1

Giuseppe Iarossi, World Bank

Federica Saliola, World Bank and University of Rome III

Giovanni Tanzillo, World Bank

Armenia

LakeSevan

BusinessClimate,

Productivity, and

Competitiveness in Armenia,2002-2005

2

Investment climate

“location-specific factors shaping the opportunities and incentives for firms to invest productively, create jobs, and expand”

World Development Report 2005

3

Business Climate Index (BCI)

1. Combines 93 variables (macro and micro)

2. Geometric Aggregation Method

4

Variables in the BCI

4 categories, 2 dimensions

MACROCost (6) Quality (17)

INPUTS Cost (10) Quality (14)

INFRASTRUCTURECost (4) Quality (5)

INSTITUTIONSCost (10) Quality (27)

5

First step in the BCI construction

Inflation variabilityExchange rate variabilityReal interest rate

variabilityCapital flowsMacro instabilityCorruption indexProcedures to start

a businessCost to start a businessMinimum capital to start

a businessCredit information indexPrivate bureau coverageProcedures to enforce

contractsTime to enforce contractsCost to enforce contracts

Factor1Factor2Factor3Factor4

(Factor1) (Factor2) (Factor3) (Factor4) = MacroQI

VARIABLESFACTORANALYSIS AGGREGATION INDEX

W1 W2 W3 W4

6

Second and third steps in the BCI construction

MacroCIMacroQI

InfraCIInfraQI

InputCIInputQI

InstitutionsCIInstitutionsQI

Factor1Factor2

Factor1Factor2

Factor1Factor2

Factor1Factor2

VARIABLESFACTORANALYSIS AGGREGATION INDEX

(Factor1) (Factor2)W1 W2

(Factor1) (Factor2)W1 W2

(Factor1) (Factor2)W1 W2

(Factor1) (Factor2)W1 W2

Macro Index

InfrastructureIndex

Input Index

InstitutionsIndex

Factor1

Factor2

Factor3

F1W F2W F3W BCIBusinessClimateIndex

FACTORANALYSIS AGGREGATION INDEX

7

Characteristic: Geometric aggregation method

Feature: Rewards more countries that improve the dimension where they perform the worst

tfpm

wwww

xINSTITindeexINFRASTindINPUTindexMACROindexBCI )()()()(

8

Sample composition of

micro data

Country 2002 2005

1Albania 170 2042Armenia 171 3513Azerbaijan 170 3504Belarus 250 3255Bosnia-Herz. 182 2006Bulgaria 250 3007Croatia 187 2368Czech Rep. 268 3439Estonia 170 219

10Macedonia 170 20011Georgia 174 20012Hungary 250 61013Kazakhstan 250 58514Kyrgyzstan 173 20215Latvia 176 20516Lithuania 200 20517Moldova 174 35018 Poland 500 97519Romania 255 60020Russia 506 60121Slovakia 170 22022Slovenia 188 22323Turkey 514 55724Ukraine 463 594

9

Business Climate Index and GDP growth in ECA, 2002-05

BCI index 2002

Kyrgyzstan

Russia

Kazakhstan

Armenia

GeorgiaEstonia

LithuaniaLatvia

Moldova

Bulgaria

Romania

Slovakia

Czech Rep.

Hungary

BelarusUkraine

PolandSlovenia

BiH

Turkey Croatia

Albania

0

2

4

6

8

10

2 3 4 5

GDP growth (average 2002-04)

10

Business Climate Index and total factor productivity in Armenia, 2002-05

-2

-1

0

1

2

15 16 17

TF

P -

200

5

BCI - 2002

18

11

II

IV

Better BusinessClimate

BC

I 20

05

BCI 2002

Change in business climate 2002-05

I

Kyrgyzstan

RussiaKazakhstan

Estonia

LithuaniaLatvia

Moldova

BulgariaRomania

Slovakia

CzechRep.

Hungary

Belarus

Ukraine

Poland

SloveniaBiH

Croatia

Albania

FYROM

Azerbaijan

Armenia

Georgia

Turkey

Improving Good

Bad Deteriorating

12

BCI Index and ranking of ECA countries, 2002-05

Country Rank 2005Turkey 1Azerbaijan 2Poland 3Albania 4Estonia 5Kyrgyzstan 6Croatia 7BiH 8Slovenia 9Lithuania 10Slovakia 11Latvia 12Hungary 13Bulgaria 14Georgia 15Romania 16FYROM 17Ukraine 18Moldova 19Russia 20Kazakhstan 21Belarus 22Czech Rep. 23Armenia 24

