, keeping public debt below the limit of 60% of GDP, has been left completely in the shadow. One reason for having omitted the debt criteria may have been that certain member states (notably Belgium and Italy) had, at that time, public debt levels far above the 60% threshold. The Commission and the Council possibly considered that discussing the enormous divergence of debt levels among member states and finding valid arguments for admitting Belgium and Italy in the EMU, despite this debt level, would simply be too complicated for the political establishment to cope with. Consequently the focus was put on the deficit. It was argued, somewhat against the spirit of the Treaty provisions, that these countries were ‘on track’ to reduce the level of their debt. Nevertheless, the problem with the initial design of the SGP is that sanctions arrive too late in the process and that, as seen, the Council may not be able to take the political responsibility to impose fines on one of its own peers. It would therefore be desirable to increase the political cost of not complying with the SGP, although it is far from evident how this could be done in practice. A preferable option might be to introduce a higher degree of automatic application of sanctions in the Excessive Deficit Procedure (EDP). Another option yet could be to request a deposit of 0.2% of GDP when the Council decides that an excessive deficit exists and to release this deposit when the appropriate corrective

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measures have been taken. This would allow the Council to avoid making difficult decisions and to make more positive ones when governments have complied. Additionally, it would be desirable to strengthen the early warning mechanism. The Commission and the Council could start putting pressure on the countries sooner, through which political cost would be imposed on the governments early enough for them to be able to take a gradual approach to reducing the deficit. If the warning is made too late the government is left with drastic and unpopular options in order to regain sustainability. What is more, the costs of complying will become much higher compared to the costs of being criticized by the Commission and the Council. Again this would require more resources for long-term budgetary analysis by the Directorate-General for Economic and Financial Affairs or by an external specialised body. Some suggestions have been made as to the possibility of amending the ceiling on budget deficits; for example, raising it to 4% or varying it according to countries’ positions in their economic cycles. Still others argue that a preferable idea would be to scrap the Stability and Growth Pact because the countries need more, not less fiscal freedom, as monetary union removes its members’ discretionary control over monetary and exchange rate policies. However, this is unrealistic because the free-rider problem will arise: if a country in the EMU ran large budget deficits (thus, higher inflation, higher debt, higher interest rates), the markets could spread the pain of higher interest rates to all countries in the EMU. Refrigerated, hospitalised, dead: these were the adjectives the press used to describe the Stability and Growth Pact on the eve of the historic ECOFIN decision in 2003 not to impose sanctions on the delinquent French and German fiscal stances. The fate of the SGP was settled in the early hours of the 25 November 2003 in what was a true institutional crisis between the European Commission and the ECB on one side, demanding for the rules to be applied, and the intergovernmentalist ensemble of the eurozone finance ministers, on the other side, rejecting the application of sanctions to the leading EU member states. The official positions were clear: Romano Prodi, European Commission president, and Jean-Claude Trichet, European Central Bank president, led demands for the rules to be applied to France and Germany. Smaller countries, led by Gerrit Zalm, Dutch finance minister, suggested that Germany was exporting its excessive budget deficit to other countries through higher interest rates. At the same time, Hans Eichel, German finance minister refused to accept the Commission recommendation, backed by the threat of sanctions, to make a further €6bn ($7bn, £4.2bn) of budget cuts in 2004. France, who itself was overshooting the 3% deficit to GDP rule for the second time in a row, strongly supported Germany as did Italy, holder of the rotating EU presidency. The Italian EU presidency pushed a political declaration through, asking France and Germany to bring their deficits within the 3% limit by 2005. Eventually, the Italian compromise proposal, put forward by Giulio Tremonti, chair of the meeting, was approved by the ECOFIN. Only Austria, the Netherlands, Finland and Spain

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voted against this political declaration to suspend the operations of the stability pact for Germany and France. Spain, which had been expected to back France and Germany, linked its change of position in the ECOFIN meeting to its opposition towards the new voting rules enshrined in the new constitution increasing the weight of big countries, especially Germany and France. It seems clear that the sanctions mechanism, which was supposed to be the underpinning of the stability pact has now become unenforceable. The Stability and Growth Pact has emerged from a major crisis after the Commission took the Council to the European Court of Justice on procedural grounds, when the latter failed to take further action against France and Germany for persistent breaches of the pact’s rules. The Stability and Growth Pact was built on convergence criteria, which member states have to fulfil in order to join the single currency. During the initial negotiations leading up to the establishment of the pact, Germany was the main driving force pushing for more rigid rules. EU finance ministers reached a hard won deal on reforms to the Stability and Growth Pact at an extraordinary meeting, in advance of the EU summit of heads of state and government on 22 and 23 March 2005. In essence, the larger countries such as France and Germany won concessions making the pact more ‘flexible’ in various parts, adding up to a considerable relaxation of the rules. In return, countries such as Austria and the Netherlands have won references to ‘enhanced surveillance, peer support and peer pressure’. The two thresholds – 60% for the debt and 3% for the deficit – remain unchanged. However, there have been the following changes: No excessive deficit procedure will be launched against a member state experiencing negative growth or a prolonged period of low growth. Previously the exception was for countries in a recession defined as 2% negative growth, something virtually unheard-of among EU member states. Member states recording a ‘temporary’ deficit or one close to the 3% reference value will be able to refer to a series of ‘relevant factors’ to avoid an excessive deficit procedure. These factors include potential growth, the economic cycle, structural reforms (pensions, social security), policies supporting R&D plus medium-term budgetary efforts (consolidating during good economic times, debt levels, public investment). Countries will have two years (previously one) to correct an excessive deficit. This may be extended in cases of ‘unexpected and adverse economic events with major unfavourable budgetary effects occurring during the procedure’. To benefit from these, countries must show proof that they have adopted the correction measures they were recommended. Member states have committed to using unexpected fiscal receipts during periods of strong growth to reduce their deficits and debt. Moreover, medium-term objectives will be tailored to individual member states based on their current debt ratio and potential growth. This will vary from -1% of GDP for low debt/high potential growth countries to balance or surplus for the high debt/low growth countries.

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The Council wants to beef-up Eurostat’s resources, powers, independence and accountability. For example, as a reaction to the Greek under-reporting of statistics, it suggests that imposing sanctions on a member state ‘should be considered’ when there is infringement of the obligations to duly report government data (). Questions: 1. What do you know about the Stability and Growth Pact? 2. What do you think about the adjectives the press used to describe the stability and growth pact on the eve of the historic ECOFIN decision on 25 November 2003? (Dead, Suspended, Violated, Sleeping, Refrigerated, Hospitalized.) 3. Do you think the Stability and Growth Pact needs reforming? (a) Should we abandon it? (b) Should we change it? (c) Should we revise it? (d) Should we amend it? (e) Should we pay attention to the structure of deficits? (f) Should we postpone it? (g) Should we adopt different rules for some countries? (h) Should we enforce it? (i) Should we impose sanctions? (j) Should we consider the Economic Recession of a country and the imposition of fines in that country? (k) Should we revise only the exceptions? (l) Should we abolish it? (m) Should we change the 3% rule? (n) Should we pay attention more closely to the debt rule? 4. What do you think of the revision of SGP that took place in March 2005?

7.3 Greece in the EU and the EMU In recent decades the issue of relations between Greece and the EEC/EU has held a central position in the debate on the role of the country in the wider European family. The path of Greece towards a united Europe began on 8 June 1959, when it lodged an application for association with the EEC which was approved by the EEC Foreign Ministers on 27 July 1959 and on 10 September 1959 negotiations commenced between representatives of Greece and the EEC. This led to the signing of the Association Agreement in the Trophy Hall of the Hellenic Parliament, in Athens on 9 July 1961. The Association Agreement came into force on 2 November 1962, having first been ratified by the Hellenic Parliament on 28 February 1962. It should be stressed that Greece was the first country to sign an Association Agreement with the newly established European Economic Community. Greece’s progress towards joining a united Europe was suspended on 21 April 1967 due to the abolition of democratic institutions by a military junta. On 14 August 1974, a few days after the restoration of democracy in Greece, the country witnessed the second wave of the Turkish invasion in Cyprus. The decision taken by the then Prime Minister, Constantine Karamanlis, was not to respond with war but to exert political and economic pressure on Turkey. At the same

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time, a particularly costly programme to bolster Greek military capacity, in order to achieve and maintain a credible balance of power in order to deter Turkish aggression, was to be implemented. It is clear that if during the period 1974–1975, Karamanlis had opted to unleash a retaliatory war against Turkey, regardless of its outcome, Greece and Turkey would have been drawn into an extended period of conflict. Consequently the accession of Greece to the EEC would have been postponed or aborted and the impact on Greek political institutions would have been extremely destabilizing. On 22 August 1974, a government of national unity led by Constantine Karamanlis lodged a memorandum with the President of the EC Council of Ministers requesting immediate reactivation of the Association Agreement. This request was accepted, allowing the Karamanlis government to lodge an application for the accession of Greece as a full member of the European Community one year later. On 9 February 1976, the Council of Ministers requested that the procedure for full accession proceed, despite reservations on the part of the Commission, which requested a pre-accession period. Thus, a few months later on 27 July 1976 negotiations began between Greece and the European Community which were successfully concluded on 21 December 1978. On 28 May 1979, the Treaty on Greece’s accession to the European Community was signed in Athens in the Zappeion Hall, followed on 28 June 1979 by ratification of the Accession Treaty by the Hellenic Parliament. Two years later on 1 January 1981 the Accession Treaty came into force. Twenty-six years after Greece joined the EU (1981–2007) and began participating in the process and development of the EU architecture, it is generally accepted that accession has brought about many significant changes within the country while also influencing foreign policy. By joining the European family through its EU accession, Greece moved from the periphery or the semi-periphery to the centre of a system of international economic and political relations. In assessing the positive impact of Greece’s accession to the European Community, one has only to recall that the net transfer of financial resources to Greece, even before the 3rd Community Support Framework began to be implemented, exceeded GRD 11–12 trillion. Furthermore, the country’s participation in the EC/EU has been marked not only by the acceptance of an intensely competitive environment but also the existence of a regulatory framework whose fundamental rules are increasingly determined at a collective level. Moreover, the manner in which the Greek economy now operates has radically changed, as have relations between Greece and the rest of the world. After a long period, the Greek economy has managed to achieve macroeconomic stability which has led to the final stage of EMU, thereby ensuring monetary stability which the Greek economy had never experienced before. After 1996 in particular, Greek efforts to achieve nominal convergence were stepped up. Efforts were made to meet the Maastricht criteria for entry into the monetary core of the Union (low inflation, low fiscal deficits, etc.) and in 2000 Greece became the 12th member of the Euro area.

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It is worth noting that no other country managed to bridge the gap between its original position and the Maastricht criteria in such a short period of time. Greece has already covered much of the distance separating it from the rest of the European Union. However, as the then Prime Minister, Costas Simitis, warned in a speech at the Thessaloniki International Fair in September 2002, ‘much remains to be done in order to ensure a creative path to the future … We need a more competitive economy and above all we must acquire greater effectiveness in public administration, education, health and combat unemployment’. The years of preparation for accession (1974–1980) and the first 13 years of EC membership (1981–1993) were a period of slow but continuous maturation of Greek society, economy and institutions. It is revealing that restrictive policies and/or stabilization programmes implemented in 1979–1981, 1983, 1985–1987 and 1991–1993 did not yield permanent gains, although they did avert a further decline in the economic situation. Things started to change during the early 1990s and more clearly so since 1994, when the new ‘1994–1999 Convergence Program of the Greek Economy’ was adopted, marking a qualitative shift in the economic policy mix. The steady improvement in the economic situation meant that sacrifices had not been wasted. Moreover, since the improvement was visible, the credibility of the reform policies was increased and it was made easier for social partners to adopt a moderate stance with regard to wages and prices. The Convergence Program relied on a balanced set of policy guidelines and thus managed to generate a ‘virtuous circle’ of lower inflation-lower interest rates-lower government deficits-lower inflation. Furthermore, inflows from the EU’s Structural Funds and falling interest payments on the public debt allowed government investment to rapidly increase. Business investment also rose at record rates, precisely because of increased confidence in the economic policy (which in turn led to positive expectations) and because firms wanted to prepare for tougher competition once ‘inside’ the EMU. The structural reforms that were undertaken in this period (the liberalization of the banking system, the partial privatization of public enterprises, the independence of the Bank of Greece, the introduction of free collective bargaining and of greater labour market flexibility – just to cite a few examples) also helped. Thus, by mid-2000, Greece had fulfilled all the nominal convergence criteria of the Maastricht Treaty and as of January 2001 Greece became a full member of the euro area. Finally, Greece has been on the path of real convergence for the last ten years (1996–2007), during which Greek GDP has been rising faster than the GDP in the EU or in the euro area. Questions: 1. What was the progress of Greece regarding the EU and the EMU? 2. Why is Greece a special case study regarding its entrance to the EMU? 3. Discuss if there is a real or nominal convergence in the case of Greece.

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7.4 Krona or Euro? The Swedish Euro Referendum September 2003 The Social Democrat prime minister, Göran Persson’s first counter-attack was pretty sweeping. In 2003, in his traditional 1 May speech he rashly promised 100,000 new jobs and cheaper mortgages if voters would vote yes for the euro. However, several economists, including those loyal to him, were quick to point out that there was really no foundation for promises of this kind. Since then, the Swedish campaign has been unexpectedly free from exaggerated predictions. In this respect the political debate (euro or not) differs greatly from the 1994 referendum campaign over Swedish membership of the European Union, which was accompanied by bold headlines about the prostitutes who would flood into Sweden in the wake of membership, about the future dominance of the Catholic Church, and, from the other side, about the golden era which membership would usher in. Around this time, the key figures kept themselves quietly concerned with more rational arguments. Supporters of the euro emphasized that the opportunity of full membership in the EMU (Economic and Monetary Union) would give Sweden the power to influence European politics and to avoid ruthless currency speculation of the kind which George Soros and others had subjected Sweden to in 1993. On the other hand, opponents of the euro maintained that ‘little Sweden’ will always be an insignificant player in the European big league. They point to unemployment figures, which averaged just above 8% in the EU as a whole but were only just above 4% in Sweden. An exception to this overriding caution hit the headlines in July (but was quickly and mercilessly dispatched), when Centre Party leader, Maud Olofsson, drew a careless historical parallel between today’s euro supporters and Adolf Hitler’s attempt to create a unified Europe. She was immediately obliged to retreat in the face of widespread criticism. The rationale for the campaign was explained by the fact that the euro issue had split Sweden’s political parties down the middle into ‘yes’ and ‘no’ factions. The EU was the only political issue over which Swedish party leaders have had to relinquish a usually strict party discipline and accept that their own members actively propagate a diverging view. To understand how the Swedish political parties ended up in this unprecedented situation we must go back to the autumn of 1994 and the referendum campaign about Swedish membership of the European Union. Sweden had hitherto remained outside the EU. This seemed quite natural to most Swedes and it enjoyed the backing of a large parliamentary majority. One reason may be the fact that the Social Democrats, the dominant party had been in power for much of the twentieth century and was fairly and squarely opposed to the EU. When the party leadership decided to change its position on this, it did so without consulting or warning its own grassroots. Instead, the proposal that Sweden should join the EU was slipped in as just one point among many others in a political crisis package put before parliament. Indeed, the media debated the crisis package for a full day before anyone even noticed the EU proposal!

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Social Democrats are traditionally deeply loyal towards their party leadership, but the habit of regarding ‘abroad’ as something strange and a trifle dangerous was too deep-seated for the party to be able to change position from one day to the next. When the Swedish government eventually consulted the people over EU membership in a referendum four years later, the Social Democratic party leadership was obliged to tolerate EU opponents within its own ranks in order not to split the party and risk losing power. Over both the EU and the euro the Social Democrats have been supported unwaveringly by three of the Parliament’s non-socialist parties (Moderates, Liberals and Christian Democrats, who together hold 37.6% of the seats in Parliament). The fourth party in this quartet, the Centre Party, gave its support somewhat hesitantly to the EU in 1994 but now says ‘no’ to the euro. It came as a surprise for the party leaderships at the beginning of the campaign to discover that there are many euro opponents in the non-socialist parties (for the Centre Party the shock was rather that it harboured a good number of euro supporters). However, due to the decision of the Social Democrats to allow actively campaigning euro opponents within its own ranks, and its decision to share the publicly allocated campaign funds with both sides, it has been impossible for the other parties not to follow suit. Even more surprising for Swedish politics is the discovery that the Left Party and the Green Party, both traditionally anti-EU (together they hold 12.9% of the seats in Parliament), harbour many euro supporters who are now mustering their forces to campaign for a Europe of the Left. Thus in Sweden, where people are used to dividing up their politicians, and indeed the world, into Left and Right, an unusual situation exists today, in which both the right and left wings are represented in the ‘yes’ campaign, while young anarchists and leading industrialists stand shoulder to shoulder in the ‘no’ campaign. The 1994 EU campaign had a further legacy which complicated the 2003 euro referendum: strictly speaking, the decision about the introduction of the euro in Sweden has already been taken. Unlike the UK and Denmark, Sweden did not request an exemption from the EU treaty and is therefore obliged to adopt the euro when it has fulfilled the economic criteria. Even though referenda are advisory rather than binding in Sweden, it would be politically unthinkable to put the question to the electorate and then ignore their opinion if they give the wrong answer. There was anxiety about the possibility of voters rejecting EU membership in 1994, which plunged the Social Democrat government into this situation. During much of that campaign the ‘yes’ side trailed in the opinion polls. They did everything to convince the electorate that the opponents’ arguments with regard to the fact that the EU was on the way to becoming a super-state, was not true. The EU supporters dismissed the contention that the EU would soon have a common currency by maintaining that Sweden would be free to choose at a later date whether the country should adopt the euro or not. This is perhaps somewhat remarkable. Nonetheless, in Brussels in the aftermath of the membership negotiations, the Swedish minister read out the following statement to his EU colleagues: ‘The Swedish parliament will decide the time for entering the final

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phase of the EMU with full regard for the Treaty’. Göran Persson is however not the kind of politician to intervene to solve a problem before it is absolutely necessary. Even though all the opinion polls indicated a considerable lead for the ‘no’ vote, it was far from a foregone conclusion that the electorate would at the final moment reject the euro on 14 September 2003. The euro supporters’ strongest card in the campaign was Göran Persson himself. Persson was seen by the Swedes as having strong credibility on the euro issue. He was himself opposed to the euro in the mid-90s when Sweden joined the EU. He predicted that a common currency would eventually necessitate more common and centralised economic policy-making and saw this as a threat to ‘the ancient right of the Swedish people to tax themselves’ (a passage in the Swedish constitution which is traditionally seen as a pillar of Swedish democracy). Persson even went so far as to call the euro project ‘risky and shaky’ in a Financial Times interview. But, since then Göran Persson acquired solid experience of EU cooperation and became a convert. He said that he had ‘been on a journey’ and arrived at the conclusion that the euro would be good for Sweden. The fact that Persson spoke aloud about his doubts and let the electors follow every step along the path towards his conversion made him credible in their eyes. He doubted, reflected and weighed things up. Then said ‘yes’. Sweden’s six-month presidency of the EU in 2001, in particular, contributed much to the domestic view of Göran Persson as a genuine statesman, who shook hands with George W. Bush one day and with Vladimir Putin the next. Even though Göran Persson is not a particularly popular person, his words carry such weight that the euro opponents had a tough fight ahead of them if they were to maintain their lead and win the campaign against the introduction of the euro in Sweden. The final result (referendum 2003) shows 56.1% voting against the euro, with only 41.8% in favour, on a turnout of 81.2%. Prime Minister Göran Persson conceded defeat on Sunday evening, saying he was ‘not surprised’ by the failure of his pro-euro campaign. Lindh was the main proponent of the ‘Yes’ campaign, and after her stabbing in a Stockholm department store most opinion polls showed support for the euro. However, the ‘No’ side was able to hold on to the majority it had throughout the campaign. BBC’s Chris Morris in Stockholm said that Sweden would vote on the euro again, but was likely to remain outside the eurozone for at least a decade. The result shows that the euro has failed its first test since the new notes and coins were introduced at the beginning of 2002. Nonetheless, the EU claimed that the euro had brought advantages to the eurozone economy, providing ‘much-needed stability’ in member-states’ economies. It declared its confidence that the Swedish Government would ‘keep the euro project alive in Sweden’. All of Sweden’s main political parties had campaigned in favour of euro membership, along with the business community. However, the ‘No’ camp struck a chord with voters by pointing out that Sweden had a higher growth and lower unemployment rates than the eurozone. The ‘No’ campaign also benefited from fears that euro membership could lead to the erosion of Sweden’s generous welfare

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state. What is more, both the ‘Yes’ and ‘No’ sides stopped campaigning after Lindh was fatally stabbed and both promised to respect the result of the vote. Lindh, aged 46, was one of the country’s best-loved politicians, and a rising star who many thought could be the next prime minister. Her death prompted an outpouring of grief, including a rally against violence which was the biggest demonstration in Sweden since the Vietnam War. Mr Persson said the result was easy to accept because the margin of victory was convincing, the turnout was high, and the issues had been thoroughly debated. He added, however, that the timing – with some eurozone countries having difficulty controlling their budget deficits – had been unfortunate. Questions: 1. Is Sweden a member of the EU? 2. Has Sweden introduced the Euro currency? 3. Why were Swedish people pressured to vote against EMU accession?

7.5. The Copenhagen Political and Economic Criteria for the Case of Romania (1993–2006) The Copenhagen Political Criteria, adopted by the European Council in June 1993 reads: ‘membership requires that the candidate country has achieved stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for and protecting of minorities’. The Copenhagen Economic Criteria requires: the existence of a functioning market economy; the capacity to cope with competitive pressure and market forces within the Union. In its 1997 Opinion on Romania’s application for EU membership, the Commission concluded that: Romania’s new institutions are democratic and their stability now seems guaranteed. They do, however, need to be anchored by greater respect for the primacy of law at all levels of the apparatus of State. Elections are free and fair; they led to a genuine change-over in November 1996. There remain a number of shortcomings with regard to respect for fundamental rights, even if the measures adopted and the undertakings given by the Romanian authorities since November 1996 are steps in the right direction. For instance, much still remains to be done in rooting out corruption, improving the working of the courts and protecting individual liberties from the activities of the police and secret service campaign or in the course of criminal proceedings. By the same token, even if the Hungarian minority seems well integrated (given the recent improvement in its situation), the same cannot be said for the Roma (gypsies), who constitute a sizeable minority in the country. Lastly, the reforms concerning the protection of children in orphanages are a major step forward but have still to bear fruit. The

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improvement now under way since the new government came to power suggests that Romania is on the way to meeting the political conditions laid down by the Copenhagen European Council.

In its 2002 Regular Report, the Commission found that: In its 1997 Opinion, the Commission concluded that Romania fulfilled the political criteria. Since then, the country has made progress in consolidating and deepening the stability of its institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities. This has been confirmed over the past year. Romania continues to fulfill the Copenhagen political criteria. Positive developments took place with regard to the treatment of minorities. Legislation extending the official use of minority languages was implemented relatively smoothly. Important steps were taken to implement the National Strategy for Improving the Condition of Roma, with the aim of effectively combating discrimination and improving living conditions, although additional financial resources will be necessary to make further progress.

A major constitutional revision was adopted in Romania following a referendum in October 2003. It introduced changes that are required for EU accession, as well as for reforming the parliamentary and judicial systems. However, government methods used to encourage voter turnout provoked criticism from independent observers. The Protocol on Romania’s accession to NATO was signed in Brussels in March 2003. Romania has achieved stability in its institutions guaranteeing democracy and the rule of law. This was the conclusion of the 1997 Opinion and the subsequent Regular Reports, and has been confirmed by subsequent developments. Romania also continued to respect human rights and fundamental freedoms. Relations with the Hungarian minority continued to be good and further progress was made during the reporting period. The revised Constitution enshrined the right of national minorities representing a ‘considerable proportion’ of a local community to use their own language when dealing with local authorities. The constitutional revision also introduced the right for Romanian citizens belonging to national minorities to use their mother tongue in court proceedings. Thus, Romania continues to fulfil the political criteria. In its 1997 Opinion on Romania’s application for EU membership, the Commission concluded: ‘Romania has made considerable progress in the creation of a market economy’; but that it, ‘would face serious difficulties coping with the competitive pressure and market forces within the Union in the medium term’. In its 2002 Regular Report, the Commission found that: Romania has continued to make progress towards being a functioning market economy, for which the prospects have improved. Sustained and full implementation of planned measures together with the completion of the reform

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Despite a less favourable international environment, economic growth remained robust. Further progress towards economic stability was achieved but macroeconomic risks have recently increased. The Romanian economy grew by 4.9% in 2002 and expanded for the fourth year in a row in 2003 as GDP rose by 4.3% year-on-year during the first semester. Against this favourable background, further gains towards domestic Stabilization were achieved as inflation fell more than targeted. The gradual reduction of inflation rates from relatively high levels continued in 2003 after advancing more than targeted in 2002. Carrying on the trend that started in late 1999, the average inflation rate dropped further, to 22.5% in 2002. After falling to 17.8% by December 2002 against an official target of 22%, the year-on-year inflation rate declined to 14.2% in August 2003. Romania can be considered as a functioning market economy once the positive progress made to date continues over a sustained period. In addition, a vigorous and sustained implementation of its structural reform programme is required in order to enable Romania to cope with competitive pressures and market forces within the Union in the short term. Despite solid economic growth, Romania has made little progress in real convergence towards EU per capita income levels. Catching up to levels of income and productivity reached elsewhere in Europe remains a major challenge for Romania. In 2002, GDP per capita in purchasing power standards increased slightly to 25% of the EU level. The latest available data suggests that regional income disparities are increasing. This is largely due to above-average growth in the Bucharest region where the 2000 per capita income was more than double the national average and nearly three times above that of the poorest region. Corruption in Romania continues to be widespread and affects all aspects of society. A number of high-profile measures were launched over the reporting period – however the implementation of anti-corruption policy as a whole has been limited. The measures taken have yet to have an impact and substantially increased efforts are needed. As at 2005–2006 Romania continues to respect human rights and fundamental freedoms, and has made good progress in a number of important areas. Romania also continues to fulfil the political criteria. Romania has made steady progress with the adoption of the acquis and is on track to transpose the required legislation before the planned date of accession, provided the current pace of progress is maintained. Weaknesses in the legislative process mean that the quality of legislation transposed is uneven and in some cases revisions will be necessary before laws can be implemented. In the accession negotiations, 20 chapters were provisionally closed. The commitments made in the negotiations are with a view to accession in 2007. They are generally being met, although delays have been noted in certain specific areas. Finally, Romania closed all chapters and entered into the EU in January 2007.

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Questions: 1. Which is the content of the Copenhagen criteria? 2. What progress did Romania make in 1997 and 2007, regarding the Copenhagen political criteria? 3. What progress did Romania make in 1997 and 2007, regarding the Copenhagen economic criteria? 4. Do you believe that real convergence of the Romanian economy towards the EU has been accomplished? 5. What is your opinion of corruption in Romania?

7.6 Restructuring and Privatization: The Case of OTE and Romtelecom in Romania (1996–2005) OΤΕnet S.A. (), a product and internet services provider, was established in 1996, under an initiative of the Hellenic Organization of Telecommunications (OTE). It is the capstone of its business strategy in the new technologies sector. ΟΤΕnet offers to home users and enterprises, access services to the Internet, data and voice IP-based telecommunications services, as well as IT applications and Internet based hosting services. The constant investments in networking infrastructure, the development of new products and services covering the needs of modern businesses and home subscribers, the excellent customer support and the flexible organizational scheme are the main characteristics that hallmark OTEnet as a leader in the Internet. Today, all its clients have at their disposal the quality, reliability, speed and consistency of the largest Internet Services Provider in Greece. COSMOTE is the leading mobile operator in Greece despite its entrance in the market five years later than its two main competitors (Vodafone and TIM/ Wind). A pioneer and market leader on all fronts, COSMOTE has over 4.5 million customers in Greece and over 7.9 million customers in S.E. Europe. Being the operator with the widest presence in the region, COSMOTE (apart from Greece) successfully operates in Bulgaria, Albania and FYROM through GloBul, AMC and COSMOFON respectively, while its subsidiary in Romania, COSMOTE Romania, recently launched commercial operations. COSMOTE played a prominent role in the success of the ATHENS 2004 Olympic Games, as a Grand National Sponsor of the event. Moreover, in June 2004, the company exclusively launched i-mode® services in Greece, while it intends to gradually launch i-mode services in all countries of its operations. Finally, COSMOTE shares trade in the Athens and London Stock Exchanges. The privatization of the Romanian national telecommunications operation, ROMTELECOM, was initiated on 18 December 1996, as indicated by a letter of intent sent to EBRD, where the Romanian Government made the commitment to start the privatization process. In March 1997, the Communications Ministry

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nominated ten companies in order to select one of them to act as financial, legal and technical consultant for the ROMTELECOM privatization: ABN AMRO Bank (N.M. Rothschild & Sons Ltd.), Credit Suisse First Boston (Europe) Ltd., Goldman Sachs, J.P. Morgan, Lazard Houses, Lehman Brothers (LCF Rothschild), Merrill Lynch International, Morgan Stanley & Co. Ltd., SBC Warburg (Investmentbank Austria), and Union Bank of Switzerland Ltd. (Creditanstalt Investment Bank AG). In July 1997, the US-based investment bank Goldman Sachs International was assigned as consultant for the Romtelecom privatization with the key objective to identify and bring forward the interest of a potential strategic investor. The detailed privatization programme included the revision of Romanian current legal, tariff and licensing policies, an evaluation of ROMETELECOM, a sales strategy development, a market research regarding the best moment for selling shares, and the preparation of the tender documents. As of 31 October 1997, after the Government Resolution No. 673/1997 was published in the Official Gazette, the State-owned independent company ROMTELECOM became a joint-stock company. In March 1998, the Communications and Privatization Ministries published the names of the companies interested in buying 35% of ROMTELECOM stock: (1) Deutsche Telekom; (2) France Telecom; (3) Koninklijke PTT Nederland – KPN; (4) OTE Greece; (5) Southwestern Bell Communications (SBC) Inc. – SBC USA; and (6) Societa Finanziaria Telefonica – STET Italy. In order to select the strategic partner, the Romanian officials were to take into account certain criteria such as a commitment to achieve the network development objectives, the commitment to ensure an increase in service quality through knowhow and training for the company staff, proposals on restructuring and improving ROMTELECOM effectiveness, the commitment to provide government support for future stock sale, and the price offered for the stock on sale. The prerequisite criteria included an extensive experience in developing and operating networks, with having at least 1 million fixed telephony service subscribers or at least 200,000 mobile telephony service subscribers. Furthermore, the telecommunications service turnover of the preceding financial year had to be at least US$1 billion. In April 1998, the US-based company SBC left the competition. In May 1998, OTE signed a Management Agreement-Alliance with the US-based concern GTE on joint co-operation in case they won the bid. As of June 1998, ROMTELECOM stock was transferred from the Communications Ministry to the State Ownership Fund. Later on, in August 1998, the Dutch company KPN also left the competition, followed, in September 1998, by SBC. In November 1998, STET and OTE issued their final bids for privatization. During the same month, the Co-ordination Committee for the privatization of ROMTELECOM indicated the Hellenic company OTE as winner of the bid. In July 2005, the Greek telecommunications company Cosmote (OTE) bought a 70% stake in the Romanian wireless operator Cosmorom from fixed line incumbent RomTelecom for €120 million. This gave them the responsibility to finance the lossmaking cell company. This move followed OTE’s previous purchases of stakes in

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parent RomTelecom – 35% in 1998, and a further 16%, bringing its overall holding to 54.01% in 2002. The remainder is held by the government. RomTelecom, which remains a 30% stakeholder in Cosmorom, says that the capital raised by the latest sale will be poured back into GSM network development. Cosmorom became Romania’s third digital mobile operator when it launched GSM services in May 2000. Since 2001, however, it has seen a relentless decline in its fortunes. It originally had serious ambitions to narrow the gap between itself and the country’s two dominant operators, MobiFon and Orange Romania, through launching a strong pre-paid offering and incentives such as free WAP access and discounted handsets. However, the drawn-out privatization of parent RomTelecom severely depleted investment and stopped any momentum it had built up. As a result, Rom Telecom failed to roll-out a full nationwide network and could not attract enough customers. At the end of March 2005 it held less than a 1% share of the market. As part of its international investment strategy, OTE Group has acquired stakes in telecom companies mainly in the area of South-East Europe. More specifically, OTE has acquired stakes in Telecom Serbia (20%), in ArmenTel, Armenia (90%), and in Romtelecom, Romania (54%). OTE is also present in the mobile telephony market of Bulgaria through GloBul and in the Former Yugoslav Republic of Macedonia through Cosmofon. OTE subsidiary, COSMOTE, acquired recently both Globul and Cosmofon, while it also owns 85% and manages the mobile telephony company AMC (Albania). Moreover, at the end of June 2005, COSMOTE’s Extraordinary Shareholders Meeting approved COSMOTE’s participation in the share capital of the Romanian mobile operator, CosmoRom, with a 70% stake, while RomTelecom retains a 30% stake (Table 7.1).

Table 7.1  Mobile operators in associate candidate countries (ACC) and Western Balkan countries (WBC) Country

Company

Status

System

Partnership

Albania

AMC

Private

GSM 900

Vodafone

Private

GSM 900/1800

Eagle Mobile

State-owned

GSM 900/1800

85% Cosmote GR, Telenor ASA NO, 15% Albanian State 51% Vodafone Group, 49% Vodafone GR 100% Telecom Albania (Albtelekom)

BH Telecom

Semi-public

GSM 900

Mobilna Srpske (MOBI’S) ERONET

State-owned

GSM 900

Private

GSM 900

Bosnia & Herzegovina

90% BiH State, 10% Private shareholders 100% Telekom Srpske 49% HT d.o.o., Zagreb, HR, 51% HT d.d. Mostar, BiH

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Table 7.1  continued Country

Company

Status

System

Partnership

Bulgaria

Mobikom

Private

Globul

Private

MobiTel AD (M-TEL)

Private

UMTS/NMT 450/ GSM 900/1800 UMTS/GSM 900/1800 UMTS/GSM 900

100% Bulgarian Telecom (BTC) 100% Cosmote (OTE Group), Greece 40% ABN AMRO Cap, Citigroup Inv. 60% founding shareholders

Vipnet T-Mobil

Private Private

100% Mobikom Austria 100% Deutsche Telekom

Tele 2

Private

UMTS/GSM 900 UMTS/NMT 450/GSM 900 UMTS/GSM 900/1800

Turkcell

Private

GSM 900

Telsim

State-owned

GSM 900

TT & TIM (AVEA)

Private

GSM 1800

FYROM Cosmofon MT (Mobimak)

Private

GSM 900

Private

GSM 900

40.28% Cukurova Group, 37.09% Sonera Holding, 6.07% M.V. Group free float 16.33%, and 0.23% Turkish Government (takeover for debt resolution) 40% Telecom Italia Mobile (TIM), 40% Turk Telecom (TT), 20% Turkiye IsBankasi Group (ISBANK) 100% Cosmote (OTE Group), Greece 51% Stonebridge Com. MATAV, 47,1% Government, 1.9% IFC

Connex GSM (Mobifon SA) CosmoRom

Private

UMTS/GSM 900

Private

GSM 1800

Orange Romania

Private

Zapp Mobile

Private

Croatia

Turkey

Romania

100% Tele 2 AB, Sweden

100% Vodafone UK

70% CosmOTE, 30% RomTelecom (54.01% OTE, GR, 44.99% Romanian Government) UMTS/GSM 96.6% Orange (France 900/1800 Telecom Group), 14.28% Polish investment funds NMT 450, CDMA 99.53% INAQUAM SA, 2000 Others with less than 0.3% each SCG

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Table 7.1  continued Country

Company

Status

System

Partnership

Serbia

Telecom Serbia Mobtel Srebjia Monte-negro Monet

Semi-Public

GSM 900

Private

GSM 900

Semi-public

GSM 900

Pro Monte

Private

GSM 900

80% PE PTT Serbia, 20% OTE Greece 51% BK Trade, Moscow, RU, 49% Telecom Serbia 100% Telekom Crne Gore (51.12% Government, 28.86% Citizens., 20.02 private inv. funds) 100% Telenor Mobile Comm., Norway

Vala 900

Semi-public

GSM 900

(MobitelMobikos)

Private

GSM 900

Kosovo

76% PTK Kosovo, 23% Monaco Telecom Mobitel, Slovenia; Mobikos, Kosov

Source: Table adapted from Verikoukis, Ch. et al. © 2005 IEEE.