Country Rank 2002FYROM 1Azerbaijan 2Albania 3Georgia 4Poland 5Kyrgyzstan 6Russia 7Kazakhstan 8Armenia 9Lithuania 10Turkey 11Slovenia 12Latvia 13Romania 14Estonia 15Belarus 16BiH 17Bulgaria 18Croatia 19Slovakia 20Hungary 21Ukraine 22Moldova 23Czech Rep. 24

13

Change in ranking 2002-05

-20

-15

-10

-5

0

5

10

15

Armenia

Georgia

Turkey

Azerbaijan

14

Components of BCI, 2002-05

0

0.5

1

Macro index

Infrastructure index

Inputs index

Institutions index

2002

2005

15

Kyrgyzstan

Russia

Azerbaijan

KazakhstanArmenia

Georgia

Estonia

LithuaniaLatvia

MoldovaBulgaria

Romania

Slovakia

Czech Rep.Hungary

BelarusUkraine

Poland

SloveniaBiH

Turkey

Croatia

Albania

FYROM

Inp

uts

in

dex

200

5

Inputs index 2002

Inputs Market Index,

2002-05

16

Kyrgyzstan

Russia

Azerbaijan

Kazakhstan

Armenia

GeorgiaEstonia LithuaniaLatvia

Moldova

Bulgaria

RomaniaSlovakia

CzechHungary

BelarusUkraine

Poland

Slovenia

BiH

Turkey

Croatia

Albania

FYROMInst

itu

tio

ns

Ind

ex 2

005

Institutions Index 2002

InstitutionsIndex,

2002-05

17

Dimensions of institutions and inputs indices in Armenia, 2002-05

0

0.5

1

Quality Costs Quality CostsINSTITUTIONS INDICES INPUTS INDICES

2002

2005

18

First step in the BCI construction

Factor1Factor2Factor3Factor4

(Factor1) (Factor2) (Factor3) (Factor4) = InputsQI

VARIABLESFACTORANALYSIS AGGREGATION INDEX

W1 W2 W3 W4

Excess laborCost of financeProximity to raw

materialsAccess to foreign inputsAccess to foreign

customersTechnologyEducation of workforceAccess to financeTrade creditAvailability of skilled

workersAvailability of managersInformality of supplier

networkLoan duration

19

Principle component factors in the Inputs Quality Index

0.1

0.2

0.3

0.4

0.5

-0.6 -0.4 -0.2 0 0.2

Factor 1

Factor 2

Factor 4

Factor 3

Change 2002-05

Wei

ght

20

Main variables underlying Factors 1 and 3 of the Inputs Quality Index

-1

-0.8

-0.6

-0.4

-0.2

0.2

0.4

0.6

0.8

1

-0.6 -0.4 -0.2 0 0.2

Percentage change in variable, 2002-05

Load

Availability of managers

Availabilityof skilledworkers

Cost of finance

Access to finance

ptimloa

pavapro Suppliers network

21

Principle component factors in the Institutions Quality Index

0.1

0.2

0.3

0.4

-0.1 0 0.1 0.2 0.3 0.4 0.5

Factor 1

Factor 2

Factor 4Factor 5

Change 2002-05

Wei

ght

22

Main variables underlying Factors 1 and 2 of the Institutions Quality Index

0.2

0.4

0.6

0.8

1.0

-1 0 1 2 3 4 5

Percentage change in variable, 2002-05

Load

Politicalinfluence

23

Main variables underlying Factors 1 and 2 of the Institutions Cost Index

0.2

0.4

0.6

0.8

1.0

-0.3 -0.2 -0.1 0 0.1 0.2 0.3

Percentage change in variable, 2002-05

Load

Corruption

MafiaFunctioning of the judiciary Crime

Regulationuncertainty

Red tape

24

Principle component factors in the Institutions Cost Index

0.1

0.2

0.3

0.4

0.5

-0.2 -0.1 0 0.1 0.2 0.3

Change 2002-05

Wei

ght

Factor 1

Factor 2

Factor 3 Factor 4

25

Main variables underlying Factors 1 and 2 of the Institutions Cost Index

-1

0

1

-4 -3 -2 -1 0 1 2 3 4

Bribes ongovernmentcontracts

BribesProtectionpayments

Excesslabor

Percentage change in variable, 2002-05

Load

26

Conclusions

• Institutions: both perceptions and costs have contributed to the deterioration of the business climate in Armenia in the last three years– More specifically, political influence,