Questions: 1. What do you think about the privatization of RomTelecom? 2. Is it a successful privatization deal? 3. Are you in favour of restructuring before or after the completion of the privatization deal? 4. What do you think about OTE’s global investment strategy? 7.7 FYROM and its Path to EU Accession (2000–2004) A number of measures have been taken which indicate a wish to accelerate EU oriented reforms within the Stabilization and Association Process (SAP). These measures include better co-ordination in the implementation of obligations deriving from the contractual relationship between the Former Yugoslav Republic of Macedonia and the EU, and recommendations made within the SAP. The government’s decision to solve the problem caused by infringement of the Interim Agreement in the OKTA refinery case was welcomed. The implementation of the Stabilization and Association Agreement (SAA) substantially increased the range and level of co-operation which already existed between the former Yugoslav Republic of Macedonia and the EU. Most structures, including Parliamentary ones, have been put in place too quickly to demonstrate their capacity to make a breakthrough in accelerating the reform process implied by the SAA. The link between strategic priorities and the definition and mobilisation of resources should be clarified. In addition, further

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involvement and mobilisation of all ministries is required in order to sustain the wide range of reforms on the government agenda. As far as the internal market related legislation is concerned the situation is obscure. Progress has been made in the areas of competition, state aid, property rights and Customs; however little change has been seen in the areas of procurement and data protection. In all areas, implementation capacity remains weak. The structural reform process regained momentum in the course of 2003. The Action Plan for the restructuring, liquidation or privatization of 40 large lossmaking enterprises, which was launched in 2000, was finally completed. The authorities then focused on a new priority: private sector development. In September 2003, the Parliament approved a law setting up the Agency for Promotion of Entrepreneurship. However, the generally poor business environment and, in particular, the inability to effectively enforce contracts and creditors’ rights hampered the lending activity of the banks. This in turn affected investment and economic development. Banking supervision in the country improved, with banks attempting to implement a new regulation on consolidated accounting and banking supervision. In 2003, the difficulties of some (mainly small) banks did not affect the financial stability of the whole system. Competitiveness and efficiency of the banking sector must improve in order to allow easier access to finance for SMEs. Finally, progress was made in the implementation of the pension reform programme. Between 1992 and 2003 the Former Yugoslav Republic of Macedonia (FYROM) benefited from European Community assistance of approximately €677 million. In 2003, €43.5 million was allocated to the country under the CARDS Programme, on the basis of the priorities set out in the Country Strategy Paper, covering the period 2002–2006 and under the Multi-annual indicative programme for the period 2002–2004, adopted by the European Commission in December 2001. Steps were taken to develop a strategic approach in certain areas such as integrated border management and the fight against organized crime and corruption. Moreover, the regional dimension has also been developed as bilateral agreements for co-operation with Bulgaria, Albania, Serbia & Montenegro and UNMIK/Kosovo have been signed. There have been measures taken to more efficiently tackle organized crime. As a follow up to commitments taken at the London Inter-ministerial Conference (November 2002), there has been implementation of specific action-oriented measures against organized crime. Moreover, the Constitution has been amended to enable the use of special investigative techniques. Furthermore, law enforcement activities against human trafficking have become more effective, even if a low conviction rate relative to arrests has however emerged as an area of concern. In this respect, the development of witness protection programmes and the provision of specific training for the Police and prosecutors are steps in the right direction. The possibilities raised by the action oriented measures against organized crime for cooperation in the region in relation to witness protection should be utilized.

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Temporary residency status for victims of human trafficking should be considered as well. Still, more needs to be done. Finally, changes in the legal framework (in the criminal procedure, the criminal code, and in the protection of witnesses and victims legislation in particular) are needed to allow for the implementation of the Constitutional amendment. In 2003, economic growth in FYROM recovered and inflation remained low. Monetary stability was maintained and the general government deficit was reduced by 4 percentage points compared to the previous year, to a low 1.5% of GDP. The most worrying signal came from the persistently high unemployment rate. Moreover, the level of foreign direct investment was lower than the low 2002 level, reflecting the perception of political risk and the difficult business environment. The agreement reached with the IMF in April 2003 on a new 14-month standby Arrangement, contributed to the maintenance of a stable macroeconomic and fiscal framework and allowed the release of substantial foreign financial assistance from donors. What is more, some steps have been taken not only in relation to transport and energy within regional initiatives, but also to encourage Small and Medium Enterprises (SMEs). However, due to the difficult economic situation and the fragile social context, little progress can be reported in relation to the changes that important sectors of the country’s economy need to make. The government has made concrete efforts to implement the Ohrid Framework Agreement (a peace deal between the government of FYROM and ethnic Albanians signed on 13 August 2001) and most signatories to the Agreement have kept to their pledge to support it. Willingness to compromise on a number of sensitive issues, including the creation of a new state university in Tetovo, has strengthened the coalition and should ease inter-ethnic mistrust. However, some opposition representatives have questioned the very principles of the Agreement. According to the EU Opinion dated 9 November 2005, the Former Yugoslav Republic of Macedonia (FYROM) is well on its way to satisfy the political criteria for the EU membership. It is a functioning democracy, with stable institutions which generally guarantee the rule of law and respect for fundamental rights. The country signed a Stabilization and Association Agreement with the EU in 2001 and has generally fulfilled the related obligations in a satisfactory manner. It has successfully implemented the legislative agenda of the Ohrid Framework Agreement, which has improved the political and security status. However, the country needs to make additional efforts to improve the electoral process, to implement reforms in the judiciary and the police, and to tighten the fight against corruption. As for the economic criteria, FYROM has taken important steps towards establishing a functioning market economy. However, on the basis of the situation in 2005–2006, the Commission considers that the country would not be able to cope with the competitive pressure and market forces within the Union in the medium term. The path of economic reform needs to be pursued with vigour, especially in areas such as land and property registration, improving the business

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274

climate, making the country more attractive to domestic and foreign investment, decreasing the size of the grey sector, and improving the functioning of the labour market and the financial markets. On the country’s ability to assume the obligations of membership, the Opinion contains a detailed analysis based on the 33 chapters of the acquis which will eventually serve as the basis for accession negotiations. Overall, FYROM should be in a position to take on most of the obligations of membership in the medium term (five years), but major efforts to ensure the effective implementation and enforcement of legislation will be necessary. Moreover, the Commission considers that the country might not be able to comply with the requirements of the acquis in the medium term in the areas of technical norms and standards, protection of intellectual property rights, competition policy, and financial control, unless efforts are speeded up considerably. Full compliance with the acquis in the field of environment could be achieved only in the long term and would necessitate increased levels of investment. New legislation and action plans, especially on decentralization and securityrelated reforms, now need to be followed up with implementation and enforcement. The reform of the judicial system, the rule of law and the fight against corruption remain areas where energetic measures are needed. Constructive commitment by all political parties, co-operation among the institutions, and a sense of ownership at different levels of government are needed to accelerate the pace of reform. The final data in 2005–2006 showed an increase both in the number and the percentage of the country’s ethnic Albanian population – from 22.7% to 25.17% – as well as a slight increase in the ethnic Macedonian population, although their percentage of the overall population decreased (to 64.18% from 1994s peak of 66.6%). Finally, more than 90% of the population supports membership of the EU. Questions: 1. In which stage of progress can we find FYROM as an acceding country at present? 2. What are the prospects of FYROM for EU accession? 3. What are the problems in FYROM? 7.8 FDI Motives/Obstacles in the Manufacturing Sector in FYROM in 2006 The issue of foreign direct investment (FDI) has increasingly triggered the interest of academics and practitioners worldwide over past decades. Besides the academic challenge of capturing the ‘rules of the game’ of this lively changing phenomenon, it is the tremendous impact that FDI exerts on the economic development of the host countries and the competitive positioning of the Multinational Enterprises (MNEs) in a climate of fierce global rivalry that explains the magnitude of the

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attention received. The emergence of the new independent states that followed the dissolution of the former socialist federations and alliances and their reorientation towards market economy, simultaneously meant the opening of these countries to foreign investment and the emergence of a completely new field of FDI research. Yet, the expectation that the opening of relatively unexplored and opportunity rich regions would attract substantial FDI, seems to have been overly optimistic, especially for the Southeast European Countries (SEECs): Albania, Bosnia & Herzegovina, Bulgaria, Croatia, FYROM, Romania, and Serbia & Montenegro. For the period 1990–2004, they managed to attract US$44.224 million, which was three times less than the FDI amount of US$145.096 million that was attracted by the three core Central and Eastern European Countries (CEECs): the Czech Republic, Hungary, and Poland. In particular, FYROM succeeded in attracting only US$1.183 million. This is by far the lowest FDI inflow among the countries under observation. The unsatisfactory performance of SEE, except for Croatia, is even more visible if measured as FDI inward stock per capita. Albania, Bosnia & Herzegovina, FYROM and Romania have gone from 432 US$ to 740 US$ per capita FDI in 2004, lagging far behind the Czech Republic and Hungary. Expressed on a regional level, the average FDI stock per capita in 2004 was 865 US$ in SEE, compared to the much higher figure of 2,479 US$ per capita in the three CEE countries. The performance of FYROM in attracting FDI was even below the regional average, amounting to 584 US$ per capita in 2004 (see Tables 7.2 and 7.3). The limited inflow of FDI in FYROM and hence its very modest potential to bring the critically needed beneficial effects to the economy heavily suffering from a high unemployment rate and trade deficits, technological obsolescence, and insufficient domestic savings and investments, was the primary reason to research the FDI determinants of the country’s manufacturing sector. The selection of this sector was primarily caused by its strong contribution to increasing employment and exports and was also inspired by Alfaro’s (2003) claim that FDIs in manufacturing exert the strongest effect on a country’s economic growth. The decision to investigate FDI was also motivated by the absence of relevant research on FDI determinants in the country and, particularly, the minor importance that the manufacturing sector has received in the existing literature.

  Due to the unavailability of population data for 2004, the data for 2003 were used as most appropriate approximation for 2004.

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Table 7.2  FDI inward stock in millions of US$ Region/ 1994 Economy

1995

1996

1997

1998

2000

2001

2002

2003

2004

SEE – 7 Albania

1902 211

2890 301

5972 349

9773 13456 17116 394 437 580

21624 787

25786 922

34287 1100

44224 1441

1199 141

1999

–

–

–

–

67

244

390

509

777

1159

1657

Bulgaria

248

338

447

952

1489

2308

3310

4123

5028

7125

8928

Croatia

237

351

862

1400

2335

3807

4894

6458

7584

9626

10702

FYROM

24

33

44

74

202

235

410

852

930

1026

1183

Romania Serbia & Mont. CEE – 3 Czech Republic Hungary Poland

549

969

1236

2457

4433

5460

6517

7675

8816

11012

16080

–

–

–

740

853

965

1.015

1.220

1.729

3.239

4233

BiH*

12897 23952 33211 43593 57026 73929 91021 106305 121917 130296 145096 1523

4085

5513

6813 10531 16855 21841

27482

35965

38066

42529

6726 11560 14893 19067 22417 25726 28489 4648 8307 12805 17713 24078 31348 40691

32418 46405

35416 50536

37571 54659

41749 60818

Note: * BiH = Bosnia & Herzegovina. Source: UNECE (2005).

Table 7.3  FDI inward stock per capita in US$ 1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Albania BIH*

46 –

69 –

98 –

113 –

129 18

143 66

189 103

256 134

298 203

354 302

463 432

Bulgaria

29

40

53

115

180

281

405

521

639

911

1141

Croatia

51

75

192

306

519

836

1117

1455

1707

2167

2409

FYROM

12

17

22

37

101

117

203

419

458

506

584

Romania Serbia & Mont. Czech Republic Hungary Poland

24

43

55

109

197

243

290

343

404

507

740

–

–

–

70

80

91

95

115

213

397

519

147

395

534

661

1023

1639

2126

2688

3526

3731

4169

655 121

1130 215

1461 332

1878 458

2216 623

2555 811

2842 1064

3182 1213

3486 1322

3709 1431

4121 1592

Note: * BiH = Bosnia & Herzegovina. Source: UNECE (2005).

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The research is based on the primary source of data, collected via questionnaire surveys of foreign companies in the manufacturing sector in FYROM. The basic criteria for selecting foreign companies to be investigated were their operations in the manufacturing sector according to NACE classification of economic activities, realized investment project, and a minimum of 30% foreign capital stake. The companies were selected from the database of the State Statistical Office, which is based on the data from the Central Register and includes all active enterprises with foreign (100%) and mixed capital (any foreign capital participation different than 0% and 100%). According to this database, the total number of companies with foreign capital participation as of 31 December 2004 was 482, thereof 206 companies with 100% foreign capital and 276 companies with mixed capital. As some of the companies with mixed capital have a foreign capital participation of less than 10% (no data on the exact number of these companies is available), the real population entails less than 482 companies. The survey was launched on 9 November, 2005 and was completed on 10 February, 2006 (see also Bitzenis, Marangos and Nuskova, 2007). In total, 165 companies were contacted and 79 completed questionnaires were gathered. This represents 16.4% of the total population. As expected (see Figure 7.1), research results revealed that low-cost unskilled labour was perceived as the most serious motive for attracting investment in the manufacturing sector in FYROM. This motive was cited as important/very important by 80% of the respondent companies and is followed by the exploiting of ownership advantages factors such as existing business links and know-how with 71% and 65%, respectively, geographical proximity (65%) and access to regional market (61%). Other top ranked motives include expected economic growth (56%), economy of scale (55%), corporate tax relief (53%), low income tax (50%) and links to neighboring countries (50%). Notably, the market factors (market size, access local market, and expected local market growth) ranked relatively low, being cited by less than half of the surveyed companies (from 24% to 43% of the respondents).

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The Balkans: Foreign Direct Investment and EU Accession

80%

Lo w-co st unskilled labo ur 71%

Existing business links Kno w-ho w

65%

Geo graphical lo catio n (pro ximity)

65% 61%

A ccess regio nal market

56%

Expected eco no mic gro wth

55%

Eco no my o f scale

53%

Co rpo rate tax relief Lo w inco me tax

50%

Links to neighbo uring co untries

50%

Stro ng branding

49%

First mo ver advantage

49% 48%

A vailability o f skilled labo ur

44%

Eco no mic stability

44%

A vailability o f raw materials

43%

A ccess to lo cal markets Lo w co st skilled labo ur

43%

Stable exchange rate

42%

Favo urable eco no mic climate fo r investment

42% 40%

P hysical infrastructure

38%

P o litical stability

37%

So cial stability

35%

Risk diversificatio n Eco no my o f sco pe

33%

Expected lo cal market gro wth

32% 31%

M o no po listic o r stro ng market po sitio n

29%

Cultural similarities and histo rical links

28%

To fo llo w co mpetito rs To avo id tariff barriers

24%

M arket size and inco me per capita

24%

Figure 7.1  Frequency of general ratings as ‘important’ and ‘very important’

Source: Bitzenis and Nuskova (2009, forthcoming).

The respondents’ ranking of the obstacles (see Figure 7.2) clearly distinguished the bureaucratic and administrative constraints (82%), corruption and bribery (68%), lack of law enforcement (67%), economic crime (64%), and slow transition and reforms (62%) as the major investment obstacles. These are followed by the

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insufficient legal and administrative framework (58%), unstable legal system (56%), mafia (55%), and underdeveloped business infrastructure (55%) obstacles. In view of the fact that the top three obstacles are frequently cited as major reasons that inhibit FDI inflows in the country, should not surprise us.

71%

B ureaucractic and administrative co nstraints

68%

Co rruptio n and bribery

67%

Lack o f enfo rcement o f law

64%

Eco no mic crime

62%

Slo w transitio n and refo rms

58%

Insufficient legal and administrative framewo rk

56%

Unstable legal system

55%

M afia

55%

Underdevelo ped business infrastructure

51%

Unfavo urable eco no mic climate fo r investments

49%

Custo m tariffs and po licy co nstraints Co mpetitio n fro m the grey eco no my

42%

Lack o f physical infrastructure

42%

Lo w co nsumer purchasing po wer

42%

P o litical instability and uncertainty

41%

Lo w eco no mic gro wth

41% 37%

Insufficient lo cal market gro wth

37%

Small size o f the lo cal market

35%

So cial instability

32%

Lack o f security

32%

Tax system

29%

Eco no mic instability

24%

Cultural co nstraints

21%

B ehavio ur against fo reign investments Exchange rate Lack o f natural reso urces

19% 19%

Unattractive enviro nment fo r fo reigners

17%

Lack o f skilled labo ur

17%

Geo graphical distance

15%

Figure 7.2  Frequency of obstacles rating as ‘very important’ and ‘important’ Source: Bitzenis and Nuskova (2009, forthcoming).

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Geographical distance (15%) and lack of skilled labour (17%) were considered as least important obstacles. As expected, local market obstacles were of quite moderate importance to the surveyed companies. Questions: 1. Which are the most important determinants of FDI in the manufacturing sector in FYROM? 2. Which are the most decisive obstacles of FDI in the manufacturing sector in FYROM? 3. What is your opinion of market size as a decisive FDI motive for the case of FYROM? 4. What do you think about the ranking order of FDI motives and obstacles for the case of FYROM? 7.9 Hellenic Petroleum and Okta in FYROM Hellenic Petroleum is presently the largest industrial and commercial enterprise in Greece employing around 2,700 people in Greece and 1,017 abroad (according to 2005 data). The company Public Petroleum Corporation S.A. (DEP) was established in 1971 by the Greek State. It was renamed Hellenic Petroleum S.A. in 1998 after the state had decided to offer 23% of its shares to the public through the Athens and the London Stock Exchanges. In 2008, its shares are traded in the Athens Stock Exchange. On May 2003, Hellenic Petroleum S.A. announced that the Hellenic State, its main shareholder, had come to an agreement with the main shareholder of the company Petrola Hellas S.A., i.e. Paneuropean Oil and Industrial Holdings S.A., for the sale of a further 16.65% of the shares of Hellenic Petroleum S.A. The merger of the two companies through the acquisition of Petrola Hellas S.A. by Hellenic Petroleum S.A was also agreed upon. The agreement was made in the context of the privatization of Hellenic Petroleum S.A., according to the context of Laws 2000/1991 and 3049/2002. On July 2003, the companies Hellenic Petroleum S.A. and Petrola Hellas S.A. signed the merger contract layout, and according to Law 2190/20, the merger was registered in the record of the Ministry of Development on 14 July 2003 and was published in the Gov. Gaz (issue 7366/14 July 2003). The acquisition of Petrola Hellas S.A. was expected to strengthen the presence of Hellenic Petroleum S.A. in the European Market and to promote decisively its business plans. Furthermore, there were significant benefits for the shareholders and the staff of the two companies, customers and the National Economy. Specifically, it was expected that the following synergies would result in the particular sectors: supply of crude oil and products, refineries operation, investment in production units and logistic centres, and financials. The magnitude of the company resulting

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from the merger would strengthen the prospects for the development of its international activities. In 2005–2006, it had coverage of 80% of the Greek market requirements and almost 100% of the Former Yugoslav Republic of Macedonia (FYROM). Hellenic Petroleum belongs to the refinery sector and amongst its activities is the refinement of crude oil and marketing of the refined petroleum products, production and trade petrochemicals and the exploration, development and production of hydrocarbons. Moreover, it deals with other activities related to the hydrocarbons industry, petrochemicals, natural gas and engineering services. Consequently, it has a leading position in the Greek market. However, its financial results are influenced by many parameters. Apart from sales volumes and competition, we have the international refining and chemicals margins, the euro/ dollar exchange rate and the international prices of oil and chemicals. The development of the group of Hellenic Petroleum S.A. took time, and its growth was gradual, enhanced primarily by funds raised from the public. Furthermore, the Group has developed joint ventures with OMV in Albania and Iran as well as with Sipetrol in Libya. Subsidiary marketing companies are found in FYROM and in Albania. As a result of its entrepreneurial activity, Hellenic Petroleum has achieved a dominant position in Greece and earned broader recognition in South-Eastern Europe. Its size, however, limits its effective participation in the wider European market, which is traditionally dominated by high-capitalization companies. The transformation of Hellenic Petroleum into an integrated international energy group, capable of competing in the European market, requires strategic partnerships with other petroleum companies, to speed up growth, facilitate access to new territories and further enhance investors’ confidence. At the same time, its transformation into an integrated energy company took place gradually and was advanced by the increase of its shares in DEPA, which is responsible for importing and distributing natural gas in Greece. The expansion of Hellenic Petroleum into FYROM was mainly reinforced by the favourable political climate in the country and by the reassurance given by the government to Hellenic Petroleum that Okta would remain a monopoly in the country. It was widely discussed and written in the press that a part of the offer of Hellenic Petroleum was given to the state in order to secure the monopoly advantages in the market of FYROM. Okta was the only oil refinery in FYROM, built in 1970 and commencing operation in 1982, with about 1200 employees. The oil refinery is designed to operate on Iraq-Kirkuk crude oil of hydro-skimming type with a capacity of 2.5 million tonnes (Mt). Most of the shares were in the possession of the government of FYROM. Over time Okta has experienced more losses than profits and at the beginning of 1999 its losses were 2.3 billion denars with an additional $30 million debt to domestic and foreign banks, shareholders and trusties. The International Monetary Fund stipulated that the FYROM government should sell or liquidate the company in order to gain additional investments and continue reforms and the transition process to a market economy.

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The prospects for the company looked questionable until May 1999, when a purchase agreement was made with Hellenic Petroleum. The agreement consisted of $32 million during a three year period, $40 million for the modernization of the facility, $20 million for gas stations and $90 million for the Thessaloniki-Skopje pipeline. The whole investment stood at $182 million and was the largest foreign investment in FYROM at that time. Many of the issues mentioned in the agreement were discussed in the FYROM’s parliament and were the subject of many debates and disagreements. For example, the agreement gives Okta the right to import oil with just a 1% charge as customs duty. Other importers face a 20% duty. Moreover, in 1999, the biggest oil company in FYROM, Makpetrol, asked the court to investigate the legality of Okta’s sale to Hellenic Petroleum. However, the case was examined by the courts for two years and in the end the agreement was signed. Due to the fact that Okta has a monopoly in the FYROM market as the only oil refinery in the country, the power of buyers does not exist. This means that the stakeholders such as buyers and companies can not negotiate prices, meaning government and Hellenic Petroleum set the price according to world trends and mutual agreement. Regarding competition in FYROM, Okta with Hellenic Petroleum are a producer of petrol and Makpetrol an importer. Thus, Makpetrol is a distributor of petrol in the country with 70% of the market share (). On the other hand, via a special agreement for a five-year period Hellenic Petroleum has a monopoly over the refinery (). However, Hellenic Petroleum’s direct competitor in FYROM, Makpetrol owns numerous petrol stations throughout the country. This is a weakness for Okta and Hellenic Petroleum and both have taken the decision to invest $20 million in the construction of petrol stations throughout the area (). Finally, Hellenic Petroleum (HP) has also signed an agreement with the government of Montenegro to acquire 54.35% of the crude oil importer and trader, Jugopetrol Kotor, for a price of 65 million euros. The Greek company HP outbid major rivals in the tender to privatize the state-owned company, including Russian oil giant Lukoil and Austria’s OMV. Bids were also submitted by Croatia’s INA, Slovenias Istrabenz and Slovenian Petrol. In addition to the cash component of its offer, Hellenic Petroleum will invest 35 million euros in the company and will pay 5.5 million euros to the local government for social programmes. Part of the proceeds to be invested in the company will be used to improve its facilities, which currently include a network of 33 petrol stations and 170,000 cubic metres of storage facilities, in mostly coastal areas. Jugopetrol sells 500,000 tonnes of petrol products per year. In 2001, it reported earnings of 200 million euros and after taxation, with profits of 10.6 million euros. It also holds the rights for hydrocarbon exploration in Montenegro. The acquisition is in line with Hellenic Petroleum’s goal to become a major player in the Balkans.

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Questions: 1. 2. 3. 4.

What is your opinion of Hellenic Petroleum? Has it been privatized? Are you in favour or against privatization? What is the role of Hellenic Petroleum in the Balkan region? Why has Hellenic Petroleum entered FYROM? What do you think about the specific privatization deal? 5. Why has FYROM decided to proceed to this privatization deal? 6. Which entry modes have been used by Hellenic Petroleum in FYROM?

7.10 Albania and its Path to EU Accession (2001–2004) On 31 January 2003, negotiations for a Stabilization and Association Agreement (SAA) were officially initiated. Nine negotiating rounds were held, and progress was made in discussing the text of the future SAA. However, actual implementation of reforms has been insufficient to properly address many of the shortcomings identified in the 2001 High Level Steering Group report, subsequent Stabilization and Association Process (SAP) reports, and in the framework of the frequent dialogue between the EC and Albania. Only a limited number of the recommendations of the 2003 SAP report and of the various Consultative Task Force meetings (CTFs) were fully implemented. Albania does not yet offer a sufficient guarantee that it will be capable of correctly implementing the future Stabilization and Association Agreement (SAA). Albania remains a young and questionably stable democracy. The mediumterm interest of the country is often sacrificed in favour of short-term, narrower political interests, although consolidation of democratic culture is essential to bring about necessary reforms. The rule of law in Albania remains deficient, as Albanian law enforcement bodies do not yet guarantee consistent enforcement of the law in accordance with international standards. Widespread corruption and organized crime continue to be serious threats to the stability and progress of the country. Therefore, further efforts are needed to ensure full respect of human rights. Some steps have been taken to improve the functioning of the judicial system, but considerable efforts are still necessary to ensure law enforcement, particularly with regard to serious crime. Public administration reform has seen some progress, however, more determination and political will is necessary to create a modern, independent and efficient public administration. Encouraging efforts have been made to strengthen civil society, but these need to be intensified. Albania’s legal framework regarding the movement of goods, services and capital, and its establishment, is in theory relatively open and nondiscriminatory. However, the limitations of the administration, as well as the serious problem of corruption, continue to have an adverse effect on the actual implementation of this legislation. This in turn affects trade relations.

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Discretionary/discriminatory implementation of laws is reportedly frequent, for example in the field of corporate taxation. Nonetheless, the lack of guarantees as regards fair implementation of procedures is an issue which requires urgent attention. Progress has been made by Albania in improving its legislation and in joining international conventions in internal-market related areas. However, administrative capacity remains, at this stage, too weak to ensure the proper enforcement of legislation and therefore Albania’s ability to comply with SAA requirements remains limited. Particular efforts are needed in the areas of customs and public procurement. However, with legislation lacking proper implementation, enforcement remains limited. Moreover, additional efforts should be made in Albania to reach higher standards concerning the protection of minority rights. In particular, Albania needs to meet requirements regarding the accurate evaluation of the size of minorities, and to change the minority-related legislation, so that it supports the implementation of international conventions ratified by Albania in this area. Although identified as a top priority in the 2003 SAP report, real progress in the fight against organized crime has been poor. According to the General Prosecution, organized crime activity in Albania increased in 2003. Current legislation does not clearly define organized crime, which is a matter to be urgently addressed, as law enforcement co-ordination aimed at efficiently fighting organized crime remains limited. The State Police’s Organised Crime Sub-Directorate has approximately 450 police officers on its staff, but its output is very low. The General Prosecutors Office has had similarly unsatisfactory results and the two agencies should therefore enhance cooperation in order to better tackle the problem. Furthermore, the present system for investigating organized crime is largely inefficient and open to corruption and intimidation of investigators. It also lacks a truly national approach. As the process is decentralised with local prosecutors having responsibility for most cases, and the General Prosecutors Office having only a watching brief, this set-up increases the risk of corruption during prosecution. Finally, Albania also needs to pay more attention to ensure prosecution of members of law enforcement bodies involved in organized crime-related activities. Albania still has a primarily cash-based economy. Whilst in the early 2000s improvements in anti-money laundering legislation have been made, it is generally considered that the laws are now adequate for this task. The amendments encompass the 40 recommendations against money laundering and the 8 recommendations against terrorist financing, published by the Financial Action Task Force on Money Laundering. More transactions are now reportable to the appropriate authorities, and non-banking institutions such as travel agents and casinos have been included in the reporting requirements. Following reduced GDP growth in 2002, the economic situation in 2003 pointed to sustained growth of about 6%. A number of elements, notably political instability, uncertain electricity supply and pending structural reforms however weigh against current performance. Export performance improved in 2003, but the trade deficit, estimated at some 21.5% of GDP, remains large. As usual, a substantial

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and stable inflow of remittances from Albanians living abroad (estimated at 12% of GDP) has compensated for the trade figures. Between 2000 and 2003 Albania benefited from around €180 million in EC assistance. Efforts to restructure key sectors of the Albanian economy such as industry, transport, environment, agriculture, energy and telecommunications should be further enhanced and maintained over the medium/long term. Albanian industry remains generally outdated and the SME sector, although developing, needs a sustained period of consolidation and growth. While steps have been taken to improve air traffic and airport security, road and railway infrastructure remain outdated. Furthermore, in the field of water management, strategies have been prepared. Moreover, in relation to the environment, a tangible improvement in the general situation is hardly noticeable, despite the efforts made to adopt and enforce legislation, including sanctions for polluters. Finally, progress is being made in addressing the ongoing problems of the energy sector, however it will take time for Albania to stabilize the situation in this area. Questions: 1. In which stage of progress can we find Albania as an acceding country at present? 2. What are the prospects of Albania for EU accession? 3. What are the problems in Albania?

7.11 FDI in Albania (1990–2004) After a three year period of decline, between the years 1990–1992 (a decline that in real terms is calculated to be almost at 40% as compared with the 1989 GDP figure), GDP in Albania sharply increased during the consecutive years 1993–1996 (almost 9% in real terms). The main contributor to this increase, around 60%, was agriculture, which was widely privatized and saw an increase of productivity. Although on a smaller percentage, a good part of this increase is also attributable to construction and services. Furthermore, the remittances from emigrants that left Albania in the first years of transition served as a potential source of savings and also had a strong impact on economic growth. While the economy experienced improvements during this period, the experience of the year 1997 showed that a fast growth may be followed by a fast decline, if it is not accompanied by consolidated and sustainable institutions. The 1997 crisis demonstrated the root problems in the governance of Albania. At the end of 1997, the GDP figure decreased by 7% and inflation rose by 40%. During 1998, Albania witnessed rapid annual economic growth by 8% and a decrease of the inflation rate to 8.7%, a significant difference from the figure of 42% in 1997. The conflict in Kosovo, the massive migration of refugees to Albania as well as the

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unclear perspective for the crisis development, created the idea that it would have been very difficult to achieve the economic reform programme of 1999. Lastly, and according to the IMF and the Ministry of Finance in Albania, the Albanian economy had seen decisive growth in recent years. Despite a low level of increase during the period 1998–2002 (4.7%), 2002 was the fifth year that Albania showed economic growth. Based on the economic growth in Albania, a significant increase in FDI inflows into Albania can seen. However, the inflows are still limited even when taking into account only those countries from the Central and East European region. It is noted that foreign capital in Albania has been stable and limited since the beginning of transition up to 1999. It should be emphasized that the years 1995–1996 were the years when fraudulent pyramid schemes flourished. This strongly affected foreign investments. Immediately after the crisis of 1997, foreign investments dropped by 50% as compared with the years 1995–1996 and the ‘picture’ of Albania after the institutional and social chaos needed a considerable amount of time in order to recover. Also in this regard, the events of September 1998 (the so called coup d’etat) sustained the image of an unstable political climate in Albania, impeding many foreign investors (for whom political stability is the prerequisite for investment) from investing in Albania. The Kosovo crisis was another factor (this time a regional factor) that had an impact in limited foreign investments in Albania. It seems that the political, social and macroeconomic instability and the rule of law, internal or regional together with high corruption rates, bureaucracy and low living standards, have been the main barriers for foreign direct investment inflows in Albania. Generally, we can identify two main categories of western companies that invest in the Balkan countries and especially in Albania. Firstly, large multinational companies (MNEs) that have a global strategy and try to increase their market share in specific markets. (e.g. Vodafone, large banking institutions from Italy, Greece, etc.) Secondly, small and medium enterprises (SMEs) that try to improve their global policies (economy of scale, market expansion, geographical proximity, cost advantages, etc). The latter comprise the majority of investing firms in Albania. The majority of foreign investors come from Italy and Greece. However, during the transition years and especially after the Kosovo crisis, there are investments from Kosovo in Albania. The majority of are situated in Tirana. Referring to foreign direct investments distributed according to sectors, we notice that they are concentrated mainly in the following sectors: (a) Tourism (34%) (e.g. hotels and restaurant buildings in the main cities of the country and along the coastline); (b) Light industry (20%) (e.g. the confectionary industry, the shoemaking industry, etc.) These products require a great deal of manual, low cost, labour and are often exported back to Italy and Greece or to other third countries (export bases). More often than not, the raw materials are totally imported from abroad; (c) Building raw materials production (approximately 15%); (d) Agrarian and foodstuff industry (18%); (e) Banking sector. 16 active foreign or joint venture banks and one central bank existed in mid 2004; and (f) the telecommunication

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sector. Nevertheless, Albania has a very low level of per capita foreign direct investment in the Balkan region. Low FDI inflows and the low FDI per capita in Albania might be explained by the following: • • • •

•

• •

•

• • • • • • • • •

Political, social and macroeconomic instability. The destabilized political situation in the country and the high criminality rate, especially during the years 1997–1998. The political situation and the destabilization of the Balkan region, in general. The high risk associated with social and political changes in Albania (high risk within the country together with the instability in the Balkan region and especially in Kosovo) influences the reduction of the possible number of foreign investors. Weak rule (enforcement) of the law, weak judiciary, political means/ strings (political influence on decisions/actions/measures), poor education infrastructure, inadequate physical infrastructure, illegal payments, briberies, low salaries and few inspections. Businesses operating in Albania deals not on the basis of the legal system, but on the ‘handshake’, illegal payments and ‘personal contacts’. Bureaucracy and corruption. Weak and inefficient tax administration. The tax environment for exports is not advantageous towards FDI and at the same time the taxes for imported machinery and equipment are not appropriate. There is evidence of a lack of a simple and general duty system and a VAT for export, together with a lack of tax credits and accelerated depreciation. The lack of entrepreneurship in Albania, together with the difficulties in finding sources of finance, a shortage of skills, poor management and low productivity. The late/delayed starting point of the foreign direct investments as compared with all the other former socialist countries. The total or relative lack of information about Albania due to its prolonged self-isolation policy. The factors inherited from the past, such as: the poor infrastructure, the outmoded production capacities, the lack of competition, etc. The relatively small size of the internal market, which is conditioned by the small population and limited purchasing power. The geographical and cultural distance from the western countries. The pyramid schemes, social instability and low living standards. The Albanian business mentality which has a close family orientation. The slow privatization process, regarding medium and large state enterprises in strategic sectors like electricity, transportation and water. Low value-added enterprises offered to foreign investors.

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• • •

Unfavourable and unfriendly business environment, constant changes in the legal framework. Weak governance, as a result of lack of accountability and institutional capacity. Other constraints such as weak financial institutions, a weak legal and administrative framework and lack of managerial expertise.

All of the above FDI constraints not only create overwhelming barriers for a friendly foreign investment climate in Albania but also hinder the promotion of domestic business at the same time. Addressing these problems is a challenge for the Albanian government (which seems to be aware of these constraints). It is not easy for the government to follow a programme where the climate for investments, in liaison with relevant international organizations that currently operate in Albania, will thrive and benefit. Questions: 1. 2. 3. 4.

Why do limited FDI inflows exist in Albania? What are the major problems in the Albanian business environment? Critically discuss the investment environment in Albania. What investment opportunities does Albania offer?

7.12 Financial Intermediaries in Albania in 2004/2005 Financial intermediaries play a decisive role in the efficient functioning of an economy. The most fundamental contribution of the financial system is to efficiently allocate resources from individuals and companies with surplus resources (lenders) to those with deficit resources (borrowers), thus accelerating investing and consumption patterns and opportunities, and thereby favouring economic growth. However, this was not the case for Albania during its transition to a market economy, a period in which banks are struggling with bad loans, and bad corporate governance, but also operated in an unfavourable business and macroeconomic environment, confronted credit, foreign exchange, and interest rate risks and operated in absence of proper accounting standards. The serious problems the Albanian banking system faced during the transition process are due to the following factors: • •

•

Its limited role as financial intermediary. The gap between a good evaluation of the credit system/schemes and the management risk associated with it (between 1992–1998 the Albanian banking system was reported to have huge amounts of ‘bad loans’ in its credit portfolios). The exchange ratio was calculated but not its risk in real terms.

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The accounting system was ‘a product’ of socialist/communist mentality and not in conformity with international laws and legislation. A shortage of experienced bankers, banking entrepreneurship and managerial skills. The first bank entrepreneurs/managers were selected by citizens for the latter’s devotion to a certain political party (political reasons) and not for their qualifications, managerial skills or performance in management.

The Albanian financial system, in contrast to that of other transition countries, did not include a ‘laissez-faire’ period in its financial policy. This largely, caused the failure of Albania’s large state-owned banks. The typical clients of Albanian banks are private micro or small enterprises, undercapitalized, not wholly stable and lacking strong relations with the banking system. A two-tier banking system was formally established in Albania in 1991. Commercial banks such as the Saving Bank of Albania (SBA) (established in 1991), the National Commercial Bank of Albania (NCBA) (established in January 1993) and the Rural Commercial Bank (RBC) (established in October 1993) were to provide a whole range of services under the supervision of the Bank of Albania. In the specific ten years of transition (1992–2002), Albania’s banking system remained fragile and ineffective. The banking sector rarely functioned effectively in terms of domestic financial intermediation. The absence of a formal financial sector and an inadequate regulatory and supervisory framework contributed to the development of pyramid schemes. However, in mid 2004, 16 licensed commercial banks as part of the second tier (the Bank of Albania (BoA) fulfils the function of a central bank (one tier)). Four of them are Greek banks/branches; three others come from Muslim/Islamic countries (Saudi Arabia, Malaysia and Kuwait), three from Germany, three from Romania, another three from the USA, and one from the region of Kosovo. Furthermore, there are two joint ventures (Italian and Arabian funds) and two new domestic banks which were licensed during the period of March-August 2003 (the Credins Bank and the Popular Bank). It is expected that these two banks will provide further incentives in credit schemes not only for short-term loans for working capital but also for long-term loans for new investment projects. Finally, there have been two successful privatization deals (Austrian and Turkish acquisitions in the Savings Bank of Albania and the Commercial Bank of Albania respectively). Until 1996, three state-owned banks operated in Albania: the National Commercial Bank (NCB), the Savings Bank of Albania and the Agricultural Bank. Two of them were privatized in 1997 and 2003 respectively and the third went bankrupt in 1997. •

The National Commercial Bank (NCB) of Albania (the second-largest bank in the country) was privatized by the Kent Bank of Turkey together

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•

• •

•

with the International Finance Corporation (IFC) and European Bank for Reconstruction and Development (EBRD) in October 2000. Although on 25 April 1999, the Kent Bank was declared the main owner, the privatization process was completed in October 2000. The Kent Bank bought a 60% stake in NCB, with EBRD and IFC, each receiving 20% (EBRD, 2001). This privatization deal was an excellent example of cooperation among the Albanian government and various institutions and organizations such as the IMF, the World Bank, the EBRD and IFC. The IMF played an important role in setting policy priorities and the time-frame for the privatization process. The World Bank provided the resources for restructuring the National Commercial Bank (in late 1996, 22 of NCB’s poorly performing branches were transferred to the Savings Bank, leaving the bank with ten main branches. In three years (1997–1999), the staff numbers were gradually reduced to one third, from 1236 to 477. The EBRD and the IFC helped with the marketing of assets and inspired confidence in potential investors from their participation in the privatization deal. Finally, in 1998, another part of NCB’s financial restructuring programme was initiated in order to clean up NCB’s bad loan portfolio. An amount of over US$70 million was transferred to the Bank Asset Resolution Trust (bad loans agency). The Savings Bank of Albania, the largest bank in the country, was bought in December, 2003 for US$126 million by the Reiffeisen Bank-Austrian Bank. In 2004, the Albanian news media reported that the Reiffeisen Bank would accelerate the transformation process of the entire Albanian banking system by giving more credit to customers, expanding corporate banking by offering favourable exchange rates between currencies, etc. The Agricultural Bank went bankrupt in 1997. It was the only Albanian bank to declare bankruptcy during the period 1991–2003. The above three banks formed GROUP 1-G1 of the state banks in the Albanian banking system. Today, G1 no longer exists, as there are no state banks in the Albanian banking system. In 1992, another group of banks, a group of joint venture banks, was established under the name GROUP II-G2:

a) The Albanian-Italian Bank (foreign participation and Albanian participation). b) The Arab-Islamic Bank (foreign participation and Albanian participation). •

From 1993 onwards, Group III-G3 was established, comprising the private banks in Albania. It is important to emphasize that in the two year period (2002–2003), two Albanian banks (100% Albanian capital) were licensed. This is evidence that local entrepreneurs are investing in the banking sector.

It is also essential to emphasize that there is strong participation of Greek banks in the Albanian banking system (the Piraeus Group, Alpha Bank, the National Bank

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of Greece and the Commercial Bank of Greece) due to the presence of hundreds of Greek entrepreneurs in the country, the geographical proximity of the two countries, the absence of local competition and western investment interest, and due to the existence of minorities. At the same time, the Malaysian Bank, the Arab-Islamic Bank and the Credit Bank of Albania (Kuwaiti Bank) focus on providing services to Albanian Muslims. From the banking point of view, it is worth mentioning that these banks show great interest in the construction and trade activity of the country and as a result their credit portfolio is geared to these sectors of the economy. Thus, due to the unsatisfied demands of the Albanian banking market that are not met by the licensed banks, there are a considerable number of banks for such a small country. The Savings Bank of Albania (65% market share) was not given any credit from 1997 onwards because of its heavy portfolio of bad loans. At the same time other banks in Albania were very strict in their credit policy and also highly bureaucratic. This led to a keen demand not only for credits and investments but also for other services to be provided by the banks. These reasons explain the new licenses given recently to two Albanian (local-private) banks and the keen interest of the Austrian Bank (the Reiffeisen Bank) in investing in the Albanian banking system. Notwithstanding the striking positive developments in the Albanian banking system, the overall financial system is still fragile. The development of the banking system and public confidence are connected with the privatization process of state banks, the growth of bank competition, the developments in the transaction process (e.g. REUTERS, RTGS- Real Time Gross Settlement System), the development in real terms and the political stability of the country. The transition to a market economy requires a sound banking system. This is a crucial factor in attracting foreign investors. Foreign direct investment in the banking sector plays a significant role in the transition countries, since experience has shown that countries around the world where FDI has concentrated have enjoyed accelerated economic growth, easier integration into world markets and less painful structural reform. Notwithstanding the unfavourable conditions of the Albanian economy, the banking system is enlarged every year through an increase in the number of private banks. This is accomplished through the privatization process and the restructuring of the state banks, through the expansion of the banking network, through improvements in banking legislation, through the growth of available credit and finally, through the supply of other new products offered in the banking market. Despite the development of the Albanian banking system and Albania’s impressive performance macro-economically, two unexpected crises during 1991–2003 left a distinct mark on the economy. The first financial crisis occurred in 1997 when over ten pyramid schemes (so called bubbles) collapsed one after the other. Thus, 1997 is known in Albania as the year of crisis, although it must be noted that this crisis was not related to the banking system itself.

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The second financial crisis, in March 2002, shook the banking world as Albania had appeared to be, once again, enjoying macroeconomic stability. It was caused by the panic in the banking sector as a result of depositors’ withdrawal (confidentiality crisis-the banking panic-liquidity crisis). The Albanian banking system is excessively liquid, owing to the lack of lending opportunities, and to the fact that banks dominate financial intermediation in Albania. However, the Albanian system seems to have developed after the privatization of state-owned enterprises, and especially the privatization of the Savings Bank of Albania in 2003. Therefore, increased competition and credit growth acceleration have been seen in the Albanian banking sector since 2004. More specifically, bureaucratic procedures are a real impediment to credit activities in Albania. The lack of financial resources seems to be another major barrier to enterprises initiating or expanding their activities. The following specific policy initiatives are suggested, in order to improve the overall performance of the Albanian financial system and economy: •

• •

• •

• •

•

•

A designed strategy of training programs for improving management skills must be realistically implemented. The training programs should emphasize: upgrading of management/entrepreneurial skills and collaboration of domestic with foreign enterprises. Technical assistance should be provided to show how a clear and straightforward strategy will help enterprises become more competitive. Strategies and government targets to reduce bureaucracy and corruption must be considered. The reduction of bureaucracy in business registration procedures, and proposals for fiscal incentives in poor regions will give a further boost to the Albanian economy. The long bureaucratic procedures for a company to gain approval for a credit line must be shortened. Action must be taken against corruption, and preparations for a more stable business environment within a stable legal framework must be made. Through this, more foreign financial institutions will be attracted, and increase competition in the financial market will follow. Interest rates must be lowered through increased competition in the financial market and through an improved Albanian macroeconomic environment. Correct implementation and enforcement of competition law can be seen as a first priority, given that competition from the informal sector in Albania arises not only from unregistered enterprises, but also from informal activities and informal behaviour of the registered enterprises themselves. Taxation rates must be reduced and governmental authorities capable of effective tax collection should be instigated in order to minimize the black economy, corruption and bribery. This will reduce the number of Albanian enterprises that ‘prefer’ to borrow money from the informal market. New credit lines must be introduced for short-term loans for working capital or for long-term loans for new investment projects.

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Proper accounting standards must be introduced and enforced. There is a need for the system to pursue efforts to increase the awareness of consumers and other bank borrowers of the risks inherent in foreign currency borrowing. This can be accomplished by encouraging or requiring banks to discuss exchange rate risks explicitly with borrowers before contracts are signed (IMF, 2005). The Albanian financial market must be broadened and deepened to encourage financial intermediation such as securities, insurance and pension funds. At the moment, the banking sector dominates the financial sector with over 90% of all the financial intermediaries’ assets (IMF, 2005). The liquidity of the system should be decreased while lending opportunities should be increased. The banking system is highly liquid, with liquid assets at a high 75% of total assets, owing largely to a lack of lending opportunities and relatively high and safe returns on government securities (IMF, 2005). Entrepreneurs must update their knowledge for the business world and view it from a new perspective. Entrepreneurs in Albania lack the financial resources, the experience and the ability to develop a well-organized strategy. Furthermore, they tend to go along with simple centralized organizational structures. In a country like Albania with a significant low GDP per capita, unstable macroeconomic environment and decisive financial problems, entrepreneurs are low risk investors and prefer not to borrow either from banks or from the informal economy. The limited tendency of Albanian entrepreneurs to borrow money for investment and other reasons is due to the fact that most of them are Muslims (around 65– 70% of the total population). It is well-known that under Islamic or Sharia law, it is forbidden to charge or pay interest in any circumstances.

If progress is implemented in the above areas, and Albania can overcome its drawbacks, its future prospects look bright. As an outcome, the GDP will be increased, new financial intermediaries will enter Albania, entrepreneurship will be encouraged, and thus the entire economy will prosper. Consequently, there will be excellent prospects for Albania to become, by the end of this decade, an accelerating economy with significant FDI inflows. More importantly it will become an official applicant for EU membership. Questions: 1. What do you think about the progress of the Albanian banking system during the transition period? 2. What was behind the slow progress in the financial intermediation in Albania? 3. What do you think about the importance of financial intermediation in general?

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4. Critically discuss the specific policies proposed above in order for the overall performance of the Albanian financial system and economy to prosper. 5. What is the difference between the Albanian banking system and the other Balkan countries’ banking system? 6. Critically discuss the origin of ownership of the various banks in Albania. 7. Critically discuss the reasons behind the limited tendency of Albanian entrepreneurs to borrow money for investment.

7.13 Serbia/Montenegro and their Delayed EU Accession (2000–2006) Economic policies in Serbia during the 1990s left the country with weak economic conditions. Broad-based economic reform and transition started only relatively recently. Following the 2000 political changes in Serbia, the new authorities initiated economic reform and stabilization. From 2000 to 2003, market-oriented stabilization policies led to a recovery of real GDP by a cumulative 19% and to a substantial reduction of inflation from well above 100% to single-digit levels at the end of 2003. Following the Council adopting negotiating Directives, the Commission started to negotiate a Stabilization and Association Agreement with Serbia & Montenegro in October 2005. The SAA is a comprehensive agreement between the European Communities and their Member States, of the one part, and the State Union of Serbia & Montenegro, the Republic of Montenegro and the Republic of Serbia, of the other part. Similar to the ‘Europe Agreements’ with the central and eastern European countries, the SAA provides the legal framework for relations between the EU and Serbia & Montenegro for the entire period prior to a possible future accession. Since 2000 the EU has granted, on an autonomous basis, generous trade conditions for Serbian and Montenegro products as part of the support package in the framework of the SAP. In order to take the full advantage of these preferences Serbia & Montenegro need to continue to develop their export capacity. Serbia & Montenegro have a substantial trade deficit with the EU. In June 2003, the European Commission officially offered the West Balkan countries one of the key instruments of pre-accession strategy for potential candidates for membership. In 2004, the Serbian Government recognized the fact that high positioning of the activities relating to the EU association needed a strong institutional framework. This resulted in the establishment of the Serbian European Integration Office – (SEIO) (Decision of the Government of the Republic of Serbia of 8 March 2004, published in the Official Journal No. 25/04). In other words, SEIO was established following the need for a strong authority that would efficiently coordinate the EU association process. Essentially, SEIO would build on the activities that were the responsibility of the European Integration Department of the Serbian Ministry of International Economic Relations. Thus, the establishment of SEIO presented a

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clear institutional determination of the government to accelerate preparations for the EU integration. The main tasks of SEIO are the following: coordinating, initiating, monitoring and reporting on the process of harmonization of Serbian legislation with the acquis communautaire. It has to plan, monitor and promote the institutional capacities of the Republic of Serbia. Moreover, it aims to consider the needs resulting from the EU association process. Furthermore, in cooperation with the relevant public administration bodies and organizations, it coordinates the training of civil servants on the EU matters. It initiates, coordinates and monitors public relations and promotes activities relating to the EU association process. In addition to this, the SEIO provides technical support and organizes meetings of the Serbian Council for European Integration. It also manages the work of the Committee for the Coordination of the EU Association Process, liaises with the Office for European Integration of Serbia & Montenegro and respective institutions in Montenegro. With a view to the above-mentioned, SEIO, in cooperation with line ministries, has created a new plan for realization of the European Partnership, adopted by the government at its session of 7 April 2006. The Serbian European Integration Office will prepare quarterly reports for the Serbian Government on the course of implementation of this plan, which after analysis and adoption, are forwarded to the National Parliament. In 2004, the EU Council of Ministers agreed that Serbia & Montenegro’s model of European integration was not efficient enough and implemented a new ‘twin track’ approach through which the economies of Serbia & Montenegro would integrate separately into the EU. In 2005, Serbian GDP was estimated to have grown by 6.5% year-on-year, driven by strong gains in trade, transportation, financial services and construction, more than offsetting a drop in agricultural output. Moreover, industrial production grew at a modest 1.3% for the whole year, while showing a robust recovery in the second half of the year. Inflation remained at double digits throughout the year and stood at 17.5% year-on-year in December, mainly driven by strong domestic demand, increases in administered prices, rising cost of fuel imports and the one-off effect of the Value Added Tax (VAT) introduced in January 2005, which was also aggravated by the widespread inflation and exchange rate indexation of prices. Fiscal policy further tightened in 2005 and the consolidated general budget was projected to have reached a surplus of 1.1% of GDP, reflecting prudent budget execution amid lower than expected revenues, and measures to curb subsidies and transfers. Monetary policy has been challenged to stem from the rapid expansion of broad money and robust credit growth, as substantial capital inflows have created appreciation pressure and the resulting foreign exchange market interventions by the National Bank of Serbia (NBS) have boosted money market liquidity, which was only insufficiently sterilised. Furthermore, the current account deficit (CAD) of Serbia has narrowed to 10.2%, on strong export growth in the first half of 2005 and subdued import growth, despite rising world oil prices. Nevertheless, exports remained at about half the amount of imports in absolute terms. The financial account substantially

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improved on surging foreign direct investment (FDI) and increased access to foreign loans. FDI surged to 7.7% of GDP, and foreign borrowing, mostly in the private sector, has increased to 7.6% of GDP. Foreign exchange reserves have risen to US$5.9 billion or 5.2 months of imports. External debt-to-GDP remained high at about 61%. Debt service has increased to 6.6% of GDP and is projected to rise further in coming years. As for Serbia & Montenegro and the IMF, after renewing its membership in the IMF in December 2000, the then Federal Republic of Yugoslavia continued to reintegrate into the international community by rejoining the World Bank (IBRD) and the European Bank for Reconstruction and Development (EBRD) in 2001. The World Bank has been active through the Transitional Support Strategy for Serbia & Montenegro by trying to enhance fiscal sustainability economic growth reforms. Since 2001, the EBRD has approved more than 20 new projects, including major infrastructure loans and investments in support of SMEs. Recently, a new EBRD strategy was approved for the country. Besides this, the World Bank-European Commission sponsored a Donors’ Conference in June 2001, which raised $1.3 billion for economic restructuring. An agreement rescheduling the country’s $4.5 billion Paris Club government debts was concluded in November 2001; writing off 66% of the debt. With the completion of the current IMF programme in early 2006, the second phase of a significant debt relief package provided for by the Paris Club of creditors came into effect, whereby 15% of the net present value of the original external debt amount was reduced. This additional debt relief amounts to an estimated 600 million euro. A similar debt relief agreement on its $2.8 billion London Club commercial debt was reached in July 2004; 62% of the debt was written off. (It should be noted that Montenegro does not owe to the London Club of creditors, since it bought it on the secondary market during the UN sanctions at the beginning of the 1990s.) As already mentioned, EU integration is one of the main political objectives of both Serbia and Montenegro. As confirmed in the Thessaloniki Summit in June 2003, Serbia & Montenegro was a potential candidate country for EU accession. Since 2001, the EU has provided its policy advice through the EU-FRY Consultative Task Force (CTF), later to be replaced by the Enhanced Permanent Dialogue (EPD). The EPD currently monitors and drives reforms on the basis of the European Partnership adopted by the EU Council of Ministers in June 2004 and on the corresponding implementation plan finalized by Serbia & Montenegro’s authorities in December 2004. Formal contractual relations between the EU and Serbia & Montenegro will be established through the Stabilization and Association Agreement (SAA) in the context of the Stabilization and Association Process (SAP). In its Feasibility Report of 12 April 2005, the Commission concluded that Serbia & Montenegro is sufficiently prepared to negotiate an SAA with the EU. On 25 April 2005, the EU Council endorsed the Feasibility Report and invited the Commission to submit the negotiation directives for the SAA. In line with the ‘twin-track’ approach, negotiations were launched with the State Union and the

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two Republics in their respective fields of competence in October 2005. The pace of SAA negotiations depends on progress by Serbia & Montenegro in addressing the issues highlighted by the European Commission. In order to progress through the various stages of the process, both during the negotiations and in order to conclude, Serbia & Montenegro must continue to co-operate with the International Criminal Tribunal for the former Yugoslavia (ICTY), and achieve full cooperation without delay. A new revised version of the European Partnership was issued on 30 January 2006 by the Council, upon a Commission proposal (Council Decision of 30 January 2006 on the principles, priorities and conditions contained in the European Partnership with Serbia & Montenegro including Kosovo as defined by the United Nations Security Council Resolutions 1244 of 10 June 1999 and repealing Decision 2004/520/EC [2006/56/EC], Official Journal of the European Union, 7.2.2006). This text takes due account of the respective competences and the different priorities of the two Republics but underlines the common challenges and the need for respecting the Constitutional Charter of the State Union. In total, combining CARDS (previously OBNOVA), macro-financial and humanitarian assistance and EU assistance to Serbia & Montenegro has amounted to more than €2.9 billion from 1991 to 2002, of which more than €2 billion was given since the fall of the Milošević regime in October 2000. The focus and main objectives of EU assistance have evolved since the 1990s, covering conflict management, post-conflict reconstruction and stabilization and paving the way for a closer association with the EU. Based on the results of the referendum held on 21 May 2006, Montenegro declared independence on 3 June 2006. On 28 June 2006, it became the 192nd member state of the United Nations, and on 11 May 2007, the 47th member state of the Council of Europe. Questions: 1. 2. 3. 4. 5.

Critically discuss the importance of SEIO. What are its main tasks? What is the economic progress of Serbia? Discuss Serbian relations with international financial institutions. Discuss Serbian – EU relations and EU prospects. Critically discuss the independence of Montenegro.

7.14 Banking Reform in Serbia (2000–2006) After more than ten years of dramatic economic decline (1989–2000), sanctions, severe regional instability, mismanagement and corruption, Serbia has embarked on a radical economic reform path with ambitious goals. At the same time, Serbia is faces both transition and post-conflict problems. After leading the transition process at the beginning of the 80s, the country now lags behind the most advanced

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transition economies. Since late 2000, the authorities initiated a comprehensive banking reform process aimed at establishing sound and efficient banking system in Serbia. It is worth mentioning that different approaches have been taken by the transition economies to the creation of market oriented banking systems. Both gradual and rapid approaches were used to achieve a market economy. The gradual method that Hungary used has proven to be successful since Hungary is the most rapidly growing nation in Central Europe. At the same time, Poland’s use of a shock therapy reform proved to be valuable, too. Rapid privatization and private companies built from scratch made Poland’s reform method extremely successful. In this research case study, we analyse and present the conditions of the Serbian banking sector prior to the reform process implementation. Furthermore, we focus our attention on the most important factors influencing the reform process, i.e. poor initial conditions in the country’s economy and particularly in the banking sector, the changes in the ownership structure and privatization that led to the reform process implementation, and the problems faced by banks during the reform. Changes in the Serbian banking sector after the reform process was initiated are discussed and future prospects for the banking sector are presented. On the whole, the Serbian banking system is a unique case study, not presented and analysed previously in the literature. In the early 1990s, Post-Tito Yugoslavia began to unravel along ethnic lines: Slovenia, Croatia, FYROM, and Bosnia & Herzegovina were recognized as independent states by 1992. The remaining republics of Serbia and Montenegro were declared the new ‘Federal Republic of Yugoslavia’ (FRY) in April 1992. In 2002, the Serbian and Montenegrin components of Yugoslavia began negotiations to forge a looser relationship. In February 2003, lawmakers restructured the country into a loose federation of two Republics named Serbia & Montenegro. Serbia & Montenegro had two separate two-tier banking systems in each republic. As a result, there were two central banks, one for each republic: the National Bank of Serbia (successor institution of the National Bank of Yugoslavia in 2003), and the Central Bank of Montenegro. The banks were charged with: monetary policy formulation, foreign exchange rate management, bank supervision and credit control. While, the dinar is the legal tender in Serbia, in 2000, Montenegro adopted the deutsche mark and subsequently the euro in 2002. The banks are independent of each other and of their respective governments but report to the parliamentary assemblies. Serbia’s ‘Law on Banks’ and the Montenegrin ‘Banking Law’ provide the regulatory framework for the banking sectors in the two republics, respectively. The laws determine the conditions and manner of establishment of a bank, supervision and control of bank transactions, as well as the legalities for the discontinuation of a bank. The recent vote of independence (2006) by Montenegro does not have any impact on the banking system in Serbia because even before the vote of independence the two countries had two different banking systems regulated by different laws.

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Due to the detrimental state of affairs associated with political instability, war and sanctions, substantial banking reform in Serbia started later compared to most of the South Eastern European countries. Although the development of the banking sector in Serbia is far behind, compared to banking systems in transition and developed countries, after only five years of banking reform the sector has substantially improved. Serbia’s transition to democracy and a market economy began under difficult circumstances. After years of mismanagement, the economy was in a virtual state of collapse. By 2000, recorded GDP per capita was less than half the 1989 level, external debt exceeded 130% of GDP and annual inflation was over 113%. Furthermore, until the end of 2000 when the newly elected government took office, the reform process in Serbia experienced substantial delay due to unfavourable political events. The newly-elected government’s plan to turn around the economy was presented by the European Commission and World Bank in the 2001–2004 Economic Recovery and Transition Program (ERTP). Consequently, there followed substantial progress in economic reconstruction and the banking sector reform. Although having led the transition process at the beginning of the 1980s, the country now lags behind most of the transition economies. As for the banking system, Yugoslavia had established at an early stage (in 1962) a two-tier banking system; well ahead of most of the SEE countries (i.e. Bulgaria, Greece, etc). Under the former Yugoslav system, interlocking ownership and the representation of companies on bank boards often led to unwise lending to shareholders with the result that banks accrued large numbers of non-performing loans. A high percentage of the total assets of the Yugoslav banking system were immobilized, consisting of: public debt, ownership of companies bringing no dividends, frozen long term loans, investments that most likely would produce no returns, obligatory reserves, and fixed assets. This situation, combined with high mandatory reserve requirements, resulted in high long-term lending rates that were more than twice the short-term rates. The reform of the banking system in Yugoslavia was initiated with the economic reforms in 1962 and 1965. However, the banking system was transformed into a two-tier system, with the central bank separated from the functions of commercial banks. Now, banks took over the function of central investment funds from the government. Moreover, banks collected private savings, handled the deposits of enterprises and the government, extended credits and mediated external payments. In this regard, banks became universal financial institutions which performed deposit and credit functions as well as functions as investment bankers. However, banks were socially owned, which implies that their basic aim was not to maximize profits from credit and deposit operations. Instead, they were dedicated to providing financial services to other socially owned enterprises. Furthermore, the banking sector was highly monopolized and banks were forced to merge into so-called ‘associated banks’. Since banks were controlled by the state, the government at that time used the banks’ services mainly for the large

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socially owned enterprises that were also indirectly controlled by the government; banks were all used for the same purpose by the government. Two causal groups, institutional and macroeconomic, led to crises in the Serbian banking sector and led to the necessity of implementing a banking reform process in order to create a sound and efficient banking system. The first group represents institutional causes that were common in transition economies. Socially owned banks were exposed to high credit risk, because their founders (government with the support of the biggest social owned companies) were also the biggest debtors. The government had used the banking sector extensively for quasi-fiscal purposes, thereby burdening the balance sheets of the Federal Republic of Yugoslavia (FRY) banks with soft credits directed at the priority sector of the economy. These assets were matched on the liability side with liberal refinancing from the National Bank of Yugoslavia (NBY) and resources attracted from abroad that carried sovereign guarantee. As with enterprises, government control over the banking sector was realized through the state monopoly over the payment system (ZOP). Given the distorted incentives commercial banks faced this control was actually fortunate in limiting the granting of corrupt loans to private affiliates. At the same time, banks were under strict political control. The National Bank of Yugoslavia (NBY) was not an independent monetary institution and it was under the influence of the government and the strongest companies. NBY did not control financial discipline in the payment system nor did it control whether banks comply with the statutory ratios regarding prudential banking behaviour. The regulatory and supervisory functions of NBY were weak, whilst corporate governance did not function efficiently under the rules of social property rights. The second group of causes were of a macroeconomic nature. As a result of the debt crisis in the 1980s, heavy internal and external debts in terms of foreign currencies persisted. Alongside the adverse initial conditions of transition, two hyperinflations took place in 1989 and 1992–1994, completely devastating dinar assets and liabilities. More specifically, given a large share of deposits, borrowing and lending denominated in foreign currency, the hyperinflation of 1993 had a devastating impact on the banking sector. Most enterprises could no longer service their foreign currency debts and consequently, banks could not meet their obligations. In addition, dinar loan deposits were eliminated. Each devaluation of the dinar caused such crisis in the banking system that even better regulation and more efficient control of banks operations were not able to significantly boost the solvency and liquidity of the banking system. Moreover, non-performing loans in addition to off-balance sheet items exceeded the amount of Yugoslavia’s social products. All of these factors combined led the general population to lose confidence in the banking sector. The government at the time took the radical measure of freezing foreign currency deposits in commercial banks. Most of these deposits remained frozen, although the Serbian government took measures to begin compensating

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depositors. The freezing of deposits, together with the financial pyramid schemes that flourished due to lax financial regulation, supplied a psychological tool to Serbian households and other depositors. The majority of savings in Serbia were held in foreign cash outside the banking system. Estimates of the amount of foreign cash held by the population are inevitably inaccurate. However, the conversion of cash deutschemarks to euros through the NBY reportedly reached a volume of €4 billion by the end of 2001 and early 2002. The FRY government issued guarantees during a rescheduling of commercial bank and debt in the late 1980s. Hence, the subsequent default of the government on these obligations included a technical default of the banks themselves. Therefore, pending the successful restructuring of this debt, access to international capital markets for Serbian banks was severely limited. This even included the acceptance of guarantees for short-term export credits. By the end of the 1990s, the banking sector in Serbia was in a virtual state of collapse, with highly negative capital and an asset dominated by non-performing loans, and was severely mistrusted by the population. Businesses which carried out financial transactions typically avoided banks, favouring the suitcases of cash of various types of mutual offsets. Finally, it would be a grave error not to talk about Milošević, Serbia’s running President from 1990 to 1999. Milošević, an ex-president of the Belgrade City Committee of the League of Communists and afterwards president of the Serbian Communist Party presided over the transformation of the League of Communists of Serbia into the Socialist Party of Serbia in July 1990 (supporting the argument that a ‘disguised transition model’ [as presented and discussed in the previous chapters] was adopted in Serbia). The old regime, having anticipated the domestic unrest and the inevitable changes in the political arena, attempted to stay in power, and ‘disguised’ itself as a democratic socialist party. To make matters worse, Serbia suffered from mass demonstrations, sanctions from UN and wars with Croats and Bosnians through which the whole transition process was halted, and specifically the banking reforms. Credit and financial markets were brought to the verge of collapse in 1999, at which point the Milošević regime ended. Last but not least, the assassination of Zoran Djindijc, in March 2003, a member of the Serbian government, caused further unrest. The reform of the Serbian banking sector started at the end of the year 2000. To this end, a comprehensive assessment of the banking sector and audit of all major banks was performed. Moreover, bank-restructuring strategies were prepared with the help of the IMF and World Bank. Preliminary assessment showed that the Serbian banking sector was characterized by: (1) a high degree of non-recoverable claims; (2) a low degree of real interest-bearing assets; (3) real undercapitalization and the impossibility of the provisions and capital to absorb the risks assumed; (4) real insolvency of the biggest banks (share of the biggest banks in the total balance sheet amount of the banking sector was 57%); (5) a high degree of illiquidity; (6) non-existence or existence of an inadequate system of internal control and internal audit; and (7) an inadequate system of risk management and insufficient professional work of external auditors. In the same year, of the 96 banks in Serbia,

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30 were considered to be insolvent. These 30 banks included the six largest banks in the country, that together held 80% of the banking system’s assets. The government indicated its initial preference to prepare rescue packages for the six largest banks on systemic grounds. However, four of them were eventually closed on the grounds of insolvency. The government had to balance the cost of creditors bearing the cost of bank failure against the huge costs of restructuring, together with international pressure to take decisive actions in reducing fiscal expenditures. Banks as the most essential financial intermediaries in a country’s financial system perform valuable roles through financial intermediation. Therefore, it was of utmost importance that the banking reform process in Serbia developed a regulated, supervised, sound, and efficient banking system. The establishment of the two-tier banking system in Serbia was initiated considerably earlier than other transition countries. However, due to adverse initial conditions in the economy, the substantial banking reform in Serbia started considerably later compared to other transition countries. The main causes behind the delay of the banking reform process in Serbia were the banking crises, dramatic economic decline, sanctions, severe regional instability and corruption. From the beginning of the banking reform, Serbia needed to divide up the mono-bank system into a central bank and state commercial or specialized banks, permit the entry of private and foreign banks and at the same time introduce and enforce a new regulatory and supervisory framework for central and commercial banking operations. The main issue was that the state commercial and specialized banks had received in the past (during central planning), non-performing loans and were already undercapitalized. Thus there was the need to clean up the balance sheets of state commercial and specialized banks from non-performing loans and to prevent the making of new non-performing loans. This could be achieved by the transformation model for banking systems through restructuring, recapitalization and privatization of state commercial and specialized banks. In early 2001, the banking system was comprised of 86 banks that were divided into four groups: healthy, solvent, insolvent but systematically important and insolvent. By the end of 2001, based on the analyses the NBY made, 23 banks lost their operation licenses (including the four big banks that had already lost their licenses at the beginning of the year 2002), four banks were given deadlines to increase their capital, and five banks were to undergo a rehabilitation procedure. What is more, in one bank administration was introduced, five banks were put in the category of problematic banks, 17 banks were placed under measures for the harmonization of operation indicators and 18 banks merged with other banks. In addition, six operation licenses were issued to five foreign banks and one domestic. After carrying out the above activities, the banking sector of the country was downsized from 86 banks at the beginning of 2001 to 49 banks at the end of the same year.