corruption, security, red tape, judicial inefficiency

– To a lesser extent, also access and cost of credit

27

Armenia’s perception of investment climate constraints

0 20 40 60 80Crime, theft,disorder

ElectricityLabor regulations

Skills of available workersTelecommunications

TransportLegal system/conflict resolution

Access to landLicensing and operating permits

Economic & regulatory policy uncertaintyCorruption

Customs and trade regulationsAnti-competitive/informal practices

Access to financeCost of finance

Tax ratesMacroeconomic instability

Tax administration

Percentage of firms rating each constraint a major obstacle Source: BEEPS 2005

28

Tax rates

30%

40%

50%

Armenia Azerbaijan Georgia Turkey

Source: Doing Business

Percent of tax on gross profit

29

Tax administration: number of tax payments and

time to comply with tax requirements

0

10

20

30

40

50

60

Armenia Azerbaijan Georgia Turkey0

200

400

600

800

1000

1200PaymentsTime to comply

Num

ber

Hours

Source: Doing Business

30

Tax collection

Source: Davoodi and Grigorian (2005)

Armenia CIS Lower middle-income countries

10%

18%Tax revenues as a share of GDP

12%

14%

16%

31

Linear model between tax evasion and number of inspections

eInspectionsiEvasioni 10

32

Probability of perceiving corruption as a constraint

Number of inspections by tax officials

0

60%

80%

100%

Probability

10 20

33

Linear model between tax evasion and number of inspections

eInspectionsiEvasioni 10

InspectionsGifttaxInspectionsEvasioni *100

1/ InspectionEvasion

uGifttax 101

34

Impact of corruption on tax evasion

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

Inspections

Inspections+ bribes

Rate of tax evasion

35

Cost of finance: Real interest rate in Armenia

Source: IMF, International Financial Statistics

0%

10%

20%

30%

2000 2001 2002 2003 2004

36

Armenia Azerbaijan Georgia Turkey

Nominal interest rate on firm loans

0

5

10

15

20

25

Source: BEEPS 2005

37

Access to finance:Share of firms with access

to bank financing

without access

with access

Short term financingwith

access

without access

Long term financing

Source: BEEPS 2005

38

Amount of collateral on loans

0%

50%

100%

150%

200%

Source: BEEPS 2005

Armenia Azerbaijan Georgia Turkey

39

Legal Rights Index

0

2

4

6

8

Armenia Azerbaijan Georgia Turkey

Source: Doing Business

40

Credit provided by the banking sector

0

20

40

60

80

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Armenia

ECA countries

Low & middle income countries

Percent of GDP

41

Conclusions

• Access to finance, red tape, and corruption are the 3 most important investment climate constraints for firms in Armenia

42

Escribano-augmented Cobb-Douglas production function

i

n

nnnieikili DEscrKLVA

1

10 lnlnln

iiii FCICTFP 210

43

Firm productivity

-20%

-10%

0

10%

Corruption Bank loan Finance index

Impact on firm productivity

Red tape

44

Priority of reforms

0

4

8

12

16

0 10 20 30 40 50 60

Share of TFP

Marginal impact on firm productivity

Corruption

Finance Red tape

45

Armenia’s productivity gap with selected countries, 2005

Georgia

Turkey

Kazakhstan

Kyrgyzstan

Tajikistan

Uzbekistan

Moldova

Estonia Latvia Lithuania

-100%

-50%

0%

50%

100%

150%

200%

46

Estimating the productivity gap

CountryDICCountryDICTFP iiii 3210

47

Impact of Investment Climate variables on Armenia’s

competitiveness compared to TurkeyTFP TFP TFP (1) (2) (3)

Armenia (dummy) -0.698 -0.795 -0.622 (1.70)* (1.09) (2.29)**

Red tape -0.005 (0.06) Armenia*Red tape 0.030

(0.40) Loan -0.760 (1.05)

Armenia*loan 0.394 (0.51)

Corruption -0.097 (0.94)

Armenia*Corrupt 0.047 (0.44)

48

Incremental impact on Armenia’s productivity, over Turkey’s

0%

2%

4%

6%

Banks,short term

Banks,long term

Trade credit,short term

Trade credit,long term

0.0

1.7%

5.3%

4.4%

49

Conclusions

• Political influence in economic activity is the main factor driving the deterioration of the business climate in Armenia in the last 3 years.

• Red tape, access to finance and corruption are the major business obstacles to private sector development in Armenia.

• Red tape is the top Investment Climate constraint affecting firm performance in Armenia.

• Better access to long term finance, both in terms of bank lending and trade credit, would help bridge the 40% productivity gap with Turkey.