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Table 7.4  Active banks in Serbia as of 21 June 2006 Ownership

Country of origin

Website

‘A Banka’ A.D. Beograd Agrobanka A.D. Beograd (Poljoprivredna Banka) AIK Banka A.D. Niš (Agroindustrijsko Komercijalna Banka AIK Banka A.D. Nis) Alpha Bank A.E. Beogradska Afilijacija Beograd and Jubanka A.D. Beograd Piraeus Atlas Banka A.D. Beograd

Domestic Domestic

– –

www.alcobanka.co.yu www.agrobanka.co.yu

Domestic

–

www.aikbanka.co.yu

Foreign

Greece (Alpha Bank) Greece (Piraeus Group)

www.jubanka.co.yu

Čacanska Banka A.D. Čačak Laiki Bank AD Beograd Continental (NLB) Banka A.D. Novi Sad Credy Banka A.D.Kragujevac Ddor Banka A.D. Novi Sad Delta Banka A.D. Beograd EFG Eurobank A.D. Beograd

Domestic Foreign Foreign

No. Name of bank 1 2 3

4

5

6 7 8 9 10 11 12

13 14 15 16 17

18 19 20 21

22 23 24

Eksport-Import Banka – ‘Eksim Banka’ A.D. Beograd HVB Banka Srbija I Crna Gora A.D. Beograd Hypo Alpe-Adria-Bank A.D. Beograd Banca Intesa A.D. Beograd Jugoslovenska Banka za Medunarodnu Ekonomsku Saradnju A.D. Beograd Komercijalna Banka A.D. Beograd Kosovsko-Metohijska Banka A.D. Zvečani Kulska Banka A.D. Novi Sad LHB Banka A.D. Beograd

MB Banka A.D. Niš Meridian Bank A.D. Novi Sad – Credit Agricole Group A.D. Novi Sad Metals Banka A.D. Novi Sad

Foreign

Domestic Domestic Domestic Foreign

Cyprus Slovenia

www.piraeusbank.co.yu

www.cacanskabanka.co.yu www.centrobanka.co.yu www.cont.co.yu www.credybanka.com (Sold to Erste Bank) (Sold to Intesa Bank) www.efgeurobank.co.yu

Domestic

– – – Greece (EFG Eurobank – Ergasias) –

Foreign

Germany

www.hvb.co.yu

Foreign

Austria

www.hypo-alpe-adria.co.yu

Foreign Domestic

Italy –

www.bancaintesabeograd.com www.jubmes.co.yu

Domestic Domestic

– –

www.kombank.com www.kosmet-banka.co

Domestic Foreign

www.kulbank.co.yu www.ppbank.com

Domestic Domestic

– Germany (LHB Bank Frankfurt) – France

(Bankrupt) www.bankmeridian.com

Domestic

–

www.metals-banka.co.yu

(Sold to HVB Bank)

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Table 7.4  continued Ownership

Country of origin

Website

Nacionalna Štedionica – Banka A.D. Beograd National Bank of Greece S.A. Beograd

Domestic

–

www.nsb.co.yu

Foreign

www.nbgbanka.co.yu

Niska Banka A.D. Niš Nova Banka Beograd A.D. Beograd (Findomestic Banka A.D. Beograd) Erste Bank A.D. Novi Sad Panonska Banka A.D. Novi Sad Postanska Štedionica A.D. Beograd Privredna Banka Beograd A.D. Beograd Privredna Banka Beograd A.D. Pančevo ProCredit Bank A.D. Beograd

Domestic Domestic

Greece (NBG – National Bank of Greece) – Italy

www.niskabanka.co.yu www.novabanka.co.yu

Domestic Domestic Domestic

Hungary – –

www.erstebank.co.yu www.panban.co.yu www.posted.co.yu

Domestic

–

www.pbbad.com

Domestic

–

www.pbp.co.yu

Raiffeisen Bank Yugoslavia A.D. Beograd Societe Generale Yugoslav Bank Srpska Banka A.D. Beograd Univerzal Banka A.D. Beograd Vojvodanska Banka A.D. Novi Sad Volksbank A.D. Beograd

Foreign

No. Name of bank 25 26

27 28

29 30 31 32 33 34

35 36 37 38 39 40

41* Zepter Banka A.D. Beograd

Foreign

Joint venture – KfW www.procreditbank.co.yu (Germany) EBRD, IFC (World Bank), FMO (Netherlands), ProCredit Holding and Commerzbank AG) Austria www.raiffeisenbank.co.yu

Foreign Domestic Domestic Domestic

France – – –

www.socgenyu.com www.srpskabanka.co.yu www.ubbad.co.yu www.voban.co.yu

Foreign

Joint venture (Volksbank Group Austria and EBRD) –

www.volksbank.co.yu

Domestic

www.banka.zepter.co.yu

Note: * In mid 2005 there were 41 banks in Serbia, by mid 2006 there were 36. Source: Bitzenis et al., 2008, 58–59.

The activities performed by the NBY in the course of 2001 occasioned decisive results. Foreign banks displayed interest in opening representative offices in Serbia as well in increasing the capital of domestic banks (Table 7.4). Households boosted their confidence in the banking system and overall the banking sector structure revived and the average weighted interest rate was significantly lowered. Besides the activities performed within the restructuring of the banking sector, serious efforts were also invested in strengthening the legal regulations governing the banking sector. At the end 2001, the most prominent banks were those in the

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ownership of domestic – the so-called social – entities (those from the previous period, owned by the government and the biggest social owned companies). These banks had been founded before 1989, well before the hyperinflation of 1993. In terms of ownership structure, the banks with the majority of foreign capital still had, despite their increased number, a subordinate role. To sum up, poor conditions in the country’s economy and in the banking sector, changes in the ownership structure and privatization, the need to reach the level of development seen in the EU banking sector, the transition process, the need to achieve a stable monetary policy/stable domestic currency and the end of economic sanctions and political changes were the most decisive factors that led to the implementation of banking reform in Serbia. At the same time, technical problems, problems with applying new regulations, unethical competition with foreign banks, lack of credit tracking history of clients, changing customer behaviour, and liquidity problems were the most dominant issues that the majority of banks faced after the reform process started. The liquidation of the four biggest Serbian banks at the beginning of the year 2002, the transfer of the payment system from ZOP (the clearing and settlement bureau) to banks, entrance of foreign banks into Serbia, increased competition and increased quantity and quality of services offered by banks were identified as the most significant changes that occurred during the reform process. However, changes in the regulation and supervision of the banking sector had little effect on the improvement of the overall banking sector performance, suggesting that changes were positive yet insufficient. A decrease in the number of small banks, mergers and acquisitions between banks, entry of foreign banks, an increased number of specialized banks, and the privatization of state-owned banks represent the future of the banking sector in Serbia. It has been envisaged that reform will provide for healthy competition in banking and therefore, prices of services will decrease, whilst the quantity and quality of services offered by banks as well as savings and credit offerings will increase. Lastly, Serbia has made intensive efforts to restore the viability of the banking sector, improve supervision, privatize publicly owned institutions and attract foreign banks to enter the market. Progress has also begun in the non-bank financial sector, including modernizing the stock exchange and improving the regulation of insurance companies. Despite initial progress, interest rates remain high and represent a major deterrent to new investment. However, many years of economic mismanagement can not be reversed in a relatively short period of time, and certainly there is far more that needs to be done. Questions: 1. Critically discuss the Serbian Banking Reform. 2. What is the difference of the Serbian Banking Reform compared to the other Balkan countries’ banking reform?

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3. What was behind the delay of the successful Serbian banking reform during the transition period? 4. What was behind the crises in the Serbian banking sector? 5. What were the characteristics of the Serbian banking system at the end of 2000 according to the IMF and the World Bank? 6. What was the outcome of the Serbian banking reform up to 2005? Was it successful?

7.15 The Copenhagen Political and Economic Criteria for the Case of Bulgaria (1993–2007) The Copenhagen Political Criteria, adopted by the European Council in June 1993 reads: ‘membership requires that the candidate country has achieved stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for and protecting of minorities’. The Copenhagen Economic Criteria requires: the existence of a functioning market economy; the capacity to cope with competitive pressure and market forces within the Union. In July 1997, when the Commission published its opinion on Bulgaria’s application for EU membership, it concluded that Bulgaria was on the way to meeting the political conditions set in Copenhagen and stated: Bulgaria’s progress in the creation of a market economy has been limited by the absence of a commitment to market-oriented economic policies; it would not be able to cope with competitive pressure and market forces within the Union in the medium term.

The first Report of the European Commission was published along with Agenda 2000. According to this, Bulgaria was about to fulfil the political criteria. However, Bulgaria had covered these political criteria in two and a half years – from 16 July 1997 to November 1999. The EU Commission published a series of yearly Regular Reports on Bulgaria, covering the years 1998 to 2002. The Commission recognized that free and fair elections were held in 1994 and 1997, which led to changeovers of government. Democratic institutions were in place and their stability seemed secure. A number of areas, however, were pointed out as sources of concern. If the overall framework seemed adequate, it still needed to be strengthened by practices, respecting the rule of law at all levels of the State apparatus. Corruption was highlighted as a major impediment, as well as the administration of justice, the protection of individual freedoms and the integration of the Roma minority. In November 1998, the Commission adopted its first Regular Report assessing the progress made over the past year. It concluded that developments confirmed Bulgaria’s fulfillment of the political criteria. The stability of Hungary’s democratic institutions was not questioned. Fundamental political, economic social and

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cultural rights continued to be respected. However, particular areas were indicated, where further efforts were still needed. Corruption was still one of these, despite the progress made. The rule of law required more attention, at all levels of state administration and in particular in the law enforcement bodies. The reform of the judiciary and the integration of the Roma minority were highlighted as priorities. The 1999 Regular Report conclusion is quite similar. It recognizes that Bulgaria fulfills the Copenhagen political criteria. It says however that further efforts need to be undertaken to strengthen the rule of law and protect human and minority rights, particularly of the Roma population. Particular attention needs to be paid to the fight against corruption and improving the functioning of the judicial system. In its 2002 Regular Report, the Commission found that: In its 1997 Opinion, the Commission had concluded that Bulgaria fulfilled the political criteria. Since that time, Bulgaria has made considerable progress in further consolidating and deepening the stability of its institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities. This has been confirmed over the past year. Bulgaria continues to fulfil the Copenhagen political criteria. Significant progress has been made on the judicial reform strategy with the adoption of an Action Plan and major amendments to the Law on the Judicial System. These need now to be implemented in order to translate them into concrete improvements in the functioning of the system. Issues relating to the structure of the judicial system and immunity still need to be addressed. There have also been positive further developments in the fight against corruption, which remains a cause for serious concern, with inter alia the adoption of an action plan to implement the National Anti-Corruption Strategy. Whilst the need to tackle corruption is now high on the agenda, Bulgaria needs to continue to make concerted efforts to implement the measures. There has been some further progress on public administration reform with revisions to the legislative framework and the adoption of a Strategy for Modernisation of the State Administration but serious efforts are now required to develop and implement reforms to ensure an efficient, transparent and accountable public administration. Bulgaria continues to respect human rights and freedoms. Bulgaria has considerably improved the legal framework, for tackling trafficking, corruption and organized crime as well as for asylum. However, there are a number of areas which continue to give cause for concern. A new issue that has been identified is the very poor living conditions of people in institutions, in particular the mentally handicapped. This needs to be addressed urgently. Bulgaria also needs to strengthen its efforts to reform the child care system, to make sure that the best interests of the child are reflected and reduce the number of children in institutions. Poor conditions for detainees in particular in police stations and pre-trial detention also need to be addressed. The recent changes to the Penal Code are an important step in removing discrimination on the grounds of sexual orientation. Concerning the Roma community, little has been done to remedy problems of social discrimination or to take concrete action

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The Balkans: Foreign Direct Investment and EU Accession to improve very poor living conditions. The adoption of comprehensive antidiscrimination legislation would be an important step forward in this regard.

In its 2002 Regular Report, the Commission also reported that: Bulgaria is a functioning market economy. It should be able to cope with competitive pressure and market forces within the Union in the medium term, provided that it continues implementing its reform programme to remove remaining difficulties.

In spite of the global economic slowdown, the Bulgarian economy continued to benefit from high growth and stability. In 2002, the real GDP growth rate stood at 4.8% with 2002 being the third year in a row with a growth rate above 4%. Inflation was on a downward path, mainly due to low food prices and low import prices following the depreciation of the dollar, mainly driven by increases in indirect taxes and administered prices. Unemployment decreased significantly due to jobs created in both the private sector and government employment schemes. The current account deficit in 2002 was lower than in 2001, but higher in the first half of 2003 than in the first half of 2002, and not fully covered by net inflows of foreign direct investment. The general government deficit was 0.6% of GDP in 2002 and was targeted at 0.7% of GDP in 2003. At the end of July 2003 the consolidated budget had a cash surplus of 1.8% of projected GDP. Average per capita income is low, 25% of the EU average (in purchasing power standards), while the labour market situation is improving. Catching up on income and productivity towards levels reached elsewhere in Europe was a major challenge for Bulgaria. In Bulgaria, as in most Balkan countries, people are reluctant to pay taxes placed on their profits. Simultaneously, however, they have a high demand for state services – they require a sound judicial system, a good and reliable police service, and request good health and retirement insurance. Accession to the European Union remains high on the political agenda of the government and enjoys broad political and public support. Efforts to make progress in accession preparations have been intensified. The Protocol on Bulgaria’s accession to NATO was signed in March 2003. Bulgaria continued to fulfil the Copenhagen political criteria in 2006. Corruption however, remains a problem and Bulgaria requires concerted efforts to implement measures in this respect. The Thessaloniki European Council in June 2003 also concluded that: Bulgaria and Romania are part of the same inclusive and irreversible enlargement process. Following the conclusions of the European Council in Copenhagen and depending on further progress in complying with the membership criteria, the objective is to welcome Bulgaria and Romania as members in 2007.

Bulgaria is a functioning market economy. It should be able to cope with competitive pressure and market forces within the Union in the short term, provided that it

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continues implementing its reform programme to remove remaining obstacles. The Bulgarian economy has achieved a high degree of macroeconomic stability. In the accession negotiations, all the chapters of Acquis were provisionally closed (the last one was closed on 15 June 2004). Finally, Bulgaria entered into the EU in January 2007. Questions: 1. What is the content of the Copenhagen criteria? 2. What progress did Bulgaria make in 1997 and 2007 regarding the Copenhagen political criteria? 3. What progress did Bulgaria make in 1997 and 2007 regarding the Copenhagen economic criteria? 4. What were the most decisive initial barriers in order for Bulgaria to meet the Copenhagen Criteria? 5. How might the problem of tax evasion be tackled? 6. How detrimental to Bulgaria is the issue of corruption?

7.16 The Bulgarian Telecommunication Company (BTC): Eight Year Delay (1996–2004) In 1999, the Greek telecommunication’s company OTE (the Greek sole provider of fixed telecommunications) and Cosmote (one of the three mobile operators – Vodafone and WIND being the other two – in Greece) formed a consortium with the Dutch KPN telecommunication company. KPN became one of the top five biggest mobile communications companies in Europe after its acquisition of 78% of the German mobile operator Mobilfunk Gmbh for US$9 billion. It also has foreign participation in the CEECs, such as Hungary, Poland, Ukraine and the Czech Republic. An offer of $510 million in cash for 51% of the Bulgarian Telecommunications Company (BTC) was tabled. Although, the consortium was approved, negotiations failed. The consortium KPN/OTE was supposed to become owner of 51% of Bulgarian Telecommunications Company (BTC) and of Mobikom (51% state-owned and BTC owner, and 49% owned by Cable and Wireless). What is more, it was to acquire the licence for the second GSM-operator for free. However, this deal never materialized. Bulgarian analysts suggest that there was a chance for the Bulgarian government to get a higher bid for BTC. For example, Deutsche Telecomm bought 51% of the Slovakian Telecommunication Company at the price of US$1 billion. The Bulgarian and Slovakian economies are approximately equal in size, but the telecommunication services are not as developed. Therefore a price of about US$500–600 million for 51% of BTC was considered more realistic. OTE with KPN failed to finalize the privatization of BTC, which can be seen as an odyssey from the fact that it was on 14 July 1996 when BTC was firstly

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offered for privatization. However, in another tender, at the end of 2000 OTE won a license for the second Bulgarian GSM operator. The first GSM operator, Mobiltel, which used to enjoy 300,000 clients belonged to the businessmen Chorni. Moreover, Greek OTE was pronounced the winner (in the year 2000) of a mobile licence (second Bulgarian GSM operator) after offering the highest bid of US$135 million, although the starting price was US$40 million. The other bidders were Telecom Italia Mobile, Sonera from Finland, a consortium from Turkey (which was rejected from the tender) and the consortium Panafon-Vodafone. Telecom Italia Mobile was the second tender with an offer of US$130 million. On 25 January 2001, OTE announced its first Executive Director and from 24 January 2001 the telecommunication company ‘Cosmo Bulgaria Mobile’ acquired its legal Bulgarian registration. Returning to the privatization procedure for Bulgarian Telecommunication Company (BTC), which had dragged on for several years, was finalized in June 2004. Following various decisions by the Privatization Agency and several court cases, the selected buyer was the Viva Ventures Company, backed by the American equity firm, Advent. According to the privatization agreement, within three years, Advent would become the owner of 100% of the stock of Viva Ventures. The deal was closed at a price of 230 million euro for a 65% stake in BTC. Furthermore, during the next five years (2004–2009) the buyer would be obliged to invest 400 million euro in BTC, plus Viva would have the option of a further 300 million euro investment. The social and qualification programme of the buyer for the first two years was 45 million euro. One of the most disputed issues during the long-running privatization procedure was the price, and even now experts’ opinions conflict. Their conclusions vary widely, from the view that this is the biggest privatization private equity deal in Eastern Europe, to the opinion that it remained a most unprofitable deal for Bulgaria, since the buyer would collect the company’s dividends for 2002 and 2003 (amounting to about 180 million euro) and the obligation to invest 400 million euro will be met using the funds of BTC, not outside funds or funds belonging to the buyer. Mainly for this latter reason, both right- and left-wing opposition parties in parliament declined to support the deal, since they are of the opinion that it is not beneficial for Bulgaria. However, the US Embassy in Bulgaria assessed the BTC deal and the agreement between Advent and the government as an encouraging sign for the whole investment climate in the country. One of the most sensitive issues during the negotiations, resulting in workforce unrest at BTC, was the forthcoming restructuring of the company after privatization. Ultimately this would result in significant personnel cuts. Around 25,000 employees currently worked at BTC (in the year 2005), and the privatization agreement foresaw a workforce reduction of 4,000, or about 20%, over the two-year period up until 2006. Neither the buyer nor the government have a clear view on the size of the BTC workforce after 2006. Senior representatives of Viva Ventures have made cautious statements that all future decisions regarding personnel will depend on how the business is run. Different estimates suggest that

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it is realistic to expect the loss of about 7,000–8,000 jobs over the three to four year period up to 2008–2009. The prospective job losses brought a sharp reaction from telecommunications workers’ trade unions, which held a number of regional and national protests. With these being amongst the best organized sectoral trade union federations in Bulgaria, it seems likely that tension will continue. Largely influenced by union pressure, the buyer of BTC made a commitment to develop a special social programme worth around 45 million euros, to be invested in programmes for alternative employment, retraining of redundant personnel, and payments for employees agreeing to voluntary departure. However, the trade unions expressed anxiety that there has been no final agreement on the programmes and no guarantees that it will be implemented. According to a document, 65% of BTC costs more than 357 million euros, while Viva Ventures paid just 230 million euros. The third GSM licence costs between 90 million and 145 million euros, while the Communications Regulation Commission granted it to BTC for 54 million leva. The Academic University professors, however, agree that 75% of the initial licensing fee should be deducted. Finalization of the deal was delayed from January 2004 up to June 2004 due to the procedure for issuing a third GSM licence for BTC, for which Viva Ventures has paid and additional 54 million leva. Bulgaria’s Supreme Administrative Court ruled on 15 June 2004 that the award prior to the month of the third GSM licence in Bulgaria to fixed-line operator BTC, as a sweetener in its privatization to Advent International, should be rescinded as unlawful. Under Bulgarian privatization law, operating licences should not be awarded without competitive tender. The Bulgarian prosecutor’s office, together with four other companies, including the two other GSM operators, Mobiltel and Globul, took legal action. BTC, which said it had paid the fixed purchase price for the twenty-year licence of 54.2 millions of leva (€27.7m), confirmed that it would appeal against the Court’s decision. Completion of the lengthy privatization process of a 65% stake in BTC, which was conditional on BTC having the licence, was finalized on 11 June (2004) although BTC’s owners confirmed that the suspension of the licence, payment for which was made by BTC outside the privatization contract, would not halt the privatization process. The Bulgarian government was supposed to sell its remaining 35% stake in the privatized telecommunications company BTC. Thus, in January 2005, the Bulgarian state initiated an Initial Public Offering (IPO) and offered a total of 2869573 shares (34.78% of BTC’s capital) at the Bulgarian Stock Exchange. As mentioned above, the government sold a 65% stake to Viva Ventures, a Viennabased unit of US equity fund Advent International, for €230m in June 2004. The state is to retain a ‘golden share’, a provision that gives it the power to block major decisions. Additionally a 40% stake in Mobiltel (which has Austrian ownership), the leading mobile operator in Bulgaria, was purchased by a private equity consortium from Austria. The deal, which had been carried out largely in secret, values the company at €1.2–1.6 billion and represents Eastern Europe’s largest ever leveraged

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buyout. The remaining existing Austrian investors retain a 60% stake and the move is thought likely to lead to a hastening of the sale of the company, which has a 75% market share, to Telekom Austria, which has long coveted it. Bulgaria had a market penetration of only 35% in 2005, lagging behind others in the region and therefore offering possibilities for growth, while Mobiltel is the only market leader in the region that does not have a strategic partner. Telekom Austria Group has acquired 100% of Mobiltel for a total consideration (Enterprise Value) of up to 1,600 million euros following the signing of a share purchase agreement on 1 June 2005. Mobiltel has been acquired from a consortium of Austrian and international financial investors. Mobiltel was consolidated into Telekom Austria’s wireless segment from 12 July 2005. Like many competitors, Telekom Austria is looking to Eastern Europe for growth opportunities as its domestic market matures and as such the company already owns operations in Croatia and Slovenia. Mobiltel, whose €450m debts have been taken off the purchase price, is currently owned by a consortium of Austrian and other international investors which have been talking to Telecom Austria over a period of time. Finally, Bulgartel, the newly-created telecoms arm of gas provider Bulgargas, created a rival to the former monopoly operator BTC. Bulgartel has built a 650km fibre network overlaying its parent company’s gas network which comprises 24 channels, just two of which will be required by Bulgargas. The company operates as a wholesale capacity provider rather than offering a fixed-line service. What is more, it has already signed capacity lease contracts with two operators, CableTel, a Bulgarian company, and PanTel, a Hungarian company. Questions: 1. What were the reasons for the delay of the BTC privatization process? 2. Did the Bulgarian government gain anything from the eight years of delay in the specific privatization deal? Was it a profitable or an unprofitable deal? 3. What do you think about a monopoly in the telecommunication industry? Is there such a monopoly in Bulgaria at the moment? 4. Compare and contrast the unsuccessful privatization deal of OTE/KPN and the successful one of Advent International. Which deal was expected to be better for Bulgaria? 5. How many mobile operators exist in Bulgaria? 6. Discuss the restructuring programme of BTC. 7. What about the competition in the Bulgarian telecommunication sector?

7.17 FDI in Bulgaria: The Key Determinants of FDI Since 2000 The cumulative value of foreign direct investment inflows in Bulgaria reached US$8 billion in the second quarter of 2004. More than 90% of these investment flows had been generated during the period 1997–2004. FDI through green-field,

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joint ventures, reinvestments and additional investments in acquired enterprises exceed the FDI flows through privatization, which had been the main source only in 1994 and 1997. In the period 1999–2004, the amount of FDI inflows in Bulgaria reached more than US$6 billion, while in the first seven years of Bulgarian transition it was less than US$2 billion. Moreover, around 30% of the total FDI inflows were derived from privatization deals when at the same time less than 5% were acquisitions of shares through the stock market (indirect investment – portfolio investment). The most important foreign investors in Bulgaria originate mainly from Greece, Austria, Netherlands, Belgium, Germany and Italy (BFIA – Bulgarian Foreign Investment Agency, 2004). Important investments have also been made through the offshore centre of Cyprus. These investments have been exploited mainly by Greek, Turkish and Russian entrepreneurs. Greece is the leading country in foreign investments in Bulgaria, thus special focus in our questionnaire analysis has been given to the Greek FDI outflows in Bulgaria. Bitzenis (2002b) ran a questionnaire survey in Bulgaria in order to identify the Bulgarian business conditions/factors (obstacles – motivations) which have been examined by foreign enterprises that enter Bulgaria. It is obvious that these factors have also been considered by MNEs to familiarize themselves with the Bulgarian business environment and thus have more profitable and successful investment projects. In this way, Bitzenis extracted valuable information regarding the determination of FDI in Bulgaria during its transition period. All in all, the purpose was to identify the kind and the type of motivations and entry barriers for inward foreign direct investment that the foreign firms have considered in order to decide whether they should make an investment in Bulgaria or not. With the help of an official document from the Bulgarian Foreign Investment Agency (BFIA), a list was drawn up of 110 foreign companies that according to the BFIA, had invested over one million US$ each in Bulgaria up to the middle of June 1998. As of 2007, these companies remain amongst the top 150 biggest foreign investors in Bulgaria (BFIA catalogue, June 2004). For the purpose of the questionnaire research, Bitzenis extended the list to 131 foreign companies, adding another 21 investors who were primarily of Greek origin. These 21 investors were not part of the BFIA official published data of foreign investment in Bulgaria due to difficulties efficiently collecting the data. Of the 131 investors, 64 companies responded (48.9%). The total invested amount for the 110 foreign companies was $1,283,419,173 US dollars and for the 21 enterprises $47.6 million US dollars. The statistical sample with 64 companies consists of a total investment amount equal to $863 million US dollars, which is 64.7% of the total investments of these 131 companies or 50.7% of the total Bulgarian FDI inflows (BFIA catalogue, Foreign Direct Investments over US$1 million (as of 30 June 1998). Data was also collected from a one to one interview.

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To be more specific, a descriptive/analytical type of research was undertaken as it best suited the research objectives examined. The sample was determined on a quota basis (non random selection) involving the selection of subjects based on the identification of specific characteristics to increase representativeness. In quota sampling the target group is divided into subgroups on the bases of different characteristics in the case of this study – companies from different types of industries, volume of investments, with quotas determined for each subgroup. Based on the criterion of the largest investment deals in Bulgaria, a quota was made with the help of BFIA.

3,13% 17,19% 20,31%

financial aspects hunters 17,19% exploiting ownership advantages 20,31%

79,69% 32,81%

62,50%

efficiency hunters 3,13%

50%

market for strategic reasons hunters 32,81% location hunters 50% factor hunters 62,5% market hunters 79,69%

Figure 7.3  Groups of motivations (hunters) Source: Bitzenis’ questionnaire research.

According to Figure 7.3, foreign investors have proved to be market hunters with a percentage of 80%, followed by factor hunters (62%), locational hunters (50%) and strategic market hunters (33%) respectively. At the same time, 20% of the foreign MNEs have invested in Bulgaria in order to exploit their ownership advantages and 18% to exploit financial advantages. Only 3% of the investors were efficiency hunters. It can be inferred from this that in a country such as Bulgaria, which has a customer base of eight million people with many unsatisfied needs, foreign investors focus primarily on the characteristics of the market.

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Regarding the entry mode of MNEs in the Bulgarian market, the author’s research has revealed that 55% of the 64 foreign investors have chosen the greenfield way as the best or the most preferable way to carry out their FDI projects, 36% of the investors took advantage of the opportunities that the Bulgarian privatization programs offered, followed by 18.8% of MNEs who created joint ventures (Figure 7.4). Joint ventures were the most preferred way of foreign entry into former communist countries in the early years of their transition, however this low percentage of joint ventures can be explained by the fact that the survey took place in the time period 1998–1999. At that time, most of the existing joint ventures from the early years of transition, had become bankrupt or collapsed either due to the insufficient cooperation by local partners with their foreign counterparts or due to the acquisition of the remaining company shares by foreign investors. Accordingly, subsequent FDI projects in the Bulgarian market followed other forms of foreign entry such as the greenfield FDI or acquisitions through privatization programs, either because or greater awareness of the sluggish Bulgarian economic environment at the beginning of transition or due to the registered failure of many joint ventures.

18,80%

0%

4,70% 35,90%

Privatisation 35,9% Phare, EU 0% From Trade to FDI 23,4%

0%

Licensing 0% Acquisition 7,8% Greenfield FDI 54,7%

23,40%

54,70% 0%

Joint Venture 18,8% Portfolio 0% Branches 4,7%

7,80%

Figure 7.4  Ways (entry modes) used by MNEs to invest in Bulgaria Source: Bitzenis’ questionnaire research.

From Figure 7.5, it can be seen that the main motivations (as expected) were: market size (94%), low labour cost of unskilled workers (67%), geographical proximity (58%), international pressures from competition (45%), prospects for market growth (44%), links to other neighbouring countries (42%), and finally, lack of local competition (40%).

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market size

67,2%

low unskilled labor cost

57,8%

geographical proximity

45,3%

international/globalization pressures

43,8%

market grow th

42,2%

link to other (neighbour) countries

40,6%

lack of local competition

37,5%

acquiring of assets

31,3%

to avoid trade barriers

28,1%

unsatisfied local demand for products

28,1%

low skilled labour cost

23,4%

cultural closeness

23,4%

follow ing the clients theory exploiting existing buiness links establishing an export base

21,9% 18,8%

lack of infrastructure

17,2%

cultural distance (as an incentive)

17,2%

follow ing the competition (theory)

93,8%

12,5%

Figure 7.5  The key motivations for FDI in Bulgaria (research from 64 MNEs) Source: Bitzenis, 2002a; 2002b.

It can be argued that market size is the most decisive FDI motivation. Although, Bulgaria is not as large a market as France or Germany, this high percentage of the market size factor is not a surprise as out of 64 interviewed companies 37 were Greek (either of Greek origin or offshore companies with ‘discovered’ Greek interest), which in turn considered Bulgaria as an important market. With its population of over eight million people, Bulgaria was ‘another Greece’ for them. Secondly, companies such as Coca Cola, KFC (formerly Kentucky Fried Chicken) and McDonalds have ambitions for every country and every market since their policy is to carry out business on a worldwide basis (market hunters – global companies). Thirdly, it is the goal of a large MNE from a western market to gain the largest possible percentage of the Bulgarian market share when the same company owns a limited percentage of a western market share. For example, a 10% market share of a large market such as France equates to around 6 million possible consumers. At the same time 80% market share of a small market such as Bulgaria one means more than 6 million possible consumers. Fourthly, the majority of the 27 foreign (western) MNEs that participated in the questionnaire research have also considered

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Bulgaria as a link to other neighboring countries and especially to CIS countries. Bulgaria is thought to be a ‘bridge’ for future expansion into CIS countries and an export base to be used to supply products to neighboring markets. It can be inferred that in a country such as Bulgaria, with a customer base of more than eight million people with many unsatisfied needs, foreign investors focused primarily on the characteristics of the market, taking into consideration simultaneously the prospects for growth of the Bulgarian market and the possibility of Bulgaria joining the EU during the current decade. Lastly, foreign MNEs believe that there are extremely high similarities among the economies in the Balkan region (similar risks, motivations and barriers). When they choose one country from this region as a destination for an FDI outflow, they then proceed to the establishment of FDI projects in most of the remaining Balkan countries.

unstable legal system

73.44% 57.81%

bureaucracy

53.13%

corruption, crime, mafia

51.56%

high investment risk

50.00%

limited purchasing power, low GDP per capita

42.19%

lack of infrastructure 31.25%

macroeconomic instability

29.69%

high VAT, high taxation

26.56%

behaviour against consumption & labour

20.31%

lack of managerial skills

15.63%

low progress in transition political instability

6.25%

Figure 7.6  The most important obstacles for Bulgarian FDI inflows (research from 64 MNEs) Source: Bitzenis, 2002a; 2002b.

The primary barriers that the investors had to deal with in the Bulgarian market are shown in Figure 7.6. The biggest obstacle was the unstable legal system in Bulgaria (74%), followed by bureaucracy (58%), corruption, crime and mafia (53%) and the high investment risk (52%).

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The Bulgarian unstable legal framework factor was mentioned by 73.4% (47/64) as the most decisive impediment for establishing an FDI project in Bulgaria. However, foreign MNEs, other than Greek MNEs, mentioned the above barrier at an extremely higher percentage of 92.6% (25/27). At the same time, only 59.5% (22/37) of the Greek MNEs investing in Bulgaria have made reference to this as a barrier. The unfamiliarity of the western foreign investors with the constant changes in the Bulgarian legal framework is a significant contributory factor to this. Greek MNEs are used to working in such an environment, characterized by constant changes in the legal framework and the inadequate enforcement of laws that leaves space for corruption, bribery and bureaucracy. Greek MNEs, however, did not reject the above barrier, but referred to it at a significant lower percentage. The high percentage of 57.8% (37/64), of the interviewed companies which mentioned bureaucracy as an important barrier for their FDI projects in Bulgaria, was expected. However, the high percentage of Greek MNEs (56.8%, 21/37) that gave mention to bureaucracy as a decisive barrier was unanticipated and a surprise given the fact that Greek entrepreneurs are familiar with Greek bureaucracy. Many managers from other western MNEs acknowledged the experience and the ability of Greek entrepreneurs to successfully cope in economic environments which are significantly bureaucratic in nature. An explanation of this outcome may be that bureaucracy in Bulgaria is at higher levels than in Greece, and that as an obstacle, bureaucracy, is a difficult task to cope with, even for experienced entrepreneurs. To conclude, the origin of MNEs did not play any role whatsoever in the consideration of bureaucracy as a barrier. While the origin of MNEs did not play any role in the consideration of bureaucracy as a barrier, the sector in which MNEs belong to played a significant role. In other words, over 70% of MNEs in the industrial/textile or services sector looked upon bureaucracy as an important barrier, when at the same time only 30% (7/23) of MNEs in the trade/food sector mentioned the above as a crucial barrier. From a statistical point of view, we assume the same, when the Pearson Chi-Square was 0.004 and thus at a 1% level of significance, it is concluded that there is a strong association between the sector that an MNE belongs to, and bureaucracy as a barrier. It can be argued that 53.1% (34/64) of the total foreign MNEs mentioned corruption, bribery or other illegal actions from mafia as serious obstacles for the operation of their FDI projects in Bulgaria. However, the fact that 78.4% (29/37) of the Greek companies made reference to the high corruption rate in Bulgaria as an obstacle is surprising. The basis for this surprise is profound when one considers that the Greek corruption rate in 2003 was on a similar level with that of Bulgaria. Yet, only 18% (5/27) foreign MNEs, other than the Greek ones, gave significance to this barrier. Expectations were that foreign MNEs, other than Greek MNEs, would acknowledge the corruption factor as a decisive barrier. Furthermore, Greek MNEs are particularly capable of working in an environment with high corruption rates.

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Table 7.5  Corruption perceptions index 2003 Country Country rank 1 2 3 5 6 7 8

11

14 16 17 18 20 21 23 25 26 27 29 30 32 33 35 37

Finland Iceland Denmark New Zealand Singapore Sweden Netherlands Australia Norway Switzerland Canada Luxembourg United Kingdom Austria Hong Kong Germany Belgium Ireland USA Chile Israel Japan France Spain Portugal Oman Bahrain Cyprus Slovenia Botswana Taiwan Qatar Estonia Uruguay Italy Kuwait Malaysia United Arab Emirates

CPI 2003 score

Surveys used

Standard deviation

High-low range

9.7 9.6 9.5 9.5 9.4 9.3 8.9 8.8 8.8 8.8 8.7 8.7 8.7 8.0 8.0 7.7 7.6 7.5 7.5 7.4 7.0 7.0 6.9 6.9 6.6 6.3 6.1 6.1 5.9 5.7 5.7 5.6 5.5 5.5 5.3 5.3 5.2 5.2

8 7 9 8 12 11 9 12 8 9 12 6 13 9 11 11 9 9 13 12 10 13 12 11 9 4 3 3 12 6 13 3 12 7 11 4 13 3

0.3 0.3 0.4 0.2 0.1 0.2 0.3 0.9 0.5 0.8 0.9 0.4 0.5 0.7 1.1 1.2 0.9 0.7 1.2 0.9 1.2 1.1 1.1 0.8 1.2 0.9 1.1 1.6 1.2 0.9 1.0 0.1 0.6 1.1 1.1 1.7 1.1 0.5

9.2–10.0 9.2–10.0 8.8–9.9 9.2–9.6 9.2–9.5 8.8–9.6 8.5–9.3 6.7–9.5 8.0–9.3 6.9–9.4 6.5–9.4 8.0–9.2 7.8–9.2 7.3–9.3 5.6–9.3 4.9–9.2 6.6–9.2 6.5–8.8 4.9–9.2 5.6–8.8 4.7–8.1 5.5–8.8 4.8–9.0 5.2–7.8 4.9–8.1 5.5–7.3 5.5–7.4 4.7–7.8 4.7–8.8 4.7–7.3 3.6–7.8 5.5–5.7 4.7–6.6 4.1–7.4 3.3–7.3 3.3–7.4 3.6–8.0 4.6–5.6

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Table 7.5  continued Country Country rank 39 40 41 48 50

53 54

57 59

64 66

70

76 77

Tunisia Hungary Lithuania Namibia Mauritius South Africa Costa Rica Greece South Korea Belarus Brazil Bulgaria Czech Republic Jamaica Latvia Colombia Croatia El Salvador Peru Slovakia Mexico Poland China Panama Sri Lanka Syria Bosnia & Herzegovina Dominican Republic Egypt Ghana Morocco Thailand Senegal Turkey

CPI 2003 score

Surveys used

Standard deviation

High-low range

4.9 4.8 4.7 4.7 4.4 4.4 4.3 4.3 4.3 4.2 3.9 3.9 3.9 3.8 3.8 3.7 3.7 3.7 3.7 3.7 3.6 3.6 3.4 3.4 3.4 3.4 3.3

6 13 10 6 5 12 8 9 12 5 12 10 12 5 7 11 8 7 9 11 12 14 13 7 7 4 6

0.7 0.6 1.6 1.3 0.7 0.6 0.7 0.8 1.0 1.8 0.5 0.9 0.9 0.4 0.4 0.5 0.6 1.5 0.6 0.7 0.6 1.1 1.0 0.8 0.7 1.3 0.7

3.6–5.6 4.0–5.6 3.0–7.7 3.6–6.6 3.6–5.5 3.6–5.5 3.5–5.5 3.7–5.6 2.0–5.6 2.0–5.8 3.3–4.7 2.8–5.7 2.6–5.6 3.3–4.3 3.4–4.7 2.7–4.4 2.6–4.7 2.0–6.3 2.7–4.9 2.9–4.7 2.4–4.9 2.4–5.6 2.0–5.5 2.7–5.0 2.4–4.4 2.0–5.0 2.2–3.9

3.3

6

0.4

2.7–3.8

3.3 3.3 3.3 3.3 3.2 3.1

9 6 5 13 6 14

1.3 0.9 1.3 0.9 1.2 0.9

1.8–5.3 2.7–5.0 2.4–5.5 1.4–4.4 2.2–5.5 1.8–5.4

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Table 7.5  continued Country Country rank 78

83

86 92

131 132 133

Armenia Iran Lebanon Mali Palestine India Malawi Romania Mozambique Russia Albania Argentina Ethiopia Gambia Pakistan Philippines Tanzania Zambia Haiti Nigeria Bangladesh

CPI 2003 score

Surveys used

Standard deviation

High-low range

3.0 3.0 3.0 3.0 3.0 2.8 2.8 2.8 2.7 2.7 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 1.5 1.4 1.3

5 4 4 3 3 14 4 12 5 16 5 12 5 4 7 12 6 5 5 9 8

0.8 1.0 0.8 1.8 1.2 0.4 1.2 1.0 0.7 0.8 0.6 0.5 0.8 0.9 0.9 0.5 0.6 0.6 0.6 0.4 0.7

2.2–4.1 1.5–3.6 2.1–3.6 1.4–5.0 2.0–4.3 2.1–3.6 2.0–4.4 1.6–5.0 2.0–3.6 1.4–4.9 1.9–3.2 1.6–3.2 1.5–3.6 1.5–3.6 1.5–3.9 1.6–3.6 2.0–3.3 2.0–3.3 0.7–2.3 0.9–2.0 0.3–2.2

Note: A more detailed description of the CPI 2003 methodology is available at ; A CPI 2003 Score relates to perceptions of the degree of corruption as seen by business people, academics and risk analysts, and ranges between 10 (highly clean) and 0 (highly corrupt); Surveys Used refers to the number of surveys that assessed a country’s performance. A total of 17 surveys were used from 13 independent institutions, and at least three surveys were required for a country to be included in the CPI; Standard Deviation indicates differences in the values of the sources: the greater the standard deviation, the greater the differences of perceptions of a country among the sources; High-Low Range provides the highest and lowest values of the different sources. Source: .

The CPI 2003 Score (Transparency International Corruption Perceptions Index 2003) (Table 7.5) recorded the degree of corruption as perceived by business people, academics and risk analysts. It ranges between 10 (highly/clean) and 0 (highly corrupt). A total of 17 surveys were used from 13 independent institutions, with at least three surveys required for a country to be included in the CPI. Throughout the years 1998–2003, Bulgaria decreased its corruption (from 2.9 in

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1998 to 3.9 in 2003). However, corruption was on the rise in Greece from 4.9 in 1998 to 4.3 in 2002. Needless to say, Greece is the most corrupt country among the EU(15) countries (Italy was in the 14th place, just before Greece). To summarize; the sample used in our questionnaire survey consisted of 64 MNEs. These MNEs made a significant volume of investment in Bulgaria, over US$1 million each. The survey makes a significant contribution to the field as not was it conducted in an ex-communist country, but also in one isolated from western investment interest in a specific time period. The sample used was relatively large, receiving a high response rate and with a proportional distribution of the participants in all the sectors of the Bulgarian economy. The MNEs were tested by their origin, and by each sector that each one belonged to. The findings have been analysed statistically and useful comparisons with the already exiting literature have been made in order to extract not only the specific motives that allured foreign entrepreneurs to invest in an ex-communist country such as Bulgaria, but also the impediments that they faced during the establishment of their FDI projects. Questions: 1. Which are the most important determinants of FDI in Bulgaria? 2. What do you think about corruption rates in the Balkan region? 3. What is your opinion of market size as a decisive FDI motive for the case of Bulgaria? 4. What do you think about the ranking order of FDI obstacles for the case of Bulgaria?

7.18 The Main Reasons for the Delay in the Bulgarian Privatization Process Until 1997 Privatization in Bulgaria in the transition years was slow and difficult due to insufficient planning and implementation of privatization schemes, often resulting from uncontrolled circumstances (see also Zloch-Christy, 1995). Such delays were sometimes so striking that they negatively affected the trustworthiness of the Bulgarian government. For instance, the privatization of 51% of Balkan Airlines was announced in the Wall Street Journal in 1993, after an already failed attempt to sell 49% of the company in June of the same year. The company was lossmaking and the agreement contained several unclear elements, although it was privatized later on, in June 1999. By 2000 it was rumoured that the Balkan Airlines license would be revoked from the owner, Israel’s Zeevi Group. These rumours became a reality due to the  M. Jean and Stephen C. Schmidt, 1995, ‘Progress on Privatization in Bulgaria’, Comparative Economic Studies, Vol. 37, No.1, Spring, 61.

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inability of the Zeevi Group to invest US$20 million, which had been included in the privatization deal as an obligation. In the end, a bankruptcy procedure was launched early in 2001 due to the poor financial position of the airline. The obstacles for privatization are generated by the considerations each government has to make before and during the privatization process. The issues a government should consider in order to efficiently start the privatization process are: • • • •

The selection of the companies to be privatized in different time periods. The specific methods to be used in each company, the use (or not) of a mass privatization method. The speed and sequence of the entire privatization process (restructuring of companies before privatization or passing this task to the new owners). The selection of the percentage that the state will maintain, and the time limit for the abolition of all monopolies.

However, two of the key adverse initial conditions, which were very strong in Bulgaria and affected the privatization process, were the state bureaucracy and the unstable business environment. A striking example, besides the Balkan Airlines issue, was the case of Rover (an automobile company). In November 1994, Rover acquired a manufacturing company in Bulgaria by investing US$1.4 million. Some time later the company withdrew the investment because of the problems it faced regarding state bureaucracy and due to certain ‘bridges/gaps’ in the agreements already signed with the Bulgarian government. Another two obstacles responsible for the slow Bulgarian privatization process were the political instability (and the conflicts of interest among politically strong parties) along with the fact that Bulgarians are either indifferent or negative towards privatization (Mladenova et al., 1997, 505). A report prepared by the Centre for the Study of Democracy revealed that in 1992, 74.6% of the population had no intention in participating in the privatization process. Until the end of 1997, the above underlying factors proved to be ‘lethal’ for the privatization process. The unstable political environment and the inability of the acting governments to plan and coordinate the economic restructuring had a direct effect on the privatization process. Moreover, the negative attitude of the Bulgarian people, especially toward privatization when there was participation of foreign investors, worsened the situation and led many government plans to fail. To make matters worse, functional problems arose to undermine the privatization procedure. The first was the widely discussed valuation problem. The former communist countries had an enormous problem in defining the assets owned by each company, and then in attributing the proper value on each asset, mainly because of the shared use of assets by companies and insufficient accounting records. Bulgaria had a  Marinov Marin Alexandrov and Svetla Trifonova Marinova, 1997, ‘Privatization and Foreign Direct Investment in Bulgaria: Present Characteristics and Future Trends’, Centre for Research into Post-Communist Economies, Privatization and FDI in Bulgaria, 108.

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significant valuation problem, which was underlined by the fact that the so-called ‘valuation experts’ used in the early years by the Privatization Agency were poorly trained Bulgarian citizens, ill equipped and lacking the expertise needed. The second problem was that after any valuation of the respective companies, the competent authorities failed to realize that the price of the company should not merely represent the value of the company. In order for the privatization deals offered to be attractive and lucrative to foreign investors, the potential risk they would undertake by investing (given the unstable and highly risky business environment and the political and economic instability), should be reflected on the price in the form of a price reduction. Since it is almost impossible to incorporate all the potential risks in a given situation, the factors which better approximate financial risk are inflation and exchange rates, which, if incorporated in the price accounting for a five-year estimation, may make the price more attractive. As this did not occur in Bulgaria, the privatized companies were offered at prices much higher than what the investors could consider an opportunity. After the introduction of the currency board in mid 1997 and especially in 1998–1999 the problem accelerated throughout the whole privatization process, when Bulgaria faced moderate inflation rates and stable exchange rates. Another negative factor in the privatization procedure was the extensive power of the nomenklatura, which was heavily involved in informal or illegal privatization. An indicative reference appears in research by Bulgarian economists, which suggests that in the time period 1991–1996, assets worth about 100 billion leva, and profits of several billions of leva were acquired or ‘privatized’ under suspicious circumstances (either illegally or by ‘side methods’). To be more specific, the parties authorized to conduct privatization deals, and especially the Privatization Agency have often been accused of improper judgment in important decisions and insufficient planning and control of the procedures. The problem of inconsistent data is apparent in the official citations and reports of the Privatization Agency. Most of the updated data retrieved from yearly reports include changes throughout the years. Given the fact that evidence on Privatization deals appears different in separate reports and in different time periods, this research will present the latest data from official PA reports after the modifications and calculations are done by the author for the purpose of higher credibility. Another important note is that according to Article 1, the Bulgarian lev shall be re-denominated whereby 1,000 old levs (BGL) shall be exchanged for one  Rayome L. David and John A. Stocker, 1995, ‘Bulgaria: Privatization, Risk and Reality’, Managerial Finance, Vol. 21, No. 4, 65–76.  Marinov Marin Alexandrov and Svetla Trifonova Marinova, 1997, ‘Privatization and Foreign Direct Investment in Bulgaria: Present Characteristics and Future Trends’, Centre for Research into Post-Communist Economies, Privatization and FDI in Bulgaria, 107.  Amended, issues 30 and 65 of 1999 of the Law on Re-denomination of the Bulgarian Lev (Adopted by the 38th National Assembly on 19 February 1999; published in the State Gazette, issue 20 of 5 March 1999) as of 5 July 1999.

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new lev (BGN). In the data presented in this paper 1 BGN is equivalent to 1DM while 1000BGL is equivalent to 1DM. However, there are different results when comparing statistical data using different sources such as the Bulgarian Foreign Investment Agency (BFIA) and the PA. At this point, it is useful to present a more detailed analysis of the reasons for the slow speed and low effectiveness of the Bulgarian privatization process. The following outline will embody the above reasons and detail some additional ones: •

•

•

•

•

•

The lack of transparency and the existence of corruption and bribery in the privatization progress discouraged both investors who had dealt with Bulgarian bureaucracy and potential investors who were informed about the situation by the experience of others. The highly unstable macroeconomic environment of Bulgaria in the time period 1989–1997, discouraged investors who in any case are heavily affected by the macroeconomic environment of a country in investment decisions. After 1997, the privatization process accelerated, as a result of changes founded on the introduction of the currency board, and the initiation of macroeconomic stabilization. The inadequate legal framework and its constant changes did not provide investors with any security. Instead, it made the trustworthiness of Bulgarian deals rather questionable, thus increasing the risk of the investment (Bitzenis, 2002b). The effort of Bulgaria to get the highest proceeds possible for the larger and more significant state companies, led the government to decide on restructuring before privatization. Besides the extra financial burden on the state budget, this resulted in companies that constituted greater investment opportunities being offered either at unreasonably high prices or not offered at all until restructuring took place. Moreover, the delay in offering significant SOEs led the Bulgarian state to offer low value added projects for privatization. This, in turn, brought about low western investment interest. Most of the SOEs had high accumulated debts that the Bulgarian state did not restructure rapidly. The restructuring of debt through the restructuring of the company, through isolation, or through debt swap operations, either delayed the companies’ offering for privatization or diminished their value without the settlement of their debts. The geographical distance of Bulgaria from the more advanced western economies, was one of the factors that affected investors in their decision to

  In many cases, a researcher may find different statistical data for the same economic event from different sources, even from the same source (see and compare Figures 7.2 and 7.5 together with Table 7.2).

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•

•

•

•

•

•

•

•

seek privatization opportunities elsewhere, in transition economies closer to their own countries or in more economically developed countries. The implementation of methods such as spontaneous privatization, MEBO etc., which were not efficiently supervised, allowed the insiders and the nomenklatura to exploit inside information and acquire state property through informal ways. The interest was personal profit rather than the effective and prosperous development of the firms. The complex criteria of selecting the buyers, a process that was in many cases already corrupted by the insiders and the nomenklatura, along with the barriers of state bureaucracy, delayed the privatization process and discouraged potential investors. The Kosovo war and the embargo that the Western countries imposed in the area cut Bulgaria off from its main export channels. This resulted not only in a drastic increase in transportation costs, but also decreased the export potential of the area and the possibility of expanding markets. The turmoil of war and its economic consequences on the entire area hardly indicated a period suitable and profitable for investments in a country such as Bulgaria, which was gravely affected by the situation. The economic crises in both Asia and the former USSR discouraged investors from investing in Eastern emerging markets. Investors indicated that the risk of the investment was high compared to the potential return or, despite any return; they were not capable of undertaking such a high risk. The lack of experience in Bulgaria, which led to decisions that negatively affected privatization, such as the choice of inexperienced valuation ‘experts’, as well as the state bureaucracy inherited from the communist years, created an insecure environment for investors. The positive changes that occurred after 1997, among which was the introduction of international consultants in the privatization deals, were a product of the experience acquired as well as the response to external pressures. Until 1997, the inability and unwillingness of the changing governments to facilitate privatization led to decisions that stalled both the process of privatization and the process of restructuring. The political instability was both a cause and an effect of the delay in the transition to a market economy. The problem of the correct valuation of the state owned firms brought about significant delays and inefficiencies in the privatization process. Initially, the lack of proper and accurate accounting records and missing documents that clarified property rights and other information about the firm, made the valuation of separate firms very difficult. There was a lack of information regarding the companies to be privatized. The existing information was based on misleading data from the former management and unreliable accounting rules and techniques. These issues should have been resolved through a proper evaluation of past performance together with the value of the assets. Specifically the data provided lacked

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•

•

327

evidence of profitability, as the state was not profit oriented and the intermediate goods were discriminatorily priced through either internal means or the Council for Mutual Economic Assistance (CMEA) trade, a fact restricting predictions on the future profits of the company. While many companies lacked evidence on purchasing prices, others which had all of the required documents, appeared to have been purchased again at discriminatory prices. Bulgarian laws were often ineffective. According to Bulgarian law, a privatization deal is consummated with the sale of more than 50% of the state company to a private investor. The 49% which belongs to the state may be sold later to other investors or remain in the ownership of the state. Nevertheless, Bulgarian corporate law allows a shareholder, or a group of shareholders, who own more than 33% of the shares, to block strategic decisions concerning the company. Thus, the IMF and other institutions put pressure on the Bulgarian government to offer more than 67% of the total shares of each state-owned company. Investors, though, are discouraged by the fact that the government may offer more than 33% of the state-owned company in MEBO, Mass Privatization, or other kinds of Privatization, since this will create problems in corporate governance and may restrict foreign investor’s strategic moves if the decisions are blocked by employees or other investors. The late abolishment of monopolies or the delay of this abolishment, the absence of an adequate competitive environment together with the lack of strong structural reforms, the lack of sound stock market and financial intermediaries and the high risk of the Bulgarian environment led again to the absence of significant western foreign investment interest. The limited personal savings of the majority of the population led to limited participation in mass privatization programs and in the inadequate creation and establishment of new private firms.

Questions: 1. What are the main reasons for the delay in the privatization process in Bulgaria? 2. What are the issues a government should consider in order to efficiently initiate the privatization process? 3. What were the obstacles responsible for the slow Bulgarian privatization process?

7.19 Fiscal Incentives Provided by the Bulgarian Government for Attracting FDI Projects in 1994–1999 All Central and East European (CEE) economies concluded that FDI inflows are a key factor in the process of transformation and restructuring. After the experience

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of 12 years of transition, however, there is still little conclusive evidence regarding the schedule and the type of incentives that each country requires in order to attract foreign investors, or to limit the cost of these policies. On the contrary, the study of the transition of the Bulgarian economy strongly suggests that the imposition of fiscal/financial incentives has only moderate results. With this in mind, the Bulgarian government diminished or eliminated most of the incentives. Incentives, provided to foreign investors in general, can be granted to all investors or selectively to specific foreign investors (specific country origin of MNEs). Alternatively, incentives can be offered to certain investors if they fulfil specific conditions. It is common for transitional economies to recognize that many fake joint ventures appear as a result of various governmental laws which discriminated against the domestic entrepreneurs (OECD, 1997, 92). These fake joint ventures enjoyed the advantages of the FDI incentives. Another specific problem, apparent in transitional economies during the imposition, enforcement, and application of these incentives is the problem of bureaucracy, corruption and bribery. There is a selective approach for choosing specific investors to whom the incentives will apply. This selection procedure opens up the possibility of time wasting as well as problems of corruption and bribery. OECD (1997, 92), argued that the greater the number of conditions to be fulfilled by the investor, the less the transparency and the greater the possibility of manipulation. In addition, selective approaches also postpone decisions and, in reality, dissuade investors while serving primarily to demonstrate who decides what in the country: the market or the bureaucrat?

MNEs more than often invest in host countries that provide a stable economic and political environment. Countries introduce in their transition policies measures to remove or eliminate obstacles and barriers that may discourage foreign investors. Therefore, it is of high priority for MNEs and/or governments to pay close attention to other forms of incentives (not imposed by the governments, but imposed by the overall current situation in the country or in the region). Some of these are: adequate infrastructure, privatization programs, granting of monopoly rights, protection from import competition, geographical proximity, lack of investment interest, lack of local competition, special concessions on the repatriation of the profits and closure of the market to further entry by others (e.g. Rover (UK) asked this from the Bulgarian government), etc. Such incentives can be called non-financial incentives (OECD, 1997, 90) or alternatively incentives that are derived from passive governmental behaviour (OECD, 1997, 98). They are measures that limit competition and thus decrease uncertainty and risk for the business operation through the provision of monopoly or other preferential modes of treatment. The abolition of a monopoly, the low price of a privatization deal, the low cost of acquisition of land, a chance to secure a new

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market, the liberalization of trade and business activities or a more transparent legislation are also defined as non-financial incentives. A fact in accordance with the results of the author’s own research is that financial incentives are not as pre-eminent in investment decisions as non-financial incentives. Indeed, investors tend to find alternative ways to avoid taxation and thus overcome tax incentives (Sergi, 2007). One way is to under-report and transfer profits abroad before taxation. Another way is to transfer pricing which is usually done by over-invoicing the imported material supplies or the imported machinery and under-invoicing the exports back to the foreign subsidiaries. A further supporting argument (regarding the limited interest of tax incentives) is the fact that foreign investors spent a large amount of money in the initial investment years and, thus, due to the depreciation of their capital, they transfer losses in these years. Furthermore, offshore companies and double taxation avoidance agreements are also factors that make investors indifferent to the tax incentives offered by the host governments. Finally, financial incentives, although significant in amount or in percentages, are frequently more minimal considerations once we consider that the specific host country is plagued with political, legal, social and macroeconomic instability or a high risk environment, dampening foreign investment in general. Generally, the results indicate that when a host country provides incentives and especially tax incentives, the outcomes are infrastructure improvements, increased employment, growth, economic stability, and other positive spillovers due to the attraction of inward FDI flows. On the other hand, there are some professionals, economists and state officials who claim that tax incentives (corporate income tax exemption, job creation tax incentive exemption, equipment and machinery tax exemption, etc.) are costly, ineffective and detrimental (Buss, 2001, 90). Buss (2001, 92), has also argued that there is little risk to politicians when incentives fail because failure can be blamed on economics, market forces, or dysfunctional corporate behaviour. According to the Association of State Development Agencies (NASDA), there are some countries that have conducted rigorous evaluations of the cost and benefit of incentives offered to private enterprises (Buss, 2001, 93). Buss (2001, 101), has also pointed out that taxes should matter to states, but researchers cannot say how, when, and where with much certainty. Firms may need tax incentives to increase their viability in some locations, but researchers cannot definitively say which businesses or which locations.

  The term fiscal incentives can be used to mean of tax holidays, reduction in social security contributions, deductions from taxable earnings (significant number of employees), investment allowances, income tax reductions, import or export duty exemptions, etc. On the other hand, the financial incentives can take the form of direct subsidies, subsidized loans, government credit, equity participation, etc.

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Thus, it is desirable for the government to evaluate the costs and benefits of different types of incentives it plans to offer foreign MNEs and to decide if there is a necessity to offer these incentives during a specific time period. Governments in transition economies are much more motivated to use FDI incentives than governments in western countries. In the former countries there is a need for modernization, structural reform, improved infrastructure, increase of capital, know-how and managerial knowledge, all of which can be provided by foreign MNEs. However, in the OECD report of 1997, FDI incentives are claimed to be more generous when offered by western countries than by transition countries due to the fact that budgetary constraints are tougher in transition countries. Thus, there is a negative aspect to financial incentives for transitional economies in the sense that the wealthier nations will most probably spend significantly more than poorer countries and consequently, will offer more generous incentives. Obviously, richer countries can decrease tax rates (income, profit tax rates) more significantly as their economies will more easily offset the negative effects of decreased revenues from limited tax payments. All countries who wish to attract FDI, include in their regulations some incentives for potential investors. Presented below are most of the incentives provided by the Bulgarian government during its transition years. According to the Law on Foreign Investments 1997 and Article 18 regarding Priority Investment Projects, Priority shall be investment projects who meet at least one of the following requirements: 1. amount of the foreign investment over 5 million US dollars; 2. creation of more than 100 new jobs; 3. investment is in areas designated by the Council of Ministers as having a high level of unemployment exceeding the average level of unemployment for the country.

Moreover, Articles 19 and 20 also referred to these priority projects and mentioned that there is a reduction of 50% on the amount of corporate profit tax for a period of 10 consecutive years. This law provided incentives for foreign companies to make large investments in specific regions for the sake of creation of new jobs and minimizing large local unemployment rates. However, only one year later in 1998 there was a break in the above settlement of priority investment projects and these incentives were repealed by a new Bulgarian law.10 According to the Law on Corporate Income Tax Promulgated, 1999 and Article 17 on Priority Application of International Tax Treaties,11   The law was passed by the XXXVIIIth National Assembly on 16 October 1997 and the State seal is affixed hereto. 10 Law on Foreign Investment supplemented with SG No. 153 of 1998. 11 State Gazette No. 115/05.12.1997, Amended and Supplemented SG No. 19/1998, No. 21/1998, No. 153/1998 effective from 01.01.1999, No. 12 /1999, No. 50/1999, effective

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Whenever in a tax treaty for avoidance of double taxation or in another effective international instrument, ratified by the Republic of Bulgaria and promulgated in the State Gazette, there are provisions differing from the provisions of this Law, the provisions of the respective international treaty or instrument shall apply.

This law ensures the avoidance of double taxation whenever a treaty exists in order for foreign companies to extract more profits when investing in Bulgaria. It also allows for offshore companies to be taxed under the regime of the tax heaven. Bulgaria loses money from the limited taxation, but gains from the actual investment and its consequent positive spillovers. According to Article 38, para 1, 1998,12 in Loss Carryovers for future tax periods any negative annual financial result of a tax liable person, before adjustment for tax purposes (losses), shall be deducted over the next five tax years, and in case of banks over the next ten years, after being adjusted with the amounts under Art. 23, para 2, with the exception of the amounts under Art. 23, para 2, subparas 3, 17, 15, 18, and 22.

This law allows companies to transfer their losses in the following five or ten years. In doing so it provides them with a degree of security and liquid funds (cash) in the first difficult years of foreign investment. Simultaneously, it reduces the risk of the investment in the initial stage which results from the lack of information about the business environment, the small percentage of the market share at the beginning, limited revenues, etc. A number of tax concessions were offered to provide foreign subsidiaries and companies with ‘an option’ to have an increased participation in the privatization of State Owned Enterprises (SOEs). For example, Article 107 of Decree 59 on economic activities mentioned that the profits of subsidiaries of foreign persons or companies with foreign participation above 49% and above USD 100,000 or the equivalent in some other currency were charged at a rate of 30% (privileged tax rate at that time).

There were also provisions according to which profits from economic activity on the territory of the duty-free border zones were exempted from tax profits in the first five years, and were subsequently charged at a rate of 20%. However, these provisions were later abolished. The above law encouraged investors to make large investments and have significant participation in local companies in order for the country to ensure the remarkable transfer of intangible assets a foreign company might hold. In this way, foreign MNEs have strong investment and profit interests and participate in from 1.01.2000, No. 51, 64, 81, 103/1999. 12  (1)Amd. – SG No. 153/1998, effective from 1.01.1998.

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the management boards of the companies, helping influence corporate decisions. The rationale behind the application of this law was that the more the foreign company risks, the larger its investment interest in the local company and the minimal the tax rate on profits. There is also a tax concession in the event of privatization of a trade company with a state or municipal participation of not more than 33% of the total number of shares. In this case, there is no taxation on profits during the first three years of operation, and for the following two years only half of the tax is due (50%). This ‘tax holiday’ is conditional upon meeting the commitments of the privatization deal and will be applied under certain conditions related to the execution of the obligations under the privatization transaction. This clause applied from 1 July 1996 to 31 December 2001 irrespective of the privatization date. Companies which were privatized before the law was enforced on 1 July 1996, enjoy the tax incentives for the remainder of the five-year period. The ‘tax holiday’ also applied: •

To all companies with (a) registered capital of at least 5 million US$ and (b) at least 50% foreign participation, if (c) they invest in fixed assets at least 50% of the tax allowance co-operatives and (d) their enterprises (established according to the Law) offer labour for rehabilitated or disabled persons.

This law also provided incentives for foreign investors to participate in privatization in order to assist the acceleration of the very slow process (up to 1997). Low taxation rates on income should be a major goal for countries seeking to attract significant FDI inflows. The Profit Tax envisaged in the above mentioned Law on Profit Tax enforced on 1 July 1996 is paid by all local legal citizens and foreign citizens operating in Bulgaria according to the amount of profit made in the country. According to Article 87 of Decree N 56 on Economic Activity, the profit tax is charged on the annual profits as the difference between total revenues and the expenses under sections I, II, and III of the Income-Outcome Statement (addendum to art. 40, par. 1, sec. 2 of the Accountancy Law). The resulting net profits are subject to restructuring under art. 73, par. 5 of the Rules for the Implementation of Decree N 56 on Economic Activity … The profits tax is charged at a rate of 40%, the banks and persons specified under art. 1, par. 4 of the Bank and Credit Activities Act pay at a rate of 50%, and the State Savings Bank at a rate of 70% profits tax.

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During the past few years corporate tax has been reduced13 from 40% to 23.5%. This situates Bulgaria’s corporate tax amongst the relatively low rates in Europe. According to the latest Law on Corporate Income Tax Promulgated,14 1999, Article 44 (1), the rate for taxation of profits shall be 25%. (2) The profits tax of tax liable persons, exclusive of banks and other financial institutions, shall be 20% if their income from sales for the previous year does not exceed 50000 BGN.

According to the article 45 of the same law, ‘the rate of the municipal tax shall be 10%’. A high VAT rate in a country may be considered as an extra barrier for some MNEs (especially in specific sectors), in their decision making to undertake an FDI project in that country. On 1 April 1994, the Bulgarian turnover tax and excise duty system was abolished entirely and replaced by the VAT and a new harmonized excise duty system. Although Bulgaria is not a member of the European Community, the VAT legislation closely follows the provisions of the sixth VAT Directive. The VAT law is comparatively simple, but its application by the tax administration is problematic. The Value Added Tax on April 1, 1994 was 18%. According to the Value Added Tax Act and its amendments15 in 1996, all transactions with merchandise and services executed on the territory of Bulgaria are liable to VAT at the increased rate of 22%, except for export and relieved transactions. Later, in June 1999, the VAT became 20%. The competent parties are considering restoring the VAT to 18%, as is the case in most of the advanced countries. Nowadays, Bulgarian legislation under the Law on Value Added Tax16 allows exemptions from VAT, according to the Import Exemptions cases. In these cases (Article 59), there is VAT exemption when a different law or an international agreement is applicable and/or goods come from a region outside the territory of the country into free areas, free warehouses or businesses licensed for foreign exchange trade. The same applies

13  Under the Bulgarian Corporate Income Tax Act (CITA) all companies and partnerships (including non-incorporated partnerships) are liable to corporate income tax. The corporate income tax rate is 15%. In addition to the corporate tax there is a municipal tax at 10%, which is deductible from the taxable base for corporate income tax. Thus the aggregate tax rate (including corporate and municipal tax) for the annual taxable income is 23.5%. 14 State Gazette No. 115/05.12.1997, Amended and Supplemented SG No. 19/1998, No. 21/1998, No. 153/1998 effective from 01.01.1999, No. 12 /1999, No. 50/1999, effective from 1.01.2000, No. 51, 64, 81, 103/1999, article 44 (1) (Amended – SG No. 153/1998, 111/1999). 15 State Gazette Issues No. 16/1996 and No. 56/1996. 16  Promulgated, State Gazette No. 153/23.12.1998; amended, SG No. 1, 44, 62, 64, 103 and 111/1999; 63, 78 and 102/2000.

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when there is an importation of life-saving and life-supporting pharmaceutical products, consumables and medical equipment, etc. Questions: What do you think about fiscal incentives? What do you think about tax incentives? Compare political and macroeconomic stability with fiscal incentives. In your opinion, which of the above discussed fiscal incentives offered by the Bulgarian government are the most decisive? 5. What do you think about the tax incentives offered by the Bulgarian government? 1. 2. 3. 4.

7.20 Bulgarian Adverse Initial Conditions During the Transition Years The adverse initial conditions of Bulgaria may be divided into the following four groups: 1. Economic conditions: Bulgarian adverse economic conditions were strong enough to underpin the delay in the whole transition process. 2. The legacy of the past: the legacy of the communist regime provided Bulgaria with elements that worsened the situation. 3. Political conditions: political instability together with the political inability or unwillingness of various Bulgarian governments to adopt adequate policies dampened a successful transition. 4. External shocks: various external shocks, which also hinder the path towards becoming a market economy. In the following section we analyse in detail the adverse conditions: 1. Economic conditions The initial adverse economic conditions for Bulgaria were: (a) Bulgaria’s foreign debt amounted to US$12 billion in 1992 (when in 1992 Hungary had $21 foreign debt and Poland $47 billion), most of which was denominated in US dollars. Furthermore, as Table 7.6 demonstrates, the Bulgarian ratio of external debt over GDP in 1991 157.4% was the worst in the region. The gap between it and the next country in the ranking, Hungary at a 67.8% ratio was vast. The continuous depreciation of the domestic currency during the early years of transition worsened the situation. Only one country, Romania, started its transition with little or no significant debt compared to the other transition countries, which was less than US$2 billion in 1989 (WIIW various Research Reports).

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Table 7.6  External debt/GDP per cent in EEC countries (1991–1993) Countries

1991

1992

1993

Czech Republic Hungary Poland Slovenia Bulgaria Romania Croatia

26.4 67.8 61.5 14.7 157.4 7.4 16.4

23.7 57.6 56.4 13.9 145.6 16.6 26.7

24.7 63.7 54.9 14.8 128.3 16.1 22.8

Source: EBRD Transition Report 1994.

(b) The Bulgarian current account deficit in 1990 was the worst in the region after Romania. This amounted to $1.7 billion deficit (Table 7.7). In 1991 the Bulgarian ratio of current account/GDP was the worst in the region with a negative ratio of -5.4% (Table 7.8). (c) Low foreign exchange reserves and a large monetary overhang encouraged the government of Bulgaria to adopt a stabilization policy by liberalizing nearly 70% of prices. However, implementing a flexible exchange rate regime resulted in an unstable macroeconomic environment. The pre-existing loans in place before initiation of the transition in hard currency, together with the devaluation of the national currency created a negative economic environment. After July 1997, the introduction of the currency board and the fixed exchange rate with the German DM, led Bulgaria to the process of economic development. Still, the decision to delay the introduction of a fixed exchange rate regime which had been taken at the beginning of the transition proved to be ‘wrong’. Although Hungary and Poland started their transition with a larger debt than Bulgaria, they had US$4.4 and 4.3 billion foreign gross reserves (including gold) respectively, while Bulgaria and Romania ran out of foreign currency reserves (WIIW various Research Reports) soon after the transition. Bulgaria and Romania had chosen flexible exchange rates due to their lack of foreign reserves at the beginning of their transition. (d) Internal shortcomings, such as delayed reforms, the slow pace of privatization, inadequate restructuring of public enterprises and a series of weak governments in the post-communist period hindered Bulgaria’s economic development. The weaker Bulgarian geographic, historic and cultural links with Western Europe also proved to be ‘lethal’ for its transition to a market economy. Moreover, Bulgarian motives such as the low labour cost, which support transition and may lead to the attraction of significant FDI inflows, were lost.

Table 7.7  Current account balances of Central and Eastern Europe, 1990–2002 (million dollars)

Eastern Europe(a) Albania Bosnia & Herzegovina Bulgaria Croatia(c) Czech Republic Estonia Hungary(d) Latvia Lithuania Poland(d) Romania Serbia & Montenegro Slovakia Slovenia(c) FYROM(c)

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

– -118

– -168

– -51

– 19

-3304 31

-2888 37

–

–

–

–

-177

-193

-748

-1 060

-1093

-1386

-1087

-1305

-1729

-1710 -621 -122 123 – – 716 -3337 – -767 518 -409

-77 -589 1708 267 – – -1359 -1012 – -786 129 -259

-360 329 -456 36 325 191 321 -269 -1564 – 173 926 -19

-1098 637 456 22 -3455 417 -86 -2868 -1174 – -601 192 -83

-32 711 -787 -167 -3911 201 -94 677 -428 -400 759 575 -263

-198 -1 407 -1369 -158 -1605 -16 -614 5310 -1774 -1037 511 -75 -299

164 -956 -4121 -398 -1146 -279 -723 -1371 -2571 -1317 -1960 56 -340

1046 -2 512 -3564 -563 -676 -345 -981 -4309 -2104 -1279 -1827 51 -286

-61 -1 453 -1255 -476 -2223 -650 -1298 -6841 -2917 -660 -1982 -118 -270

-652 -1 397 -1462 -247 -2435 -654 -1194 -11553 -1437 -716 -980 -698 -32

-704 -459 -2718 -294 -2900 -493 -675 -9952 -1355 -350 -702 -548 -72

-842 -725 -3273 -339 -1754 -732 -574 -7166 -2223 -648 -1746 37 -244

-713 -1908 -4415 -799 -2655 -647 -734 -6700 -1525 -1731 -1939 314 -325

-15773 -18664 -21364 -24975 -22472 -21751 -25913 -62 -254 -65 -133 -163 -218 -407

Note: (a) Totals excluding Bosnia & Herzegovina and Yugoslavia; (b) IMF projection; (c) Excludes transactions with the republics of the former SFR of Yugoslavia: Croatia (1990–1992), Slovenia (1990–1991) and The Former Yugoslav Republic of Macedonia (1990–1992); (d) Convertible currencies: Hungary until 1995; Poland until 1992. Source: National balance of payments statistics, IMF.

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Table 7.8  Current account in per cent of GDP in EEC (1991–1993) Countries

1991

1992

1993

Czech Republic Hungary Poland Slovenia Bulgaria Romania Croatia

1.2 0.8 -2.6 1 -5.4 -4.1 -3.2

-1 0.9 1.1 7.4 -9.3 -8 8

0.3 -9 -0.7 1.5 -12.8 -4.5 5.5

Source: EBRD Transition Report 1994.

More specifically, Bulgaria, Romania and Russia are the countries with the lowest level of wages in the CEE region, however Bulgarian competitiveness in terms of cheap skilled, semi-skilled and unskilled labour force was under increased threat in the period just after 1998/99, as the depreciation of the ruble in Russia (end of 1998) saw wages fall below those in Bulgaria. For example, in Bulgaria the average wage was 76 euros (based on exchange rate at end of period) in 1998 and 85 Euro in 1999; in Russia they were 144 euros in 1997, and only 43 in 1998 and 56 in 1999 (WIIW various Research Reports). Thus, as Bulgaria and Russia share a largely common export profile of goods such as metals and chemicals, and Russia has already attracted limited foreign investments in respect on its population, the competition created problems not only for Bulgarian exports, but also in the inflows of FDI. However, the signs of the time period 1997–2000 brought much hope for the future. 2. The legacy of the past The legacy of the communist regime had negative repercussions on the Bulgarian transition environment, which led to the negative attitude against consumption, labour and entrepreneurship, non-profit oriented enterprises, a low level of productivity, non-efficiency oriented behaviour, and an absence of the private sector to pursue profitability and efficiency. In particular, the adverse initial conditions due to the legacy of the past were: (a) A lack of regulations, legal framework, financial intermediaries and stock market exchange – all essential elements to facilitate a market economy. (b) Macroeconomic instability due to the burden of fiscal deficits, low productivity, external and internal loans (bad loans), an increasing shadow economy, heavily industrialized GDP, low quality of (produced) products together with the lack of new trade partners, inability to balance the state budgets, monetary overhang and depressed inflation.

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(c) The very low per capita income and living standards (one of the lowest compared to other Central and Eastern European countries), and growing poverty; which led to scepticism within Bulgarian governments and at times caused them to postpone or reverse the tightened policies in the early years of transition. (d) Insufficient quality and variety of products, which were unable to offset the lost trade partners with others from the West. (e) Illegal activity during the transition process, which made the business environment unwelcoming. (f) The magnitude of the restitution problem and the significant delay in reprivatization of property, created a subsequent delay in the privatization process. 3. Political conditions Politicians and governments were unable to adopt adequate transition policies to transform Bulgaria into a fully functioning market economy. Adverse governmental conditions include: (a) The three economic crises, two of which occurred in less than a year, saw the Bulgarian people lose a significant amount of their money savings, and brought them to one of the lowest per capita consumption levels (devaluations and hyperinflation – loss of their savings). Moreover, the crisis proved to be an entry barrier for most of the foreign companies that were in the procedure of examining and ranking the possible countries of the region as future host countries in which to direct their investments. In March 1994, the first economic crisis hit the country, doubling the exchange rate between the lev and the dollar. Inflation rose to over 100% annually. Currency substitution began to intensify, affecting the banking sector (the monthly rate of inflation is presented in Table 7.9). The second crisis in 1996 included an overall loss of credibility and confidence in domestic economic policies and domestic financial institutions. The specific macroeconomic policy response to the unfolding crisis was, of course, very complicated. Given the circumstances, the stabilization of expectations that underlined the demand for the lev could most likely be achieved only through a policy that explicitly used the exchange rate as an anchor. While Bulgarian monetary authorities have indeed implicitly attempted to use the exchange rate as a stabilization anchor in recent years, the explicit pre-announcement of targets would help to reduce uncertainty and to promote enforcement.

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Table 7.9  Bulgarian inflation rate, 1990–2000 (per cent) Feb Mar Apr May Jun

Jul

Aug

Sep

Oct

Month

Jan

Nov

Dec

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

2.3 2.3 2.3 2.3 2.3 4.1 3.5 10.9 4.5 4.1 4.9 10.4 13.6 123 50.5 2.5 0.8 5.9 8.4 7.5 3.8 3.3 5.0 4.9 4.8 5.8 3.8 3.2 11.9 5.8 2.8 1.2 3.4 6.2 6.7 4.6 6.9 4.7 5.6 3.9 5.3 4.1 1.0 2.6 3.8 4.2 4.6 3.9 3.8 4.6 7.5 21.7 7.9 4.1 0.6 5.2 11.0 6.9 5.5 5.0 3.9 3.8 3.4 1.0 1.9 0.5 1.5 0.5 4.8 2.5 2.6 2.6 2.3 1.9 1.7 2.9 12.5 20.3 23.3 17.1 18.8 16.7 9.7 26.9 43.5 243 12.3 -0.7 5.7 0.8 3.7 5.5 3.6 0.5 0.5 1.5 1.98 1.74 -0.1 0.11 0.46 -1.9 -1.5 -0.9 3.02 -0.3 -0.94 -0.7 1.6 -0.6 -1.0 -0.6 -0.7 -0.5 3.2 1.0 1.5 1.0 0.6 0.7 3.1 0.6 -0.6 -0.9 0.2 0.1 0.5 3.0 2.4 1.2 -0.2 1.4

Source: BNB various annual reports.

The headlong plunge of the lev in January and February of 1997 (third crisis) pushed the rate of monthly inflation into the hyperinflationary range. After the resolution of the political stalemate which led to the appointment of a caretaker government in preparation for the April elections and the decision by the IMF to pro­ceed with negotiations on a standby agreement with the caretaker government, the lev stabilized and inflation slowed dramatically. The financial crisis of 1996, as well as the one of 1997, has had unfortunate negative consequences on the Bulgarian economy from many perspectives. The crisis in general provided a context to realize that painful but necessary decisive measures had to be taken to deal with loss-making banks and enterprises, to accelerate privatization, and to improve the overall environment for domestic and foreign businesses. Through this, the currency board came into existence on 1 July 1997 and the Bulgarian lev was pegged to the DEM as a reserve currency on July 1 at a rate of 1000 BGL/DEM, then it became 1 to 1 (three zeroes deleted) and then it was pegged to the euro. To sum up, stabilization of Bulgaria’s crisis-hit economy depended on the introduction of the currency board, a restructuring of the economy, and foreign financial support for reforms. Both the Socialists and the Democrats recognized that the introduction of a strict monetary regime was the way forward. (b) There was a significant delay in the liberalization of prices on products that were produced by state monopolies in sectors such as energy, gas, petroleum, telecommunications, railways, television, etc. (c) Ineffective governmental policies and noticeably slow progress in the development and enlargement of the private sector. In 1991 only 19% of enterprises

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belonged to the private sector, one of the worse percentages in the region, larger only than that of the Czech Republic (17%), Slovenia (16%), and Slovakia (15%). In 1999, the Bulgarian percentage (increased to 62%) was still lower – by almost 15% – than that of the counties which had begun with a worse initial percentage (Hungary increased to 85%, Poland 81% and the Czech Republic 75%). Not only the slow privatization progress, but also the slow creation and establishment of new small enterprises due to the inadequate institutional framework contributed to the sluggish environment in the public sector (EBRD various reports; Economist Intelligence Unit, IMF Staff Country Report No. 99/26 April 1999). (d) The ‘favourable introduction of the laws’ introduced in the early years of the Bulgarian transition for the ‘nomenklatura’ as well as the governmental financial support these laws received, created an unfavourable business environment with no significant economic development, low FDI inflows, soft budget constraints, slow and inadequate restructuring, inefficiency of the state-owned enterprises, accumulation of new debts and low privatization process of the state owned enterprises (SOEs). (e) In order to overcome the initial negative conditions the Bulgarian government borrowed in convertible currencies from private commercial banks. However, the situation worsened, as the national currency was devaluated. (f) The efforts of Bulgaria to get the highest proceeds possible for the larger and more significant state companies, led the government to decide on restructuring before privatization. This, in turn, led to a slower privatization process and to a lack of significant investment offers from foreign investors. (g) The lack of transparency in the privatization progress, the inexperience in the valuation of SOEs, bureaucracy, the complex criteria of selecting the buyers, corruption, the late introduction of bankruptcy laws and hard budget constraints as well as the accumulation of bad loans and the large debt of most of the SOEs, which the Bulgarian state did not restructure rapidly and effectively. (h) The inability to stop inflation before the introduction of the currency board. (i) The inadequate legal framework and its constant changes. 4. External shocks External shocks were even more problematical for Bulgaria, which managed to overcome most of their subsequent negatives outcomes only after 1999. The Persian Gulf crisis, which caused higher oil prices, the interruption of the trade between Iraq and Bulgaria as well as the collapse of trade relations with the Soviet Union, East Germany, and Council for Mutual Economic Assistance (CMEA) members, all brought Bulgaria close to disaster in times when the country was

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at its most vulnerable. The changes in Bulgaria’s familiar trade environment were, most probably, the strongest obstacles for its economic reform. As a result, Bulgaria started the transition to a market economy with one of the worst trade initial conditions amongst CEE nations. In detail, the external shocks were: (a) The collapse of CMEA: Bulgaria was one of the least industrialized countries of CEE and depended mainly on agriculture before the communist revolution. After the rise of the communist regime in 1949 Bulgaria developed a strong dependence on the Soviet Union, a country that was the cornerstone of Bulgaria’s industrial development, providing the new communist country with capital and energy resources, the two resources Bulgaria lacked the most. The country experienced growth during the communist period but failed to build a solid base for an independent and prosperous economy, due to the controlled economy that prevented competition and gave no incentives for quality and efficiency. By the early 1980s, Bulgaria had become an industrialized country with a more-or-less stable economy and a reported per capita income roughly similar to other European countries such as Poland, Hungary, Portugal and Yugoslavia (European Economy, 1991, 160). However, the stable economy was a product of the protective environment of the CMEA. The data provided in Table 7.10 below shows that the largest percentage of Bulgarian foreign trade was conducted with CMEA country members. Those trade partners had little concern about the quality of the products they bought and were not looking for a better deal elsewhere. The CMEA was perceived as a continuation of the Soviet autarchic growth strategy due to its Soviet type structure and the fact that the USSR dominated, in percentage, the total trade amount. This was certainly the case of Bulgarian foreign trade. From the second half of the 1950s, approximately 50–55% of the total Bulgarian foreign trade turnover was with the Soviet Union and around 30– 35% with other CMEA countries, especially the German Democratic Republic and Czechoslovakia. The CMEA had a positive effect on the East European trade. During the period 1956–1960 East European trade had a larger growth rate than the total world exports and even the trade of Western industrialized countries (Bruno, 1992, 763). However, the growth rate decelerated from 1961 to 1965, to a rate below the Western one, only slightly above the world total. During the 1960s Bulgaria had the fastest rate of growth of foreign trade among the CMEA countries with exports growing considerably faster than imports. By 1972, Bulgaria had the largest amount of foreign trade among the CMEA countries, followed by Romania, Poland, Hungary, the USSR, the GDR and Czechoslovakia, respectively. At the same time, Bulgaria’s economy was heavily dependent on imports, as it lacked raw materials.

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Table 7.10  Direction of Bulgarian trade (1945–1998) Direction/ Source Years

Other Eastern Total Eastern USSR European countries European/ (or Russia (Cuba’s percentage CMEA (or after 1990) is also added former CMEA) [1960–1983])

Western Countries/ other

Exports 1945 1950 1960 1965 1970 1975 1980 1983

1990 1991 1992 1998

95 54 53.8 52.1 53.8 54.6 49.9 58.5

3 37 30.2 27.2 25.5 25.4 23.5 20.6

98 91 84.2 79.6 79.7 80 70.8 76.4

64 49.8 17.1 5.5

12.1 5.2 5.1 4.2

76.1 55 22.2 9.7

80 50 52.6 50 52.2 50.7 57.3 58.5

13 36 32.7 24.3 24 21.3 21.6 21.8

93 86 84 74.2 76.1 72.5 78.9 80.2

2 9 15.8 20.4 20.3 20 29.2 23.6 EU

Other

5.6 17.4 31.5 49.7

18.4 27.6 46.3 40.7

Imports 1945 1950 1960 1965 1970 1975 1980 1983

1990 1991 1992 1998

56.5 43.2 22.7 20.1

11.6 3.2 5.3 5.2

68.1 45.4 28 25.3

7 14 16 25.8 23.9 27.5 21.1 19.8 EU

Other

11.5 26.4 35.5 45.2

20.4 27.2 36.4 29.5

Sources: WIIW database, EIU various reports.

Most of the trade among the CMEA countries was conducted on a government-togovernment basis. It was based on five-year agreements, supplemented by annual protocols which fixed the quantities and prices of the products to be traded. The

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commodity composition of CMEA trade and the international trade of the country was planned by the government. This, however, was one of the problems of a centrally planed international trade. Central planning tends to be biased against foreign trade. Planners crave certainty, and foreign trade, even between planned economies, involves uncertainty. It is hard to plan production, harder still to plan consumption, and very hard to plan the differences between them. To plan trade between two countries, moreover, the planners have to match the two countries’ differences, imparting more uncertainty to each country’s plan. (Kenen, 1991, 239)

The prices of primary commodities according to the Bucharest formula adopted in 1975 were based on a five-year moving average of world prices but tended to lag behind them. Approximately 60–70% of the intra-CMEA trade of the Central and East European countries was with the USSR. The USSR’s share in total foreign trade with Hungary was below 20% by 1990. In contrast Bulgaria had almost totally Soviet-oriented development policies and trade. In sum, the ‘… CMEA collapse in 1989, caused the most damage in Bulgaria, the bulk of whose exports had gone to the CMEA’ (Bruno, 1992). Probably no other country received so much assistance from the combined effects of generous Soviet supplies of energy and raw materials, together with an equal amount of Soviet willingness to accept Bulgarian manufactured goods in return. This resulted in extremely generous barter terms of trade during the communist period. In the West, Italy and Germany were the main trade partners of Bulgaria. Trade with the US was negligible. The chief exports were machinery, food products, tobacco, non-ferrous metals, cast iron, leather products, and textiles. The principal imports were petroleum, natural gas, machinery, transportation equipment, steel, cellulose, and timber during the transition period. Bulgaria’s dependence on the CMEA and the USSR is demonstrated by the data on foreign trade in Tables 7.11 and 7.12 during the communist and transition years. After the collapse of both (CMEA, the USSR) in 1990, the Soviet Union itself began to unravel. By the end of the year the Soviet Union had become nonexistent, to be replaced by a Commonwealth of Independent States (CIS). On 25 December, Gorbachev resigned and on midnight of 31 December, the Soviet flag atop the Kremlin was replaced by the Russian tricolors. Consequently, Bulgaria was left without its main trading partners, and with production which would not stand a chance, in terms of competitiveness, in a non-controlled market.

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It is clear that in the 1990s there was a significant decrease of Russian trade with Bulgaria, and a subsequent increase of the Bulgarian trade with the EU countries. The transition in Bulgaria brought about a dramatic rearrangement of the geographical distribution with the CEE foreign trade. The share of the CEE dropped radically and that of European Union increased significantly. The CEE relations with the Soviet Union and then with Russia stopped playing a dominant role in the region. On the other hand though, the pre-existing industry links established by USSR financial aid, along with Bulgaria’s highly skilled and relatively cheap industry workers gave it an advantage among the other transition economies for foreign investors. (b) The unification of Germany and the loss of the GDR as a trade partner. The unification of East Germany, who was also a major trade partner during communist years, with West Germany was another strike against Bulgaria’s already weak economy. (c) USSR’s energy crisis (after 1988) and the termination of the USSR subsidies and exports of energy sources and commodities in preferential prices, together with the subsequent political fragmentation that followed the USSR’s collapse, had a devastating effect on Bulgarian economy since Bulgaria’s trade and energy supplies depended heavily upon the former super-power. Furthermore, the ex-USSR impact on the Bulgarian economy during the energy crisis was also devastating due to the strong dependence of Bulgaria in oil imports from the USSR. The energy crisis in the USSR resulted in a severe energy shortage in Bulgaria. (d) The Gulf crisis cost approximately US$2.5 billion. Iraq was one of Bulgaria’s largest debtor through trade relations (with US$1.239 billion in 1989 and another US$0.7 billion on 1990 from Iraq’s non-repayment of debt). Therefore, the agreement of repayment of the loan with the delivery of 600,000 tons of oil was devastatingly postponed due to the UN embargo. This cost Bulgaria US$565 million – the cost of replacing of Iraq contracted oil at higher prices.

Table 7.11  Merchandise exports of Eastern Europe, 1980, 1989–2002 (billion dollars) 1980 Eastern Europe Albania Bosnia & Herzegovia Bulgaria Croatia Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Serbia & Montenegro Slovakia Slovenia FYROM

1989

1990

1991

56.367 63.850 61.733 57.241 0.320 0.302 0.231 0.101

1992

1993

61472 0.072

66872 0.123

–

–

1994

1995

1996

77.621 100621 107064 0.139 0.202 0.213

–

2.100

1.850

–

–

7.160 – –

6.651 2.600 –

5.232 4.020 –

3.433 3.310 –

–

4.461

4.651

4.704

2.539

–

–

– 1.836 –

– 3.408 0.654

– 4.118 1.113

– 3.874 1.095

3.500 6.681 1.199

5.458 6.083 1.055

6.714 6.828 1.086

1997 115895 0.137

1998

1999

2000

2001

127933 125527 141.886 157275 0.207 0.352 0.260 0.305

2002 178809 0.330

0.024

0.058

0.193

0.352

0.518

0.675

0.752

0.733

3.992 3.769 3.935 5.345 4.353 3.709 4.260 4.633 8.767 14.463 15.882 21.273 0.444 0.802 1305 1838 8.609 9.673 9.731 10.226 10.681 8.921 10.701 12.867 0.843 1401 0.968 1304 0.852 1994 2031 2705 13.071 14.665 18.291 14.912 13.187 14.202 17.240 22.887 9.217 8.076 4.570 4.266 4.363 4.892 6.151 7.910

4.890 4.512 22.180 2079 15.704 1443 3355 24.440 8.085

4.940 4.171 22.779 2934 19.100 1673 3860 25.756 8.431

4.194 4.541 26.351 3236 23.005 1812 3711 28.229 8.302

4.006 4.302 26.265 2938 25.012 1723 3004 27.407 8.487

4.825 4.432 29.052 3176 28.092 1865 3809 31.651 10.367

5.113 4.666 33.397 3307 30.498 2001 4583 36.085 11.385

5688 4899 38402 3423 34337 2279 5518 41010 13869

1.531

1.846

2.677

2.858

1.498

1.723

1.903

2275

8.585 8.316 1.204

8.822 8.310 1.147

9.640 8.369 1.237

10.775 9.050 1.311

10.277 8.546 1.191

11.908 8.732 1.319

12.704 9.252 1323

14532 10357 1158

Note: Trade flows reported include the ‘new trade’ among members of the dissolved federal states: former Czechoslovakia (from 1993), the former SFR of Yugoslavia (from 1992). Source: UNECE secretariat, based on national statistical publications and direct communications from national statistical offices.

Table 7.12  Merchandise imports of Eastern Europe, 1980, 1989–2002 (billion dollars) 1980

1989

1990

1991

1992

Eastern Europe 65.443 61.185 63.408 61.610 70190 Albania 0.320 0.385 0.381 0.409 0.524 Bosnia & – 1.850 1.750 – – Herzegovina Bulgaria 6.321 7.325 5.584 2.700 4.530 – 3.750 5.133 3.811 4.346 Croatia Czech Republic – – – – 10.368 Estonia – – – – 0.406 Hungary 9.188 8.863 8.797 11.449 11.123 Latvia – – – – 0.794 Lithuania – – – – 0.602 Poland 14.705 12.941 12.619 15.531 16.141 Romania 11.061 5.834 6.889 5.793 6.260 Serbia & – 5.383 6.701 5.548 3.859 Montenegro 3.889 Slovakia – – – – Slovenia 2.463 3.216 4.727 4.131 6.141 FYROM – 0.934 1.531 1.274 1.206

1993

1994

1995

1996

1997

1998

80386 0.421

91379 0.549

125033 0.650

–

–

0.524

1.204

1.555

2.120

5.120 4.166 14.617 0.896 12.648 0.961 2244 18.758 6.522

4.272 5.229 17.427 1659 14.554 1240 2352 21.566 7.109

5.638 7.510 25.265 2540 15.466 1818 3649 29.043 10.278

5.074 7.788 27.919 3231 18.144 2320 4559 37.137 11.435

4.932 9.104 27.563 4441 21.234 2724 5644 42.314 11.280

–

–

2.665

4.113

6.332 6.501 1.199

6.634 7.304 1.484

8.777 9.492 1.719

11.112 9.421 1.627

1999

2000

2001

2002

185473 1.059

202087 1.317

226270 1489

2.431

2.290

2.463

2758

4.957 8.383 28.789 4786 25.706 3189 5794 47.054 11.838

5.515 7.799 28.126 4108 28.008 2946 4834 45.911 10.557

6.507 7.887 32.183 4256 32.080 3189 5457 48.940 13.055

7.261 9.147 36.472 4291 33.682 3507 6353 50.275 15.552

7897 10713 40757 4779 37612 4040 7768 55113 17857

4.826

4.830

3.296

3.711

4.837

6320

11.622 9.367 1.779

13.006 10.098 1.915

11.265 10.083 1.776

12.660 10.116 2.085

14.689 10.148 2094

16544 10929 1694

145996 159004 173259 167558 0.913 0.620 0.795 0.903

Source: UNECE secretariat, based on national statistical publications and direct communications from national statistical offices.

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(e) The embargo on Yugoslavia cost in total approximately $8 billion (1,833 million dollars from the impact on balance of payments and another $6.2 billion in the period July 1992–September 1994) and provoked real problems with regard to Bulgarian trade because of the loss of Yugoslavia as a trade partner. Moreover, the ex-Yugoslavian road, rail and river routes had been the cheapest, nearest and often the only way for Bulgaria to export its products to the West (a fall in the trade with neighboring countries, sharply increases the transaction costs). The rail and road routes through the former Yugoslavia had been indeed some of the leading arteries for Bulgarian trade, and the alternative results of Romania and the Black Sea proved slow and overcrowded. Apart from the front-line states (Albania, FYROM and Yugoslavia), Bulgaria was probably the country most affected by the war in Kosovo. Before the war, some 50% of Bulgarian exports were transported through Yugoslavia. The magnitude of the damage to the Yugoslavian infrastructure indicates that the problem for Bulgaria will remain for a long time. In less than two years from the beginning of transition (1989–1991) Bulgaria, Romania and Albania lost half of their exports. Although the other two countries had recovered by 2000, Bulgaria had not. In 1991, Bulgaria’s imports had deteriorated to 1/3 compared with the 1989 volume. At the same time, all other countries, more or less retained constant their volume of imports. The decrease of imports was not indicative of an increase in the local production, but of the loss of trade partners. (f) The economic crises of Mexico, East Asia and the former USSR in the 1990s discouraged investors from investing in Eastern Emerging Markets (see Table 7.13). External shocks such as the various financial crises of the 1990s in Mexico, East Asia, and particularly in Russia, contributed to delaying or interrupting the recovery of output in transition economies. Furthermore, repressed inflation, high black market exchange rates, and the war and civil strife in Armenia, Azerbaijan, and Tajikistan in 1992–94, in Georgia and Moldova in 1992, and in Croatia and FYROM in 1991–94, all took a major toll on lives of the people in transition economies, on infrastructure, and the institutional development, undermining the political consensus on reforms required for successful transition (World Bank 2002, 11–15).

Table 7.13  Inflows of foreign direct investment(a) in Central and Eastern Europe, 1990–2002 (million dollars)

(b)

Eastern Europe Albania(c) Bosnia & Herzegovia Bulgaria(c) Croatia Czech Republic Estonia Hungary(d) Latvia Lithuania Poland (cash basis)(c) Romania Serbia & Montenegro Slovakia Slovenia FYROM(c)

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

– –

– –

– 20

– 68

– 53

– 70

8756 90

11374 48

17547 45

20136 41

21855 143

22007 207

25491 135

–

–

–

–

–

–

–

–

67

177

146

125

293

4 – 132 – 311 – – 10 –

56 – 513 – 1459 – – 117 40

41 16 1004 82 1471 29 8 284 77

40 120 654 162 2339 45 30 580 94

105 117 869 215 1146 214 31 542 341

90 114 2562 202 4815 180 73 1132 419

109 511 1428 151 2364 382 152 2768 263

505 533 1 300 267 2229 521 355 3077 1215

537 932 3718 581 2036 357 926 5130 2031

819 1 467 6324 305 2012 347 486 6474 1041

1002 1089 4986 387 1697 410 379 8293 1037

813 1651 5641 542 2599 164 446 6995 1157

905 1124 9305 285 858 382 132 4119 1144

–

–

–

–

–

–

–

740

113

112

50

165

475

18 4 –

82 65 –

100 111 –

195 113 –

269 117 24

308 151 9

353 174 11

220 334 30

684 216 128

390 107 33

1 925 136 175

1 579 370 442

4012 1644 77

Note: Changes in coverage are available in UNECE, Economic Survey of Europe, 2001 No. 1, chap. 5, box 5.3.1; (a) Inflows into the reporting country; (b) Excluding Bosnia & Herzegovina and Yugoslavia; (c) Net of residents’ investments abroad. Bulgaria, 1990–1994; Poland, 1990–1992; (d) Exclude reinvested profits. Source: National balance of payments statistics; IMF, Balance of Payments Statistics (Washington, DC), various issues and Staff Country Reports (www.imf.org); UNECE secretariat estimates.

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Questions: 1. Critically discuss the grouping of adverse initial conditions. What are the most serious adverse initial conditions? 2. What do you think in regard to the case of Bulgaria and its adverse initial conditions? Are they particularly negative? 7.21 Determinants of Greek FDI Outflows in Bulgaria in the 1990s Greece and Bulgaria have had trade relations for centuries, mainly on account of their geographic proximity, their cultural closeness, similar Balkan business mentality, and common religious beliefs. The people of Bulgaria have always admired Greek traders. The fact that the two countries were historically related both via the Byzantine Empire and the occupation of the Ottoman Empire brought the two countries even closer. Although, the rise of the communist regime and the ‘cold war’ between Eastern Europe and Western countries largely deactivated the relations of the two countries, after the fall of communism, the relationship recovered significantly and the two countries are currently on very good terms. There are numerous reasons why Greek enterprises, both small and medium (SME), and large, are so economically active and welcome in Bulgaria,17 as well as in other South East European countries (SEECs) such as Albania, FYROM, Serbia & Montenegro and Romania. Greece is a member of the European Union (EU), and the Economic and Monetary Union (EMU) and at the same time it supported the membership of Bulgaria in the EU (Bulgaria together with Romania entered the EU in 2007). The Greek business presence in Bulgaria started in 1992 and it is possible to distinguish six time periods. The first period is between 1992–1994, the main characteristic of which was the ability of Greek firms to obtain quick and easy profit. The CEE market in general was viewed as an ‘El-Dorado’ country. Therefore, over 500 small entrepreneurs, most of whom never activated their business, registered for entry in the Bulgarian market by paying a trivial amount in return. The core activity of the vendor–traders in this period was focused on food products, clothing and footwear, as well as the exportation to Greece of industrial products, such as scrap, sheet-iron and buildings’ iron. Several large companies gradually started to carry out the first market research programs and established representative offices. An increase of exports to Bulgaria of final food products was observed.

17 Moreover, of over 4 million tourists visiting Bulgaria in 2004, more than 700,000 were from Greece (the greatest number). The remaining were from Germany, the UK, FYROM, Serbia & Montenegro, and Russia. Bulgarians travel mostly to Turkey (more than 1 million per year), Greece (more than half a million), Germany, Serbia & Montenegro, and Italy respectively.

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The second period, from the end of 1994 (after the first economic crisis in Bulgaria) and well into 1995, was mainly characterized by the entry of significant Greek firms inside the Bulgarian market, which targeted their business activity mainly in the food products, the durable consumer goods and the services sector. Moreover, on a smaller scale, Greek industrial activity focused on the manufacturing industry, trade activities and recreation services. The main characteristic of the third period (1996–1997) was that although a significant amount of new Greek companies registered in Bulgaria, they did not actually become active due to the two bigger Bulgarian economic crises which took place in 1996 and early 1997 (two crises in less than one year). The repercussions of which led some Greek entrepreneurs to go as far as to withdrew their business from Bulgaria. In the fourth period, from mid 1997 until 1998, when the situation changed for the better and the country tried to become politically stable (with a fixed exchange rate, a currency board and a significantly lower inflation rate), most of the remaining larger state and private owned Greek companies slowly overcame their fears and cautiously entered the Bulgarian market. There was a distinct predominance of larger sized firms along with the creation of vertical and horizontal joint ventures, focusing again on the sectors of food products, beverages, durable consumer goods and services. The fifth period, 1998–2000 is characterized by an active interest on the part of major Greek banks to participate in the Bulgarian market through acquisitions and participation in the Bulgarian privatization programmes. In the sixth period, 2001 and onwards, there had been positive expectations for Bulgaria to enter the EU before 2010 (which actually took place in 2007). The economic and political stability in the country, together with the difficulties that arose in the Greek business environment (intense competition), caused entrepreneurs look upon Bulgaria as a feasible business destination. Some Greek companies have lost their competitive advantage, such as a low production cost, when Greece became an EMU member and the euro was introduced in the market. Thus, Greece became an increasingly expensive country (in terms of prices and production costs) in comparison, for example, to its neighbours such as Turkey and the entire Balkan region. Furthermore, because of the increased competition and the saturated market in specific sectors in Greece, many Greek SMEs finally entered the Balkan region, especially Bulgaria, Albania, Serbia & Montenegro, Romania and FYROM. There are numerous reasons behind the accumulation of Greek entrepreneurs in the Balkan region and especially in Bulgaria. According to Salavrakos and Petrochilos (2003, 332), the main determinants of Greek outward FDI in the CEE region are: •

the special position of Greece as the most advanced economic country in the area of the South-East Europe and the Black Sea basin.

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• • •

•

351

the break-up of the former Soviet Union, the new geography of Europe, the programmes of restructuring and privatization. the transition of the old command economies into market ones and the openness of these economies (thus receiving FDI flows). people and governments of this region welcome the Greek presence and regard it as a useful means towards achieving their aims of a closer economic integration of their economies with Western economic structures. the Greeks have had, for centuries, a lengthy presence and entrepreneurial activity in these countries (historical dimension).

Iammarino and Pitelis (2000) focused on the Greek outward Foreign Direct Investment (FDI) in Bulgaria and Romania and reported the following motivations ranked according to their importance: the expected economic growth, geographical location, investment incentives, labour costs, increase in domestic market share, and increase in regional market share. Less important FDI motivations were proximity to the EU market, the source of raw materials, and cultural similarities. Moreover, the main constraints and risks faced by investors in undertaking production activities were: bureaucratic/ administrative constraints, business infrastructure constraints, legislative constraints, general economic climate constraints, an incoherent and unstable legal system and lastly, a high investment risk. Furthermore, other researchers such as Labrianidis (1996/1997) added the Greek mentality for quick and easy profit as a determinant for the accumulation of Greek investors in the Balkan region. In addition, Petrakos (1997) argued that the infrastructure projects and services needed in the Balkan region, especially after the NATO bombing, provided opportunities for Greek construction companies such as Michaniki, Sarantopoulos and Latsis Group to undertake large infrastructure projects, which have also been subsidized by the Greek, Bulgarian and Russian governments and through European funds such as Phare, Intereg II, III, etc. As a result of the accumulation of Greek companies in mid 2004, there were more than 4,000 Greek registered companies in Bulgaria, of which only a quarter are active. At the same time, around 8,000–10,000 Greek companies are registered in the whole Balkan region of which less than one third or even one quarter are active. Two groups of reasons exist for the wide difference between the registered and the actually active companies: either they have never initiated operations – they have been acquired, merged, moved to a third country or they have even returned to their home country, went bankrupt, closed or failed in their operations. In the first group of reasons, there is no significant loss of investment funds because Greek companies have: •

never initiated operations. They have just remained registered, waiting for an opportunity (better days) to start operations or to become MNEs, due to their registration in a foreign country.

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• • •

proceeded to a Merger & Acquisition by locals or other foreign MNEs or even other Greek MNEs. moved to other countries, especially to a neighbour country to exploit cost factors and favourable agreements with CIS countries. returned to their home country (due to increased competition, the prevalent economic crises, the failure to put business plans into practice, etc.).

However, in the second group of reasons there is a significant loss of money when companies went bankrupt, closed or failed in their operation, due to: •

•

•

• • •

incorrect expectations, having failed to carry out market research or being poorly organized to begin with. Also, a trend at the time was the accumulation of numerous Greek enterprises in the Balkan region. The Greek or Balkan mentality for quick and easy profit worsened the situation. the high risk environment, difficult business relations with bureaucracy, bribery, corruption, the unstable legal framework, etc. (higher than the entrepreneurs’ expectations). increased competition in the host countries when western companies entered the region and offered better quality products at more affordable prices. the lack of experience and skills, in particular no previous entrepreneurial experience, and the lack of managerial skills. the mentality of local entrepreneurs (the inability to cooperate successfully led to the failure of joint ventures). the lack of financial sources in the host country (limited owned-sources for the Greek companies).

In order to determine the motivations and barriers of inward FDI in Bulgaria and to divide them into several groups according to the FDI theory (Dunning, 1993; Dunning, 1988), research was conducted using a questionnaire and the results analysed and studied with the help of statistics. According to Figure 7.7, 80% of foreign investors have proved to be market hunters, 62% factor hunters, 50% locational hunters, and 33% strategic market hunters. At the same time, 20% have invested in Bulgaria in order to exploit their ownership advantages and 18% to exploit financial advantages. Only 3% of the investors were efficiency hunters. Thus, one can infer that in a country such as Bulgaria having a customer base of eight million people with many unsatisfied needs, foreign investors focus primarily on the characteristics of the market. However, Greek investors have proved to be mainly factor hunters (instead of market hunters) with a percentage of 84%, closely followed by a percentage of 78% that are locational hunters, 76% that are market hunters, and 16% that are strategic market hunters.

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353

79.69

Market hunters

76 62.5

Factor hunters

50

Location hunters Market for strategic reasons hunters

16

84 78 All Foreign MNEs

32.81

Greek MNEs

20.31

Exploiting ownership advantages

17.19 27

Financial aspects hunters

3.13

Efficiency hunters

0

50

100

Figure 7.7  Groups of motives (hunters): Foreign vs. Greek MNEs in Bulgaria

Source: Bitzenis’ questionnaire research.

The absence of Greek MNEs that exploit their ownership advantages in their investment projects in Bulgaria confirms their small and medium size and the limited importance in worldwide economic figures. Apart from the obvious reason of geographical proximity (locational hunters in the second place), the change in the ranking of the group of motivations for Greek entrepreneurs is also due to the fact that most of the 37 Greek companies participating in the research were in the textile, industrial and food sectors, which require low labour force costs (factor hunters – 1st place). Regarding the entry mode of MNEs in the Bulgarian market, the author’s research has revealed that 55% of the 64 foreign investors have chosen the greenfield way as a best or preferable path for their FDI projects, followed by 36% of the investors who took advantage of the opportunities that the Bulgarian privatization programmes offered, followed by 18.8% of MNEs who created joint ventures (Figure 7.8).

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The Balkans: Foreign Direct Investment and EU Accession

Acquisitions through Privatization

18.9

35.9

23.4 24.3

From Trade to FDI

54.7

FDI

73

Greek MNEs

18.8 21.6

Joint ventures

Representative office/branch

4.7 8.1

Acquisitions

7.8 5.4

0

20

All Foreign MNEs

40

60

80

Figure 7.8  Ways (entry modes) used by MNEs (foreign vs. Greek) in order to invest in Bulgaria Source: Bitzenis’ questionnaire research.

Although it is well-known that joint ventures was the preferred way of foreign entry in the ex-communist countries in the early years of their transition, this low percentage of joint ventures can now be explained from the fact that the survey took place in the time period 1998–1999. At that time, most of the joint ventures which had been created in the early years of transition had collapsed either due to the insufficient cooperation of local partners with foreigners or due to the acquisition of the remaining shares by foreign investors. Later establishments of FDI projects in the Bulgarian market followed other forms of foreign entry such as the green-field FDI or acquisitions through privatization programmes, either because of greater awareness of the sluggish Bulgarian economic environment as it had existed at the beginning of the transition or due to the registered failure of many joint ventures. Regarding the ways of investing, Greek investors also preferred the green-field way. At the same time, they rejected privatization as a means of FDI as Greek investors are mainly SMEs.

ry ) (th eo ti tion e ) p m v o ti e e co sam ing th ce (a e n iv follow t ta is mo ral d as a c ultu ture se s truc rt ba o ra f p x in e of g an FDI) la ck in h to s e li T rad es tab y (from theor link s s s li ents e c in s s e s u th b e n g ng in se existi follow ral clo iting c ultu o st ex plo our c b la k illed c ts s u d w o lo r for p d n a DI) F em c al d ade to m Tr fie d lo ts o r s e ti F s ( a rs f as uns ar ri e ion o de b on quis it ra ti t c ti a e g mp co min al co O ver tries of loc c oun la ck ) r u o b h ig wth ( ne et gro other mark s r fo li nk to s s ure ects n pr e pr osp za tio ity li a im b x ro a l/glo ic al p ation raph ost in tern geog bor c la d il le k e s n et siz lo w u mar k

0

12.5 17.2 17.2 18.8 22 21.9 19

19 19

33

23.4 23.4

40

28.1 28.1 30 31.3

All Foreign MNEs Greek MNEs

37.5 30

30

40.6 46 42.2

54

43.8 45.3 57.8 67.2

20

40

60

80

100 84

93.8 92

100 120

Figure 7.9  The most important FDI motives for MNEs (foreign vs. Greek) that invested in Bulgaria (research from 64 MNEs) Source: Bitzenis, 2004c.

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The Balkans: Foreign Direct Investment and EU Accession

Figure 7.9 indicates that the main FDI motives were: market size (94%), low labour cost of unskilled workers (67%), geographical proximity (58%), international pressures from competition and globalization (45%), prospects for market growth (44%), the link to other neighbouring countries (42%), and lack of local competition (40%). With respect to the separate motives, Greek investors as expected ranked geographical proximity (100%) as the main motive for their FDI activity. Other important factors were the market size (92%) and the low labour cost for unskilled workers (84%). The significant trade relations between Greeks and Bulgarians can be viewed from the results, as 33% of Greek MNEs exploit existing business links when entering Bulgaria (only 21.9% of all foreign MNEs). Actually, we can argue that the total trade volume between Greece and Bulgaria has increased six to twelve fold from the 1990s and on. Thus, we can argue that trade and FDI are complementary for the case of Greece and Bulgaria when the exports from Bulgaria to Greece and the Bulgarian imports from Greece increased proportionally. Every year gives a positive balance for Bulgarian trade of around US$50–150 million. Actually, establishing an export base has been mentioned by 22% of the Greek MNEs in our questionnaire survey which also supports the suggestion that trade and FDI are complementary. Main exported goods to Greece are from the garment industry – shirts, blouses, knitted wear, t-shirts, men’s suits, coats, sports wear, and sweaters at a percentage of around 35%, followed by electrical goods (10%), and iron and steel products (10%). Again, the main imported goods from Greece are in the garment industry: shirts, blouses, knitted wear, etc. with a percentage of around 25%, followed by oil, gas and iron products at 10%. Moving now to the FDI inflows in Bulgaria, Figure 7.10 shows the primary barriers investors had to deal with in the Bulgarian market. The biggest obstacle was the unstable legal system in Bulgaria (74%), followed by bureaucracy (58%), corruption, crime and mafia (53%) and the high investment risk at 52% (for more see Bitzenis, 2006b). With reference to the Greek entrepreneurs, we can conclude that the main barrier that Greeks had to face was corruption, crime and mafia (78%), followed by the unstable legal system (59%), followed by bureaucracy (57%) and the low per capital income (57%). These results are somewhat surprising because the same conditions as far as bureaucracy, the unstable legal system and corruption are concerned, also prevail in Greece.

political instablitiy

3

low progress in transition

6.25 15.63

0

lack of managerial skills

16

20.31

behavior against consumption & labour

26.56 29.69

high VAT, high taxation macroeconomic instability

31.25

16

lack of infrastructure

41 38 42.19 43

low GDP per capita

All Foreign MNEs 50

Greek MNEs 57

51.56 51 53.13

high investment risk corruption, crime, mafia

78

57.81 57

Bureaucracy Unstable Legal Framew ork

73.44

59

0

10

20

30

40

50

60

70

80

90

Figure 7.10  The most important FDI obstacles for MNEs (foreign vs. Greek) that invested in Bulgaria (research from 64 MNEs) Source: Bitzenis.

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The Balkans: Foreign Direct Investment and EU Accession

The most important barrier for foreign MNEs was the unstable legal framework – the lack of appropriate laws and their enforcement, and the constant changes of laws which surprised foreign entrepreneurs. Moreover, we mean the discrimination in the enforcement of the laws, the existence of unclear laws which leave space for ‘riding them’ by using some loopholes in the laws. Apart from that, the existence of corruption and briberies in order to overcome the enforcement of the laws and/ or the imposition of the fines, the lack of state inspection for violations of laws, and the limited/insignificant fines, all lead to the inadequate legal framework. As mentioned in Bitzenis, 2006b, foreign MNEs other than Greek MNEs, mentioned the this barrier at an extremely high percentage of 92.6% (25/27). At the same time, only 59.5% (22/37) of Greek MNEs investing in Bulgaria also made reference to this factor as a barrier, due to the fact that western foreign investors are not familiar with constant changes in the legal framework. At the same time, Greek MNEs are experienced in working in such an unfavourable legal environment, with inadequate law enforcement which in turn leaves space for corruption, bribery and bureaucracy. Greek MNEs did not altogether reject this as a barrier; however they did refer to it at a significantly lower percentage. The majority of Greek MNEs (31/37, 83.8%) mentioned that the low cost of unskilled labour force was a significant motive for the establishment of their investment projects in Bulgaria, when only 12/27, 44.4% of other MNEs made reference to the above as important. The cost factor was important, especially for Greek MNEs which were mainly SMEs. With the help of geographical proximity, Greek MNEs exploit this specific motive (most of these SMEs created an export base, thus not serving the local market). It is our conclusion that the origin of the enterprises together with the size of the firm and the sector that each company belongs to played a decisive role in the company’s strategy to enter a foreign country. Thus, Greek companies took advantage of their size and flexibility and entered Balkan markets where competition from other large western companies was limited. Moreover, when companies’ vulnerability to the conditions of the local business environment is concerned, again Greek companies became more exposed due to their size and sector. On balance, Greek companies would need to derive the net balance of their decision subtracting the disadvantages faced by the business environment from the advantages gained through conquest of a market niche. It is our finding that Greek investments in Bulgaria exceed the amount of US$ 1 billion. This is attributed to the fact that there are a few large Greek MNEs that have invested in Bulgaria through offshore companies established in Cyprus or Luxembourg (others that followed the same investment path were Russian and Turkish). Although, on the one hand, very few large Greek MNEs have invested most of the total Greek FDI outflows (in US$) in the whole Balkan region, on the other, more than 3000 Greek active companies (especially SMEs) offered and still offer value added activities, such as job placements, quality and variety of products, significant contribution to the GDP, higher wages, etc., to the Balkan economies.

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It is our firm belief that the leading FDI motivations for the Greek entrepreneurs in Bulgaria were geographical proximity, market size, low labour cost, and the use of Bulgaria as a link to neighbour countries. The Greek firms planned to use Bulgaria as a bridge for further investments in other neighbour countries and their previous trade relations have proved helpful in their decision for FDI. From the survey results, it can also be argued that the Greek enterprises’ decisions for FDI outflows were also based upon the lack of foreign and local competition, and cultural closeness. The lack of significant western interest for FDI outflows in Bulgaria has provided Greek enterprises, especially large ones, the opportunity to become MNEs and to invest in neighbour countries such as Bulgaria, a relatively large amount of US$ if we consider and compare the Greek economy with the German or the British one. Problems such as corruption, a shadow economy, bureaucracy, and the primitive market infrastructure, discourage foreign investors and additionally decrease the competitiveness of the Bulgarian economy. We must stress once again that the importance in the consideration of corruption, bureaucracy, mafia and briberies as a barrier for the Greek MNEs came as a surprise. However, we based our arguments firstly on the fact that a lot of small in size Greek MNEs which participated in the Bulgarian business environment were vulnerable to the mafia (it was easier to be approached and to be frightened by the mafia), secondly, on the Balkan enlargement spirit and thirdly, on the tendency of Bulgarians (the same is valid for most of the ex-communist citizens) to respect and mimic western civilization and thus the large western MNEs and their business activities. Questions: 1. What are the most decisive motives for Greek entrepreneurs investing in Bulgaria? 2. What are the reasons behind the great accumulation of Greek entrepreneurs in the Balkan region? 3. What are the reasons for the failure of many Greek companies in the Balkan region?

7.22 Bulgartabac as a Corrupted and ‘Stop and Go’ Privatization Trial (1997–2008) Bulgartabac was created as an industrial and trade company in 1947, owned by the Bulgarian Communist Party government. In 1993 Bulgartabac became a Holding company (BTH), comprising 22 joint-stock companies with predominantly state ownership. At that time BTH owned more than 85% of its subsidiaries. BTH holds a monopoly position in the domestic cigarette market, with an 85% market share. It is one of the largest tobacco companies in Central and Eastern

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The Balkans: Foreign Direct Investment and EU Accession

Europe, and is a major cigarette manufacturer in Europe. BTH’s subsidiaries are vertically integrated to perform all activities in the tobacco manufacturing process, from primary processing of tobacco to production of cigarettes. BTH is of great importance to the Bulgarian economy. It is one of the largest tax payers in Bulgaria and it generates approximately 4% of the budget revenues. Tobacco is an important product to Bulgaria, both in the form of tobacco leaf and in packaged cigarettes. Bulgaria is a leading grower of high quality tobacco leaf that is used by international tobacco companies (including Phillip Morris, RJ Reynolds and BAT) for production of cigarettes sold around the world. Tobacco and tobacco products account for 40% of Bulgaria’s agricultural exports, and 5% of Bulgaria’s total exports. Outside the Bulgarian market, BTH has exported raw tobacco into Central and Eastern Europe, Russia and the Middle East. BTH owns more than 50 cigarette trademarks distinguished by the blend type, level of nicotine and tar. BTH has stated that its growth strategy is to focus on opportunities to export its products into new markets such as Latin America and Asia through a combination of direct entry and joint ventures. Presently BTH operates factories in Russia, Ukraine and Romania. The topic of the privatization of the Bulgarian tobacco monopoly Bulgartabac has been in the news continuously in the last decade (1997–2008). As mentioned, tobacco production is a strategic sector to Bulgaria both economically and socially and who will own the holding and control the industry is therefore of particular interest. Bulgartabac is also amongst the monopoly companies and along with the energy companies is considered as one of the ‘pearls’ of the Bulgarian economy. Although several governments expressed readiness to denationalize the tobacco sector, Bulgartabac was first put up for sale by the UDF Government in 1998. The first privatization procedure was initiated in April 1998 and the Privatization Agency (PA) started collecting bids from potential buyers. Two years later, in May 2000 government attempts to sell the entire Holding failed – any potential bidders were put off as they were only interested in the profitable factories. In July 2000, the PA cancelled the tender and invited new bids for a second time. In March 2001, the Agency terminated the privatization procedure again without selecting a buyer. Thus, the first two attempts failed in the time period between 1998–2000, after the Bulgarian Government sought to sell the company as a whole and demanded that the prospective buyer undertake not to fire any staff. No bidders appeared. With the term of the UDF Government drawing to a close and elections approaching, after the Bulgartabac privatization procedure was cancelled in the spring of 2001, there was no time to issue a new tender. The parliamentary elections in the summer of 2001 were won by Simeon II National Movement (SIINM), which assumed power together with the Movement for Rights and Freedoms (MRF). A few days after the electoral victory, the new Minister of the Economy and Vice Prime-Minister Nikolay Vasilev announced that the 3rd privatization trial of Bulgartabac tobacco would be completed by the end of 2001. However, owing to political and economic constraints, the new bidding

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did not commence until the spring of 2002. Nevertheless, the media had started covering extensively the preparations much earlier. The most frequently used words during the Bulgartabac privatization ‘trial’ were ‘corruption’ and ‘games’. These two words actually reflected the two aspects of media coverage of the problem with corruption and the non-transparency of the Bulgartabac deal. On the one hand, doubts were expressed almost openly. On the other hand, the use of the word ‘games’ obfuscated the message about the suspiciousness of the procedure, of the intentions of the buyers, and of the actions of the state institutions. At the same time, the word corruption occurred mostly when citing a statement, comment, or interview – i.e. when the responsibility for the accusations lay with a source outside the medium itself. The word ‘games’ was used above all in the analyses, commentaries, and investigations of journalists, experts, political observers, and economists. This distinction was even more marked in terms of news reports/opinion pieces. Two more words were also predominant in media coverage of the privatization of Bulgartabac – ‘favourite’ and ‘bribe’. Ever since the tender was first issued, it was clearly stated in the media that the government had a definite favourite among the candidate buyers – throughout the period the mention of Tobacco Capital Partners was accompanied by the explanation that this was the sellers’ favourite. The word ‘bribe’ occurred more often in the second quarter of 2002; this was when (in April) the Executive Director of the Holding, Georgi Popov, was accused of having asked for a $500,000 bribe. Over the next two months the media followed closely the reactions and statements of the authorities concerned with the case – the prosecution and the court – and those of the parties implicated. Following the discharge of Georgi Popov, the number of publications in which the word ‘bribe’ appeared fell sharply. The phrase ‘under the table’ was associated with the doubts expressed in the media about possible friendly arrangements in the process of negotiation. However, it occurred relatively rarely. In a sense, a similar message was conveyed with the use of the term ‘games’ in the respective combinations. In the period under review the number of items dealing with the case of Bulgartabac was extremely unevenly distributed. In February 2002 controversy flared up regarding the employment contract of Bulgartabac Executive Director Georgi Popov. The cause for indignation was the huge – by Bulgarian standards – monthly remuneration and generous benefits agreed for Popov. The media covered the conflict between the Minister of the Economy Nikolay Vasilev and his Deputy, Lyubka Kachakova, over this important contract clause. Kachakova was discharged at the end of the month on grounds of ‘disloyalty’ and ‘inability to work in a team’. A few days later the media published a photocopy of Popov’s contract, clearly stating the amount of the salary – 130,000 leva. The media chiefly stressed the fact that the contract did not appear to be undersigned by Kachakova. Thus the media unanimously concluded that the reason for her dismissal was her disagreement with the conditions under which

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Popov was to be hired. Several investigative reports were published showing the direct relation between the Vice Prime Minister and Popov, best man at Vasilev’s wedding. This led to the conclusion that appointments were being made on the basis of personal connections, meanwhile commentaries centring on the ‘friendly relations’ between the two proliferated (the number of publications reached 87). A second scandal exploded in the 3rd privatization trial of Bulgartabac and especially in the months of April/August 2002. In April, the representative of the Russian-Bulgarian company Soyuzkontrakt Tabak, Garegin Gevondyan, accused the Executive Director of Bulgartabac Holding of having asked him for $500,000 dollars at their meeting on 1 April, 2002. The case had nothing to do with the imminent process of privatization. The money was requested in connection with the forthcoming reforms in the Holding’s international partner system. Soyuzkontrakt Tabak wanted exclusive rights as the sole distributor in the Russian market. According to the representative of the Russian-Bulgarian company Gevondyan, Popov set the price for this at 500,000 dollars. There followed an immediate and resolute denial by the Ministry of the Economy. In May 2002, the media continued to be preoccupied with the alleged bribe of the amount of $500,000 dollars requested by Georgi Popov. The focus, however, gradually started shifting towards the imminent Bulgartabac tender. On 7 May, 2002 bids were submitted by Metatabak – with principal stakeholder Michael Chorny, barred from Bulgaria; the Vienna-based Tobacco Holding; Hungarian V Tabak; Tobacco Capital Partners, represented by the law firm of Djingov, Gouginski, Velichkov & Kyutchukov; and the Russian bank Regionalna Perspektiva. Already at this early point the Ministry of the Economy declared that ‘maximum transparency’ of the process would be ensured. August 2002 proved laden with events and information; the finalization of the privatization deal and the announcement of the official buyer of 80% of the Holding seemed imminent. Many media published chronological accounts and analyses and some even went as far back as 1998 to the very beginning of the privatization of Bulgartabac (see also The Bulgartabac Odyssey [DNEVNIK – , 8 February 2002]). At the beginning of August 2002 the Privatization Agency turned down the candidates’ requests to improve their bids. However, they were asked to answer 77 clarifying questions. For the first time since the launch of the procedure Michael Chorny intervened in the conflict, threatening to withdraw his investments from Bulgaria and to seek court protection because of the corruption in the government. By the end of the month, however, it had become clear that Metatabak was not withdrawing from the tender after all and had, therefore, submitted the answers requested by the Privatization Agency (PA). On 23 August 2002 the PA announced the final winner: Tobacco Capital Partners was declared the exclusive buyer and Michael Chorny’s consortium dropped out. In August, the investigation of the bribe, allegedly requested by Georgi Popov, which had been the top news story in the previous two months, was relegated to

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the background, with few new commentaries. In one of his statements, Michael Chorny said that in his meeting with Georg Tsvetanski (Executive Director of Balkanpharma) the latter had said he did not believe Minister Nikolay Vasilev had anything to do with the bribe requested because ‘he is an honest fool’. Once the buyer of the tobacco holding was announced in September 2002 the focus in the media shifted to the reactions of the parties concerned, in particular the mass protests of the tobacco growers, backed by others working in the industry, in connection with the purchase of the new tobacco crops. The other items in September 2002 were mainly chronological overviews of the entire procedure and of the irregularities that had occurred. In the beginning of October 2002 the Supreme Administrative Court reviewed the complaints filed by Tobacco Holding, the consortium Metatabak, and Ros Bulgartabac against the decision of the Privatization Agency to choose Tobacco Capital Partners as the exclusive buyer. Meanwhile it emerged that one of the candidate buyers – Tobacco Holding – had filed a complaint with the European Commissioner for Enlargement, Gunther Verheugen, referring to violations in connection with the privatization of the tobacco holding. At the end of the month, the Court cancelled the PA’s choice of exclusive buyer of 23 August and recommended proceeding with the bidding. In November 2002, the Bulgartabac deal was cancelled and Tobacco Capital said it would keep the parameters of its offer for future bidding. There were hardly any items on the case in this period. The subject of corruption was typically brought up in interviews with opposition leaders, in analyses and commentaries by experts and journalists. But it was set in the general context of corruption in government and the case of Bulgartabac was only cited as an example of favouritism and advancement of private interests. The same tendency continued in December 2002. The Bulgartabac topic was considered in the context of the discord between the government and the judiciary about the course of the judicial reform. Quite unexpectedly, the US Ambassador to Bulgaria, James Pardew, became involved in the conflict. In an official statement, he declared his support for the government’s actions in connection with the tobacco holding deal and accused the court of impeding the privatization process and thus undermining the country’s image. Parallel to this, the Bulgarian Ambassador in Moscow was handed a note from the Russian Foreign Ministry (backed with the appropriate documents) demanding the restitution of property of the ex-USSR in Bulgaria. Most attractive among these assets was the share of Bulgartabac Holding. The media saw the two events as yet another stage in the clash of interests accompanying the denationalization of important national assets. This time, however, the conflict appeared in the sphere of international relations. On 10 March 2003, the Bulgarian government named again a Deutsche Bank led consortium the winner of an auction for 80% of Bulgartabak for 110 million euros ($121 million). This was the 4th privatization trial. The government confirmed Deutsche’s consortium as the buyer after a supreme court annulled an earlier decision by the sell-off agency to pick the group as the preferred buyer. The deal has yet to be approved by parliament. Economy Minister Nikolai Vassilev

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said that the sale of Bulgartabak, long delayed by court battles, would meet the government’s goals of attracting major foreign investors and secure employment in the tobacco sector. Vassilev had said that Deutsche’s consortium had pledged to cover 38 million euros worth of outstanding debts, which Bulgartabak owes to the state budget, and invest 71.185 million euros over the next five years. The country rejected a planned 110 million euro sale of 80% in Bulgartabac to a Deutsche Bank-led consortium in March 2003, saying the deal was unfavourable. A previous attempt to sell the tobacco monopoly attracted four bidders but world industry heavyweights ignored the tender, saying they would only be interested in the profit-making factories. In October-November 2003, the Bulgarian parliament adopted another strategy for another (fifth) privatization trial of Bulgartabac Holding AD. On 19 April 2004, leading world tobacco company British-American Tobacco, once again confirmed its interest in the privatization of Bulgarian tobacco giant Bulgartabac. Bulgaria’s Economy Minister Lidia Shuleva held talks with representatives of the major company who told her that British-American Tobacco had already worked out its strategy. The leading company stated its firm interest in the privatization deal in October 2003. Tobacco giant Phillip Morris withdrew from the tender to sell Bulgaria’s Bulgartabac company, according to Sofia press reports on 8 October 2004. Bulgaria’s Pari daily reported that the US company did not send representatives to conduct due intelligence of Bulgartabac factories, although the term had been extended until 29 October. The newspaper cited sources inside Phillip Morris saying that the holding is not participating in current talks. The other candidates for Bulgartabac were Imperial Tobacco Group and British American Tobacco. The receipt deadline for submitting binding bids for twelve tobacco-processing subsidiaries of state-owned Bulgartabac expired 12 November 2004. All deadlines under the procedure for the sale of Bulgartabac plants were extended until the middle of October after poor levels of investor interest. The twelve companies are pooled in two groups. The first group consists of Gotse Delchev BT, Pazardzhik BT and Kardzhali BT. Candidate buyers for this group were required to place a deposit or bank guarantee totalling BGN 100,000 for each company. The second group consists of Dulovo BT, Harmanli BT, Parvomai BT, Smolyan BT, Yambol BT, Dupnitsa BT, Isperih BT, Sandanski BT and Topolovgrad BT. The required deposit or bank guarantee for the companies in this group was set at BGN 30,000. Binding offers, accompanied by a bank guarantee for 100,000 levs ($1=1.61 Bulgarian levs), for the first three companies were required to have been submitted by November 12, 2004. A factor in the evaluation of the bidders was also their track record in tobacco processing. Almost all the companies, whose annual production capacities vary between 2,000 and 8,000 tonnes, had reported losses for 2003. Mainly Bulgarian companies were expected to bid for them. The preliminary conditions that were presented before the buyers requested that the applicants should have at least five years of experience in

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cigarette-making, and at least 500 million euros net revenue from selling tobacco products in the last financial year. On 11 March 2004, Morgan Stanley’s London office was contracted as a consultant on the privatization of Bulgartabac Holding. Morgan Stanley worked in conjunction with Freshfields Bruckhaus Derringer, a leading international law company that specializes in mergers and acquisitions in the tobacco sector. Morgan Stanley’s fees were determined by a percentage of the sale price. The Independent Trade Union of Tobacco Workers (ITUTW), affiliated to the Confederation of Independent Trade Unions in Bulgaria (CITUB), organized a protest demonstration and meeting on 23 March 2004 in front of the Ministry of the Economy, aimed at protecting the rights of Bulgartabac workers and asking for the outstanding wage arrears totalling 4.2 million Bulgarian New Leva (BGN) across 11 group companies. Some 1,200 workers from all tobacco firms in the country participated in the protest, under the slogan ‘No to privatization without social obligations’. In a declaration delivered to the Ministry of Economy, the protesters called for consultation and discussions on obligatory conditions to be imposed on prospective buyers of Bulgartabac, and on criteria and engagements related to employment and social issues. In June 2004, after a number of meetings between trade union representatives, the government and Bulgartabac management, the parties signed an agreement on social aspects of privatization that satisfied all parties to some extent. However, shortly afterwards, trade unions claimed that the Ministry of Economy and the Bulgartabac supervisory and management boards had breached a number of clauses of the privatization strategy. It was claimed that no action had been taken to achieve the economic recovery of the Bulgartabac enterprises or to find potential buyers. It was also not clear how the Bulgartabac enterprises would be restructured if their trade-mark licenses were taken from them, and how machinery would be transferred from enterprises in Haskovo, Shoumen, Vidin, Assenovgrad and Pleven. On 19 July 2004 the privatization procedure officially began, and notices for the sale of the four most profitable companies, members in the group of Bulgartabac, were published in the Financial Times and two Bulgarian daily newspapers. The companies were grouped into two pools: Blagoevgrad BT and Stara Zagora BT in the one pool, and Sofia BT and Plovdiv BT in the other pool. The information memorandum was available to potential investors on 2 August 2004. The deadline for submission of offers was 30 September 2004. Candidates were required to have at least five years of experience in cigarette production and have at least 500 million euros in net revenue for the last financial year. The short-list of potential purchasers was announced at the end of November, and the sale was planned to be completed by the end of 2004. Morgan Stanley & Co. Ltd. confirmed that major tobacco companies had shown interest in the sale, including British American Tobacco (BAT), Philip Morris, Imperial Tobacco, Korean KT&G and British Gallaher. Among the bidders, BAT and Phillip Morris looked most promising as they bought two cigarette plants in neighbouring Serbia in 2003. Specifically BAT

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was also one of the bidders in an earlier cancelled privatization in Turkey. Analysts predicted that ‘BAT wants to seal the deal as soon as possible, as they want to benefit from the country’s competitive advantage of not (yet) being part of the EU (this will be in 1.1.2007)’. The participation of group companies in Haskovo, Shoumen, Vidin, Assenovgrad and Pleven in Bulgartabac’s foreign partnerships was terminated and their licenses to produce tobacco products was withdrawn. The situation led to an escalation of the social tension among the workers at Bulgartabac Holding enterprises, and to a number of protest actions. Moreover, on 8 September 2004 around 100 Bulgartabac workers protested in front of the Holding’s headquarters in Sofia. The workers warned that they would launch a number of regional protest actions and national protest meetings in order to protect their jobs, their rights and the future of Bulgartabac. The protesters held posters with inscriptions including ‘We Want Our Salaries’ and ‘Stop the Mindless Liquidation’. To the tune of the Beatles’ ‘Let It Be’, they chanted ‘We want work’. The ruling National Movement Simeon II suggested that a delay of the privatization reduces the price of the companies within the holding. The movement for Rights and Freedoms, the junior partner in the ruling coalition, held the opinion that the privatization process should continue but not at any cost. However, Coalition for Bulgaria (dominated by the Bulgarian Socialist Party) insisted on termination of the procedure. The right-wing opposition said that privatization was needed but the goals, set in the privatization strategy, were not being fulfilled. ‘We are faced with two possibilities: to continue or halt the privatization of Bulgartabac. If it is stopped the responsibility will rest with Bulgarian Parliament. If we continue we will give the workers a chance to get their unpaid wages’, Agriculture Minister Mehmed Dikme said. British American Tobacco (BAT) placed a sole bid in October 2004 offering to buy the two best performing cigarette plants located in Sofia, and Plovdiv. No submissions were made for the other package of factories that includes Blagoevgrad BT and Sluntse – Stara Zagora BT. Consequently, this led to a serious drop in the price of the shares of Blagoevgrad BT on the stock exchange market. Meanwhile, it became clear that Bulgartabac had to pay millions of dollars in damages arising from the legal claims brought forward by the US government. Deputy Economy Minister Radoslav Boyadjiev, who also chaired the board of directors of Bulgartabac, said that the demand of the left to stop the privatization procedure came too late, ‘The restructuring and privatization of the holding involved a difficult and painful procedure leading only to negatives but these are things that have to be done’. The price that BAT was willing to pay was 200 million euro (US$260 million) but if the deal was closed, BAT would have had to make buyout offers for the plants, which would have taken its total investment in Bulgaria to 250 million euros as quoted by the then Minister of Bulgarian Economy, Lidia Shuleva. BAT had promised to use at least 30% Bulgarian tobacco in cigarettes produced in the local factories until the country joins the EU in 2007. This translates into at least 7,000 tons of tobacco purchased annually from small

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tobacco growers who are mainly ethnic Turks. Bulgartabac purchases 13,000 tons of tobacco annually, despite industry experts who say most of this tobacco is not necessary and it is stored in warehouses without being used. As part of its final offer, BAT pledged to make the country a centre for its cigarette production in southeast Europe, producing cigarettes not only for the domestic market but also for the entire southeast European region. BAT also promised to upgrade the production facilities and boost the plant’s efficiency. Shuleva said the terms of BAT’s offer were in line with national interest and failure of the deal would put Bulgaria back on the list of countries seen to have high political risk. Despite these assertions, the opposition Socialist Party opposed the sale and said the privatization plan for BTH needs to be revised as it might harm the future development of the tobacco sector in Bulgaria. Agriculture Minister Mehmed Dikme, a member of the Turkish Minority party and Bulgartabac supervisory board, said: ‘The company should be privatized but not at all costs. We should allow for a competitive cigarette market to develop in Bulgaria.’ The cabinet of Prime Minister Saxe-Coburg Gotha delayed its decision on the sale for several months mainly due to objections to the deal by the junior partner in the MRF, the predominantly ethnic Turkish party. The party requested on numerous cases that the government reject the deal as it was against the strategic interests of Bulgaria. Parliament resolved to call Shuleva to answer questions on Bulgartabac during an extraordinary sitting on 2 November 2004. Coming to Parliament for the extraordinary session, Shuleva announced that the four factories had been prosecuted and fined in the US, thus serving the biggest surprise to both incumbents and opposition. ‘The fact that the factories were fined forced Imperial Tobacco, which also had expressed interest in taking part in Bulgartabac’s privatization together with BAT and Philip Morris, to pull out’, Shuleva said. The cigarette makers in Sofia, Blagoevgrad, Plovdiv and Stara Zagora had been sentenced to pay many millions of US dollars for illegal exports to the US by the end of 1999. ‘No offers were submitted for the pool of Bulgartabac BT and Sluntse – Stara Zagora BT because of the actual bankruptcy of Sluntse’, Shuleva said. ‘There are no orders, the companies operate with less than one-third of their capacity, no receivables have been paid to the budget, social security and employees, and salaries are paid for idle time and not for completed work …’

… Shuleva said in a comment on the poor condition of most of the companies within Bulgartabac Holding. She was referring to the other cigarette manufacturing plants of the holding (out of the four best performing), such as the ones in Shumen, Vidin and Haskovo, which would also be difficult to sell. Under the Government plans, they also had to be restructured and sold too or face closure. ‘The Cabinet is not keen to siphon money from the well performing factories in Blagoevgrad and Sofia in order to finance the failure of the rest’, Shuleva said. In her opinion, the solution for the plants in Shumen and Haskovo was their immediate restructuring,

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which would turn them into tobacco processing factories and would discontinue the cigarette production. At a later stage they will undergo privatization. When the opposition suggested that the closure of some factories will destroy the tobacco industry of Bulgaria, Shuleva replied that this is how all the world’s leading companies operate. The most serious criticism on Government’s policy towards Bulgartabac was aimed by Angel Naidenov, a socialist MP (a Member of Parliament, or MP), who called the privatization of the holding ‘economically inexpedient’ and asked for the matter to be debated in the plenary hall. Parliament decided to hold such a debate on 5 November (2004). While Shuleva was unveiling the poor state of Bulgartabac Holding, over 100 employees of Haskovo BT were protesting outside the Parliament’s building. ‘Shuleva out! Resignation! We want our money!’ the protesters shouted. During the first privatization procedure, Philip Morris and British American Tobacco abandoned their acquisition attempts, due to the disadvantageous terms and the very onerous social commitments imposed by the 2001 tender. In 2004 Bulgartabac management established a ‘social fund’ having the aim to finance the social expenses related to Bulgartabac restructuring – i.e. compensation in the event of dismissals, training and financial support for former employees to start their own businesses. As mentioned above, the agreement signed with the trade unions in June 2004 provided for dismissal compensation of up to 20 month’s pay per worker, which is the highest level so far, offered in the history of Bulgaria’s privatization process. As a result of the government’s lack of decision on February 1, 2005, British American Tobacco announced the withdrawal its 200 million euro bid on the cigarette factories, as per its quote: We have told the Bulgarian government that we are withdrawing from the transaction … In the difficult political environment, which continues to worsen, we do not believe we can complete the transaction to a timescale that will ensure that we make a worthwhile return on our investment.

Foreign and local analysts as well as industry experts predicted that the lack of an agreement would have a negative effect on Bulgaria and its tobacco industry. ‘A halt in the sale will definitely hurt Bulgaria’s image’, Yarkin Cebeci senior economist at JP Morgan in Istanbul, told SeeNews in a statement. But people understand how difficult it is for the government to compete the deal as it has already lost majority in parliament and there will be a new general election in five months.

Krasen Stanchev, head of the Institute for Market Economics, agreed that the tobacco factories could be sold at a later time, but he said that the buyer and price

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would hardly be as good: ‘The price will be definitely lower, as the company will continue to be used for social purposes and that costs a lot to the tax-payers’. Thus, a fifth attempt to sell a few of the company’s factories – in Sofia, Plovdiv and Blagoevgrad – to BAT fell through on 1 February 2005 when BAT withdrew its offer because of what it said was ‘the difficult political environment’ in the country. Parliament voted on 11 February 2005 in favour of opening another (6th) privatization procedure for Bulgartabac Holding, after British-American Tobacco (BAT) withdrew its offer to buy the company in February 2005. We have to speed up the privatization process to make the Bulgarian tobacco industry competitive. Once the protective duties are lifted in 2007, the year in which we will join the European Union, it will become difficult to sell Bulgarian cigarettes …

… Deputy Prime Minister and Economy Minister Lydia Shuleva told the National Assembly. She was personally blamed by opposition and ruling coalition members for being responsible for the failure of the most recent deal. The MPs’ decision paves the way for a 6th attempt to privatize Bulgartabac. Media reports suggested that BAT had offered to pay 200 million euros for Bulgartabac’s best performing cigarette plants. The debate in Parliament on 11 February 2005 showed that Movement for Rights and Freedoms (MRF), the junior coalition partner to the ruling National Movement Simeon II (NMSII), holds Shuleva personally responsible for the failure of the attempt to divest Bulgartabac. The opposition did not agree with this however, and blamed the MRF and the incumbents. ‘The MRF reacted with a delay and improperly laid the blame on Shuleva’, said Blagoi Dimitrov, MP of the United Democratic Forces (UtDF). In his words, the MRF reaction came only when tobacco growers in certain regions started staging protests. ‘The MRF is responsible for the bad strategy and the failure of the deal for Bulgartabac with BAT’, Dimitrov said. The blamed mainly Turkish-ethnic movement did not try to further refute the allegations and just demonstrated once they were pleased with the negative impact. Hyussein Chaush of the MRF said that the Council of Ministers should open a new privatization procedure, which must be transparent, objective and accommodate the country’s national interests. That was a view opposition MPs could not agree with. ‘The Bulgartabac crisis caused serious jolts in Bulgaria’s political life’, said Georgi Bozhinov of the Bulgarian Socialist Party-dominated Coalition for Bulgaria. In his words, the choice of the Government was to reduce Bulgartabac Holding to the matrix proposed by the only possible buyer. ‘The strategy was entirely wrong, Bulgartabac could have sought a merger with national monopolies at worst’, Bozhinov observed. During the Parliamentary hearings, Shuleva, who challenged her critics, presented a review of the privatization progress made so far. According to her, a total of 17 tobacco factories were in sales procedures, with deals almost completed for six of them. Bulgartabac’s supervisory board had taken a decision on two privatization

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contracts (for the factories in Topolovgrad and Parvomai), the approval of the other four sales was just a matter of time. ‘The best option for the future of the cigarette industry in Bulgaria is concentrating production in two factories only – the ones in Blagoevgrad and Sofia’, Shuleva said. ‘The restructuring of the other enterprises should continue. This proposal is contained in the supervisory board’s report to parliament of 19 November 2005’ she recalled. The decision of the parliament to recommend the opening of a new sales procedure means that the holding’s privatization strategy remains in force and future deals will be closed for separate factories. The holding will remain a state structure until the objectives of the strategy are achieved. The receipts from the sale of companies will be credited to the holding, not the budget. The body responsible for approving the sale of factories will be the supervisory board. The only outstanding issue for the time being is the membership of the board, due to the expected cabinet reshuffles. The disappointment of the Government in the failure of the negotiations with BAT and the latter’s withdrawal was seen in statements that preceded the debate and decision in Parliament on 11 February 2005. On 9 February 2005 Finance Minister Milen Velchev, said that a new procedure for the privatization of Bulgartabac Holding should be opened as soon as possible. A successful deal would have secured a much faster rise in Bulgaria’s credit rating, he said. The sale of Bulgartabac, which analysts have seen as key for Bulgaria’s image among the international investment community, has been drawn-out for years. ‘Actually the last privatization trial and actually the most transparent mechanism for the privatization of tobacco and cigarette producer Bulgartabac was through the stock exchange’, labour union representatives said. Representatives of Bulgaria’s two leading labour unions met Economy and Energy Minister Roumen Ovcharov to discuss the sale of Bulgartabac, Focus news agency reported. Union representatives said that the Cabinet should try to provide more guarantees for the transparency of privatization procedures. Stock exchange transactions gave no chances for preliminary talks and preference of one candidate over another, unions said. Ovcharov said that the ministry was going to do its best to ensure the development of Bulgaria’s tobacco production. The Bulgartabac factories in Stara Zagora and Plovdiv would be privatized as soon as possible, probably by February 2007, said Ovcharov. Bulgaria’s Bulgartabac Holding Group would sell four of its companies on the Bulgarian Stock Exchange (BSE) in late 2006, beginning 2007. The holding already managed to sell one of its companies, cigarette packaging firm Yuri Gagarin BT, in two BSE auctions, for 32.4 million leva. It was the first big deal accomplished from the strategy for privatization of Bulgartabac, Lalchev then said, and proved it was a successful strategy. Bulgartabac would launch a tender for its non-public companies by the end of 2006, Lalchev said. The companies (plants) in Sofia, Plovdiv and Stara Zagora would be sold in 2007, he said. Bulgartabac would keep only four of its companies, Lalchev said. The state controlled tobacco holding Bulgartabac sold out 85.24% of its tobacco processing unit in Pazardzhik at the price of BGN 4.7 million (2.4 million

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euros) on the local stock exchange market on November 2006. The price is more than three times higher than the set bidding floor and well above the expectations based on the weak income balance of the plant. Four companies have participated in the auction but names have not been officially announced yet. Bulgartabac has sold 80.6% of its printing and paper packaging plant in Plovdiv for EUR 16.6mn on the stock exchange in early October 2006. It will tender several other tobacco processing units in short terms but will retain majority stakes in the main cigarette makers in Blagoevgrad, Sofia, and Plovdiv. The state holds 80% of the holding while the remaining 20% is floated on the local stock exchange. It has posted a non-consolidated net profit of BGN 20.9mn (10.7 million euros) in Jan-Sep 2006 and the net earnings rose further in Q4 of 2006 on the back of the sell-offs mentioned above. However, the sell-offs of the Bulgartabac shares in the stock exchange market started firstly during the first wave of mass privatization in 1995 when 7.16% was placed on the Bulgarian Stock Exchange and the remaining 92.84% of BT Holding’s capital remained state-owned. The ownership of the company shares was as follows: Ministry of Economy: 92.84%, Portfolio Investors: 5.98%, Individuals: 1.18%. Afterwards, there was another sale of Bulgartabac at the Bulgarian Stock Exchange which was successfully completed in June, 2003 after 112572 stocks of Bulgaria’s tobacco monopolist Bulgartabac were bought up on the Privatization segment. A total number of 112572 shares in BGN 80.18 average price in exchange for payment in compensatory instruments were bought. However, from the start of the tender and after a three-week period in June 2003, 259038 shares were sold, including the initial 112572 stocks. This means that another 4% of Bulgartabac was privatized. 259038 of total 985804 shares of Bulgartabac that were floated on the Privatization segment were sold during the first 17 days of the sale. The company has 7.367 million shares in total. The government’s latest strategy (7th) in privatizing BTH is to sell the factories separately, rather than as a group as it had intended to do in the past. To facilitate the process, BTH appointed a Supervisory Board and a Management Board. The Supervisory Board will dictate the privatization procedures (in accordance with government regulations), while the Management Board will arrange the sale of BTH’s daughter-companies, subsequent to Supervisory Board approval. According to the Ministry of Economy, the government expects to gain the following from a privatization of BTH: • • • • • •

Attract strategic investors to send a signal about future privatizations. Secure maximum cash proceeds from the privatization. Implement long-term social support to the employed in the sector and to guarantee effectiveness of state aid. Maintain a certain employment level in the privatized companies in compliance with the business plan proposed. Accelerate development of the cigarette and tobacco sector. Develop foreign markets for Bulgarian cigarettes.

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•

• •

Restructure Bulgartabac Group and the sector in order to increase the value and competitiveness of Bulgartabac Group’s subsidiaries and to recover the companies in grave financial state. Provide an alternative and more profitable occupation for tobacco growers. Improve the country’s investment climate as part of the state policy for EU accession.

While Bulgartabac has a near monopoly position in the market, smuggling of international cigarette brands into Bulgaria is an issue, and has created a large black market for foreign cigarette brands. Demand for cigarettes is strong in Bulgaria. Despite US and other Western European countries efforts to curtail smoking, Bulgaria has no anti-smoking movement, and currently has high rates of smoking, with 56% of men and 32% of women regular smokers. Therefore, the government has chosen to privatize the company prior to Bulgaria’s entry to the EU in 2007. Any delay of privatization decreases the price of both the holding company as a whole, and of the group’s subsidiaries. Entry into the EU will certainly lead to loss of its monopolistic position in the Bulgarian tobacco market, and the financial state of some of the Group’s subsidiaries is unsatisfactory. The implementation of social programmes to overcome the consequences from the sector’s restructuring is even more important. Timely privatization will provide the necessary resources and speed up the undergoing process of change for tobacco farmers as they adjust to the competitive market situation. Postponing this vital step will only aggravate the social problems of the employed in the sector and might lead to social complications at a critical time. The liberalization of the prices of cigarettes in Bulgaria at the end of 2006 proved to be a catalyst for new players to enter the Bulgarian market. An increase in excise duties on tobacco products in 2006 because of EU requirements did not deter international companies from competing for Bulgarian consumers. Currently, the excise on 1,000 cigarettes is 35 euros, but by 2010 the excise level has to reach the minimum requirement of 64 euros for 1,000 cigarettes. The overall cigarette market value in Bulgaria is estimated a 17 billion leva a year. Foreign companies in the sector will fully use this potential, and after just a few months, Bulgartabac’s head start evaporated as companies such as Philip Morris and British American Tobacco entered the market. In the middle of 2006, Bulgartabac’s market share was 99.3%, while in December 2006 it fell to 98.5% and in February 2007 it was 86.4%. Bulgartabac Holding would be sold by the end of 2008, Yordan Tsonev, head of the parliamentary Economic Policy Committee announced on 28 May 2008. The statement was made after Movement for Rights and Freedoms and Bulgarian Socialist Party withdrew their joint proposal the holding to be taken out of the list of companies of importance to the national security.

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Questions: 1. What were the ‘keywords’ mentioned in the media coverage about the Bulgartabac deal? 2. How many trials took place in order for the Bulgarian government to denationalize the tobacco sector (Bulgartabac)? 3. What was the role of the media in Bulgaria in terms of public concern and national interests? 4. What were the pressures upon the executive director Georgi Popov? Why? What were the results? 5. What is your opinion of denationalization and restitution of property? 6. What do you think about the restructuring of State Owned Enterprises (SOEs) and about the social aspects of privatization? 7. How many failed privatization deals existed? 8. Has Bulgartabak been finally privatized? Is it a privatization method the sale of part of Bulgartabac assets through the stock exchange market? 9. What will be the situation for Bulgartabac after the Bulgaria’s accession to the EU? 10. What will be the benefits from Bulgartabac’s privatization? Critically discuss. 11. What is the privatization solution for Bulgartabac? 12. Critically discuss (compare and contrast) the ways that the Bulgarian government has followed in each privatization procedure trial. Is there any restructuring process that took place?

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Chapter 8

Conclusion

The aims of transition were clear from the very beginning: establishing political pluralism similar to Western Europe’s, substituting the administrative planning system with market-based decision making, speedy integration into the world economy and participation in the EU. The transition strategies adopted in Central and Eastern Europe resulted in large decreases in output, inflation or even hyperinflation, unemployment, collapse of trade, corruption and crime, and the destruction of the state apparatus. The destruction of the state apparatus in Central and Eastern Europe created an environment in which the role of the state in the unfolding market process has been handicapped. As most of the countries of Central and Eastern Europe have joined or are in the process of joining the European Union, many commentators argue that the transition process is over. However, the South East European Economies are still lag behind as only Romania, Bulgaria, and Slovenia have entered the EU (until 2008). South East European Economies have barely achieved their 1989 real GDP and industrial output levels and the scars of the transition process are still present in the region, taking more time to heal than originally expected. As the South East European transition economies struggle to achieve the institutional prerequisites for their EU accession, the differentiated outcomes of the transition process have increased. The transition experience demonstrates that institutions and governance matter, although a best-practice approach that fits all countries does not exist. The transition to a market economy needs a sound banking system, which is a crucial factor in attracting foreign investors. Foreign direct investment in the banking sector can be of great importance to the transition countries since experience has shown that countries around the world in which FDI has concentrated have enjoyed accelerated economic growth, easier integration into world markets and less painful structural reform. The size of the market, low unskilled labour cost, geographical proximity, prospects for market growth and the use of the host country as a business and investment link to other neighbour countries were all considered important reasons for undertaking FDI projects in a Balkan country. On the other hand, an unstable legal framework, bureaucracy, corruption, shadow economy, the primitive market infrastructure, and a generally high risky environment were the most decisive barriers for foreign MNEs, when considering investing in a Balkan country. Therefore, such problems discourage foreign investors and additionally decrease the competitiveness of any economy. We also concluded that the constant changes in the legal framework, lack of adequate and efficient laws, and the insufficient enforcement of laws, which leaves space for corruption, bureaucracy and bribery,

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typically discourage foreign investors from participating in such a business environment. FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration, a goal increasingly recognized as one of the key aims of any development strategy for an increased growth rate. In this framework, world FDI inflows grew rapidly and faster than world GDP and world exports during the last two decades. Moreover, the dramatic increase in FDI over the last decade (until 2000) was based on several reasons such as globalization and economic integration, technological improvements in communications, information processing and transportation, new organizational structures and restructuring processes adopted by companies in order to become more competitive and effective, the changing framework of international competition and the deregulation of several key sectors such as telecommunications which led to the liberalization of capital flows among countries. Moreover, the increase in FDI flows was largely related to the sharp increase in investments in the high-tech and telecommunication sectors in the advanced economies and in the increased M&As cross-border transactions. Lastly, developing and transition countries were increasingly liberalizing their regimes and abolishing their barriers and obstacles in order to receive decisive inward foreign direct investment flows. Thus, an increase of FDI flows is also due to the abolition of monopolies, the elimination of tariffs and quotas and to the increased free trade transactions as a complement to the FDI flows. On the other hand, major factors are responsible for the dramatic decrease in FDI flows after the year 2000. First is the slowdown in the world economy which has reduced world demand and accelerated the global restructuring process of major MNEs in sectors characterized by excess capacity. Especially in 2001 and afterwards, the decline had resulted from the terrorist event of 11 September 2001 in New York City. The decline in 2001 which was mainly concentrated in developed countries was also a result of a decisive drop in cross-border Mergers and Acquisitions (M&As). The economic recession especially in the USA and the EU has intensified competitive pressures (globalization and competition pressures), and thus forced companies to search for cheaper locations (this is a reason for the stable FDI flows to the CEE region). Furthermore, the issue of lower demand (the economic recession resulted to lower GDP per capita) can be offset by lower prices and lower production cost which may increase the demand. This trend may result in increased FDI flows in activities that benefit from relocation to low-wage economies (e.g. increases of Japanese FDI outflows in China and EU outflows in the CEE region). In general, there has been a redistribution of FDI towards reinforced by the growth in the number of bilateral investment promotion and protection treaties. However, on account of a strong increase in FDI flows to developing countries in 2004 saw a slight rebound in global FDI after three years of declining flows. At $648 billion, world FDI inflows were 2% higher in 2004 than in 2003. Many factors help to explain why the growth of FDI was particularly pronounced in

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developing countries in 2004. Intense competitive pressures in many industries are leading firms to explore new ways of improving their competitiveness. Some of these ways are by expanding operations in the fast-growing markets of emerging economies to boost sales, and by rationalizing production activities with a view to reap economies of scale and to lower production costs. Western investment interest in Central and Eastern Europe is very low considering that only a percentage between 2–5% of the worldwide FDI outflows goes to these countries. For example, only 145 billion US$ are the total FDI inflows, in the time period 1989–2000 in the whole Central and East European region, when at the same time period the Balkan region has received only 13% of the total FDI inflows in the CEE region. The FDI inflows in the Balkan region is insignificant when the total FDI inflows in eight countries of the Balkan region account for less than 20 billion US$ in the last 11 years (1989–2000). In other words, these eight countries in a period of 11 years time, have not managed to receive an amount that equals to one-year German or British FDI total outflows. Moreover, the existence of a regional concentration of FDI cannot be denied as seen from the examples of Greek MNEs which became dominant entrepreneurs in the Balkan region, the Austrians in Slovenia and Croatia, the Nordic countries (Sweden, Norway, and Finland) in the Baltic region (Estonia, Lithuania and Latvia), the Japanese FDI outflows to China and SE Asia, and the US FDI outflows in Canada and Mexico. Indeed, it is safe to conclude that geographical proximity still matters when the trend of FDI inflows is considered. As far as globalization is concerned, it is a term used to express the tendency for the world economy to integrate, not only in respect of markets, finance, technology, and cross-countries’ trade and investments, but also in regard to the harmonization of laws and regulations of every day activity (political, economic, social, cultural and ideological). The core of the concept of globalization is that the world displays a strong tendency to become one entity. Globalization is not a new phenomenon, but just a new phase, something that is much more pervasive, deeper, and different from previous phases. Some researchers accept that globalization is an established process, that it is unstoppable and irreversible due to the liberalization of international trade of goods and services and free market, the significant growth of the services sectors, especially those dealing with knowledge and information, the rapid growth of a new generation of technology, the high degree of openness, and the huge and quick circulation and distribution of information mainly through the Internet. A major debate is being carried out as regards the question of the benefits and the cost of globalization. However, summarizing both the supporters’ and the opponents’ arguments for and against the globalization process, globalization can not be classified as either bad or good. It is its evaluation that matters most, because challenges and threats are subject to continuous changes. Globalization, which the transition economies struggled to become part of, in its economic form envisages an interdependent world economic system dominated by global enterprises not identified with any individual country. Integration means

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that a country becomes part of the globalized world. Integration is the goal of globalization, and integration is defiantly achieved by inviting multinationals and entering the EU. Integration is further enhanced by membership of the EMU and the adoption of the single currency. Both the EU and the EMU are the best examples of both integration and globalization, as membership involves the abolishment of barriers to entry, liberalization policies, and the adoption of the 35 chapters of the acquis (6th EU enlargement policy). All of them determine the legal, political and economic convergence among member countries, and create the fundamentals for stability and a sound business environment to attract FDI and trade flows for the members. In conclusion, the terms ‘integration and transition’ are more appropriate than just ‘transition’ of what essentially took place in the CEE and generally in transition economies. In fact, it is an integration-assisted transition. These terms, integration, assistance and transition, are not substitutes but complements in demonstrating the transition process in the CEE economies. The European integration is a radical multidimensional transformation of the European Region. The benefits from integration are multidimensional: political, economic and cultural, while the EU entrance is not considered to be without costs; for example, expenses related to the adoption of all EU norms and standards by enterprises, threats to domestic producers’ market position, and reduced autonomy in countries’ decision making process. The benefits for entering the EMU are mainly connected with the five Maastricht criteria (low interest rates, low inflation, stable monetary policy, stable exchange rate policy when one common monetary policy and one currency are utilized, strict budgetary policy – limited debt/GDP and deficit/ GDP ratios), while the EMU participation is related with costs for improvement of legislation, costs of compliance with European principles, and costs for total modernization of the industrial potential. Deeper economic and monetary integration took place through the establishment of the Economic and Monetary Union (EMU) and especially in its third stage with the introduction of Euro currency. We have concluded that realized and/or perceived benefits from the EMU and the EU membership depend mainly on special characteristics of each country member. To sum up, one must consider that the market conditions are always changing and the changing character of the boundaries and the globalization theory will definitely create new challenges and opportunities for a company to seek valueadding activities internationally in ways different from the ones studied up to now. As the authors of the FDI theories concluded on reasons on why a company may undertake FDI by examining certain subjects (countries, motives, barriers) in certain time periods, we could argue that no theory can be general and applicable for any country, for any time period to any foreign company. Since each country offers different motives and incentives for investment and has different obstacles that are all submitted to considerable changes through time, the MNEs choose the country that maximizes the possibility of success for their investment plan. Even when two countries hold the same properties, an MNE bases its investment decision on evaluation of all factors in relation with the corporate priorities and

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needs. The choice requires examination on the part of the country and the MNE (or the industry), and the choice must always be in relation to the time period.

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Index Page numbers in italics refer to tables. acquisition of existing company 77, 78 adverse initial conditions Bulgaria 334–49 four groups of 52–5 impact on transition process 45–55 speed/sequence of 45–50 success of 50–2 Albania economic growth 22 EU accession path (2001–2004) 283–5 prospects for entry into 247–8 FDI (1990–2004) 285–8 FDI barriers 111, 113 financial intermediaries (2004/2005) 288–94 mixed transition reform path 17–19 Almunia, J. 213, 255 Amsterdam Treaty 159 auctions, sale of state property 62 balance of payments (BOP), impact of FDI in host countries 123–4 Baltic states, mixed reform path 16–17 banking sector Albania 288–94 privatization and restructuring 29 reform 32–3 Serbia (2000–2006) 297–306 barriers 98–100 and motivations 103–21, 274–80 privatization 72–3 see also costs/benefits analyses belligerent transition reform path model 13–14 see also mixed reform model bilateral regional agreements 136, 137

Bitzenis, A. 4, 36, 43, 73–4, 77–8, 90–2, 98–9, 100–1, 135, 136, 137, 153, 154, 313 and Andronikidis, A. 157, 190–1 and Marangos, J. 6 and Szamosi, L. 91–2 Bosnia & Herzegovina economic growth 22 prospects for entry into EU 248–9 reform path 13–14, 21 Bretton Woods system 128, 162–4 brownfield investment 77, 78 budgetary deficits see Excessive Deficit Procedure (EDP) Bulgaria adverse initial conditions in transition 334–49 determinants of FDI barriers 113 Greek outflows (1990s) 349–59 since 2000 312–22 economic crises in early transition period 24, 338–9 economic growth 22 EU Copenhagen criteria (1993–2007) 306–9 prospects for entry into 242–3 government fiscal incentives for attracting FDI (1994–1999) 327–34 mixed transition reform path 19 reasons for delay of privatization process until 1997 322–7 Bulgarian Telecommunication Company (BTC) (1996–2004) 309–12 Bulgartabac (BTH) privatization trial (1997–2008) 359–73

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capital and trade balance, impact of FDI in host countries 123–4 capital transfer effects in host countries 121–2 CMEA see Council for Mutual Economic Assistance commercialization 61 communism, transition to democracy 7–22 company strategic behaviour, FDI theories based on 85–6 competition, impact of FDI in host countries 123 compromised reform model 11–12 Copenhagen criteria and EU membership 218–24 Bulgaria 306–9 Romania 264–7 corporatization 61 COSMOTE see Hellenic Organization of Telecommunications (OTE) costs/benefits analyses of EU membership 220–4 of Euro and EMU membership 190–5, 378 of FDI home countries 124 host countries 121–4 of privatization 58–60 see also barriers; motivations Council for Mutual Economic Assistance (CMEA) 340–4 Croatia 55, 111, 137 EU acquis communautaire 220, 221 prospects for entry into 243–4 reform path 13–14, 15, 21 cross-border agreements 140 see also globalization currency exchange systems 163–6 see also Exchange Rate Mechanism Daytona Peace Accord 21 democracy, transition from communism to 7–22 diplomacy reform model 10 see also mixed reform model disguised reform model 11 see also mixed reform model

EBRD 7, 8, 22–3, 28, 29, 31, 33, 36, 70, 112–13 ECB see European Central Bank ECU see European Currency Unit Ecofin Council 197, 204, 256–7 econometric studies, determinants of FDI 114–21 economic conditions 52–3 Bulgaria 334–7 economic crises 24, 138, 338–9 economic growth 22 impact of FDI in host countries 123 and inflation 51–2 economic integration, forms of 155–7 Economic and Monetary Union (EMU) 159 costs and benefits of Euro and membership 190–5, 378 development historic 162–8 stages 173–90 member countries’ prospects 210–18 vs. European Monetary System (EMS) 212 economic stabilization approaches 22–6 employment effects, impact of FDI in host countries 122–3 European Central Bank (ECB) 173–4, 212 European Constitution 160 European Currency Unit (ECU) 166–7 European Monetary System (EMS) 165–6, 167, 171, 173, 176 vs. Economic and Monetary Union (EMU) 212 European Union (EU) forms of economic integration 155–7 membership 218–24 costs and benefits of 220–4 prospects for Balkan countries 242–51 real or nominal convergence 225–42 treaties 156–62 see also Stability and Growth Pact (SGP) Excessive Deficit Procedure (EDP) 196–7, 198–210 passim, 255–6, 257 exchange rate based vs. money based stabilization approaches 23–5

Index Exchange Rate Mechanism ERM I 167–8 reasons for crisis 168–71 ERM II 171–2, 176, 212, 215–18 external help, sources of 35–6 external shocks 54–5 Bulgaria 340–7 Factor Endowment Theory (Heckscher and Ohlin) (H/O theory) 88 factor hunters 94 financial aspects, hunters of 96–7 financial institutions speed of reform 33 see also banking sector financial intermediaries Albania 288–94 sale of state property through 62 financial restructuring 70–1 foreign direct investment (FDI) causes of increase and decrease 134–5, 376–7 definition 79–80 difficulties of 80–3 determinants 100–2 econometric studies 114–21 questionnaire surveys 103–13 as entry mode 75–80 influential factors 89–100 major developers of theory 83–9 foreign involvement as market entry strategy 75–7 foreign trading 75 Former Yugoslavian Republic of Macedonia (FYROM) adverse initial conditions 52, 55 economic growth 22 EU accession path (2000–2004) 271–4 acquis communautaire 220, 221 prospects for entry into 249 FDI barriers 111, 112, 113 and motivations in manufacturing sector 274–80 Greek 110

405

Hellenic Petroleum and Okta 280–3 reform path 10, 13–14, 15–16 France, Stability and Growth Pact (SGP) 199, 200, 202, 204–5, 207–8, 257 GDP see Gross Domestive Product Germany reunification and Bulgaria 344 and DM 168–9 Stability and Growth Pact (SGP) 199, 200, 202, 204–5, 207–8, 257 globalization and alternative trends 139 comparative phases 128–30 cross-border mergers and acquisitions (M&As) 142–4 cross-border transactions under 141–2 FDI trends 144–51, 377–8 trade and 151–3 impact of 130–3 neoliberalism and role of multinationals 139–40 regionalization and concentration of FDI 127–8 statistical perspective 133–8 ‘Golden Rule’ of public finances 206 gradualism vs. shock therapy debate 36–40, 41, 43–4, 45–50, 67–72 Greece determinants of FDI outflows in Bulgaria (1990s) 349–59 EMU entry into 176–85, 186, 187, 188, 240–2 in EU and 258–60 FDI preferences 110 Hellenic Petroleum and Okta in FYROM 280–3 restructuring and privatization: OTE and Romtelecom 267–71 Stability and Growth Pact (SGP) 203 greenfield investment 77, 78 Gross Domestive Product (GDP) Albania 284–5, 293 Bulgaria 308, 334, 335, 337, 358 Greece 260

406

The Balkans: Foreign Direct Investment and EU Accession Romania 266 Serbia & Montenegro 294, 295–6, 299 threshold for Excessive Deficit Procedure (EDP) 209–10, 255–6

Hellenic Organization of Telecommunications (OTE) and Bulgarian Telecommunication Company (BTC) 309–10 and Romtelecom 267–71 Herzegovina see Bosnia & Herzegovina ‘hidden privatization’ 67 home countries, costs and benefits of FDI for 124 host countries, impact of FDI in 121–4 IBRD see International Bank for Reconstruction and Development ‘illegal privatization’ 67 IMF see International Monetary Fund inflation and EMU 190–1, 194, 206 and growth rate 51–2 macroeconomic stabilization approaches 22–6 initial public offering (IPO) 64–5 ‘insiders’ vs. ‘outsiders’ privatization 61 institutional reforms 31–4 importance of 40–5 ‘integration and transition’ 6–7 internalization, FDI theories based on 86–7 International Bank for Reconstruction and Development (IBRD) 163 international institutions 35–6, 81 International Monetary Fund (IMF) 35–6 definition and components of foreign direct investment 79, 80–1 founding of 163 membership of Serbia & Montenegro 296 and OECD study 79, 80 investment risk, minimization of 90 involved ‘parties’, impact of FDI on 121–5 Iraq, and Bulgaria 344 joint ventures 77 leasing, privatization through 64

legacy of the past 53 Bulgaria 337–8 liberalization of economic activities 26–8, 40–1, 42, 51 of prices 26–7, 41, 42, 51 liquidation 61 asset privatization through 64 literature reviews, determinants of FDI 103–21 living standards, impact of FDI in host countries 123 location hunters 95–6 Maastricht conversion criteria 175–6, 190–1, 214–15, 227–31 Maastricht Treaty 159, 169, 173, 174, 175–6, 196 macroeconomic stabilization approaches 22–6 ‘mafiasation’ 67 management and employee buyouts (MEBO) 63–4 Marangos, J. 3–4, 8, 14–15, 28, 41, 60, 70 Bitzenis, A. and 6 market economies characteristics 4–6 vs. planned economies 3–7 market entry strategies 75–80 market hunters 92–4 market imperfections/failure 6 FDI theories based on 83–5 overcoming 98 market liberalization 26–8, 40–1, 42, 51 mass/voucher privatization, sale of state property through 62 Merger Treaty 158 mergers and acquisitions (M&As) 77–8, 142–4 minimization of investment risk 90 mixed privatization 71–2 mixed reform model 15–17 examples 17–22 money based vs. exchange rate based stabilization approaches 23–5 Montenegro see Serbia & Montenegro motivations 90–8 and barriers 103–21, 274–80

Index see also costs/benefits analyses multinational enterprise (MNE) 75 global strategies 131–2 impact of FDI on 124–5 role of 140 see also named companies and countries neoliberalism 139–40 ‘nomenklatura privatization’ 67 OECD 328, 330 and IMF study 79, 80 organizational restructuring 70 OTE see Hellenic Organization of Telecommunications ‘outsiders’ vs. ‘insiders’ privatization 61 ownership advantages, exploitation of 96 peaceful/quiet reform model 10–11 see also mixed reform model peg exchange rate system, US dollar and gold reserves 163–4 physical restructuring 70 political conditions 53–4 Bulgaria 338–40 political factors in FDI 97–8 political transition 7–22 portfolio investment 75, 77, 84 price liberalization 26–7, 41, 42, 51 privatization costs and benefits 58–60 definition 57–8 methods 30–1, 61–7 reasons for delay 72–3 and restructuring 28–31, 42–3 dilemma 67–72 see also named companies Privatization Investment Funds (PIFs) 65 productivity efficiency, impact of FDI in host countries 123 Public Participation Shares (PPSs) 65 questionnaire surveys, determinants of FDI 103–13 quiet/peaceful reform model 10–11 see also mixed reform model ‘quiet’/’underground privatization’ 66

407

rapid privatization 71 re-privatization/restitution to ‘real owners’ 65 rebellion reform model 12–13 see also mixed reform model regional agreements, bilateral 136, 137 regional economic integration see Economic and Monetary Union (EMU); European Union (EU) regionalization 127–8 resource transfer effects, impact of FDI in host countries 121–2 Romania determinants of FDI 101, 103, 104, 107–8, 109–10, 111 economic growth 22 economic stabilization 24 EU Copenhagen criteria 264–7 prospects for entry into 242–3 Greek FDI 110, 112 restructuring and privatization: OTE and Romtelecom 267–71 political transition 12 Russia 24, 46, 48 determinants of FDI 103, 104, 108, 109, 110, 111 economic crisis 138 economic growth 22 mixed transition reform path 19–20 see also USSR SAAs see Stabilization and Association Agreements SEA see Single European Act SECI see Southeast European Cooperative Initiative survey sequence of reforms 40–5 see also speed/sequence of reforms Serbia & Montenegro banking systems 298 economic growth 22 EU delayed accession (2000–2006) 294–7 prospects for entry into 250–1 human development index 239 mixed transition reform path 20–2

408

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reform path 13–14, 20–1 Serbia, banking reform (2000–2006) 297–306 SGP see Stability and Growth Pact shock therapy vs. gradualism debate 36–40, 41, 43–4, 45–50, 67–72 Single European Act (SEA/1986) 158–9 Slovakia 103, 104, 158, 213 Slovenia 136, 137 determinants of FDI 103, 104, 110–11 EU and EMU 158, 213, 216, 217–18 reform path 13–14, 15 slow privatization 71 small and medium size businesses (SMEs) 193 small, privately owned companies 66 Smithsonian Agreement 164–5 ‘Snake in the tunnel’ mechanism 165 social policy reform 31 SOEs (state-owned enterprises) see privatization Southeast European Cooperative Initiative (SECI) survey 110–11 speed/sequence of reforms financial institutions 33 impact of adverse initial conditions 45–50 privatization and restructuring dilemma 67–72 shock therapy vs. gradualism debate 36–40, 41, 43–4, 45–50, 67–72 spontaneous privatization 65–6 Stability and Growth Pact (SGP) 195–210, 254–8 criticisms of 198–201 early warnings based on 201–3 revision 208–10 sanctions: Excessive Deficit Procedure (EDP) 196–7, 198–210 passim, 255–6, 257 solutions: three proposals 203–8 Stability Pact for Western Balkans 253–4 Stabilization and Association Agreements (SAAs) 254 Albania 283 FYROM 271–2 Serbia & Montenegro 296–7 state, role in transition 43

state-owned enterprises (SOEs) see privatization statistical perspectives globalization 133–8 transition period 80–3 Sweden entry into EMU 186, 189, 190, 210 Euro referendum (2003) 261–4 tax incentives for FDI, Bulgaria 330–4 tax reform 31 technology transfer effects in host countries 121–2 trade and capital balance, impact of FDI in host countries 123–4 and FDI trends 151–3 liberalization 26–8, 40–1, 42, 51 trade theories, FDI theories based on 88–9 transition, planned economies vs. market economies 3–7 transition process impact of FDI on 125 see also adverse initial conditions transition reform four steps 22–36 models 8–22 sequence of 40–5 see also speed/sequence of reforms ‘transition shock’ 26–7 transparent transition reform path model 14–15 Treaty of Nice 159, 160 Treaty of Paris 157 Treaty of Rome 157–8 Turkey, prospects for entry into EU 244–6 UK and EMU 210–11 UN 58, 65 UNCTAD 129, 130, 137, 140 ‘underground privatization’ 66 UNECE 25–6, 27, 129 US dollar and gold reserves 163–5 USSR and CMEA 340–4 energy crisis 344 see also Russia

Index vertical integration 83–4, 85 violent reform to democracy model 12 see also mixed reform model voucher privatization, sale of state property through 62 wholly owned subsidiary 77 ‘wild privatization’ 66–7 World Bank 36–7, 52, 55

409

International Bank for Reconstruction and Development (IBRD) 163 Serbia & Montenegro 296 survey of FDI barriers 111–12 World Economic Outlook 30, 31, 32, 33, 38, 45, 68 World Trade Organization (WTO) membership 28