ANADOLU UNIVERSITYENGLISH ECONOMICS

DEPARTMENT

EZGİ SANDAL11311144130

ÖMER AKKUŞ41018108036

DISCIPLINE AND ENCOURAGEMENT

DECEMBER 2009

Discipline and EncouragementDiscipline requires imposing hard budget constraints on enterprises and banks. This entails eliminating a wide range of explicit and implicit mechanisms to channel public resources to ;

enterprises and

banks,

including tax exemptions,

fiscal and financial subsidies,

budget and tax offsets,

directed credits,

and contingent liabilities.

Discipline and Encouragement

Some countries, such as Belarus, Turkmenistan, andUzbekistan, have managed to maintain discipline over managers in state enterprises without liberalizationor hard budget constraints, but this has occurred largely through administrative methods heldover from the Soviet-style command economy.

However, discipline also refers to measures to prevent the misuse or theft of assets in both privateand state-owned enterprises through asset stripping, tunneling, and expropriation of minority shareholders.

Discipline and EncouragementEncouragement starts with liberalizing prices and trade to enable the entry of new enterprises.

But it goes much further to encompass policy and structural reforms that promote an attractive investment climate.

There are an enormous number of factors that affect the decisions of economic actors to invest.

These can be roughly divided into two categories:

the quality of public goodsthe extent of nonmarket obstacles to competition

Discipline and Encouragement

Juxtaposing discipline and encouragement with protection and discouragement highlights two contrasting modes of adjustment.

In reality, country outcomes span a range of intermediate possibilities depending on whether liberalization, hard budget constraints, and an enabling business environment were pursued—and in what order and how vigorously.

Though it is not possible to categorize transition economies into a spectrum of different modes of adjustment, country examples can be used to exemplify alternative transition paths:

Discipline and EncouragementThe policies of discipline and encouragement were pursued most consistently in Estonia, Hungary, and Poland.

Within the broad category of discipline and encouragement, softer budget constraints— and hence less discipline—prevailed for a long time in the Czech Republic, Lithuania, and the Slovak Republic.

Czech crisis in 1996–98. Harder budget constraints and faster restructuring can help reorient these economies toward the path followed by the first group.

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Discipline and Encouragement

Bulgaria, the Kyrgyz Republic, Moldova, Romania, the Russian Federation, and Ukraine liberalized their economies, but for a long time failed to maintain discipline through hard budget constraints—and they could not contain tunneling and theft through either law or administrative control.

The competition for resources between old and new enterprises makes it difficult to provide encouragement if the discipline for old enterprises is relaxed. Russia and Ukraine encouraged new entry early in the transition.

Discipline and Encouragement

Belarus, Turkmenistan, and Uzbekistan, which neither liberalized nor hardened budget constraints, strongly discouraged new entry.

Meeting the challenges of discipline and encouragement is important if growth is to be restored, its quality enhanced, and its benefits widely shared.

Industrial enterprises also face major obstacles to downsizing if arrangements to help them divest social assets, such as housing, sanatoriums, and kindergartens, are unavailable.

Discipline and EncouragementIf the state cannot administer the rule of law, particularly contract enforcement and secure property rights, rent seeking and widespread theft of erstwhile state assets dominate economic activity. The state

Effective administration of programs of social assistance and insurance are required so that the “reform dividend” generated by growth is used to assist those adversely affected by transition.

cannot afford the social safety net required for restructuring or investments in human capital if, together with enterprises, it is caught in a pervasive web of arrears and unpaid taxes.

New Enterprises Drive the Transition

The success of a discipline-and-encourage strategy is predicated on the ability of new and restructured enterprises to emerge as engines of economic growth. Moving assets from the public to the private sector is thus an important element of transition.

New Enterprises Drive the TransitionIn 1999 the share of the private sector in CIS GDP was 20 percent in Belarus; 55 percent in Kazakhstan and Ukraine; 60 percent in Armenia, Georgia, and the Kyrgyz Republic; and 70 percent in the Russian Federation

These figures compare favorably with Central and Eastern Europe: 55 percent in Macedonia and Slovenia, 60 percent in Bulgaria and Romania, 65 percent in Latvia and Poland, 80 percent in the Czech Republic and Hungary.

1998 was around 55–65 percent of GDP in the Czech Republic, Hungary, and Lithuania, compared with 10–20 percent in Belarus, Kazakhstan, Russia, and Ukraine. Data on small enterprises as providers of employment divide countries into two groups: leading reformers and countries further behind. Small enterprises’ share of employment in 1998 was about 50 percent for leading reformers such as the Czech Republic, Hungary, Latvia, Lithuania, and Poland, roughly the same as the European Union. For countries less far along the path to a market economy, such as Belarus, Kazakhstan, Russia, and Ukraine, the share was between 10 and 20 percent.

New Enterprises Drive the Transition

The share of small enterprises in employment and value added differs widely across the region.In contrast, the share of small enterprises consistently account for a larger fraction of total value added than of total employment. Labor productivity is indeed higher in small enterprises compared with large enterprises. Moreover, this is true independent of progress toward a market economy. New companies are more productive than inherited enterprises in countries as diverse as Hungary and Ukraine.

A Small Number of High-Productivity SmallEnterprises Is Not Enough

As the transition proceeds, labor shed by downsizing old enterprises either finds its way into new and more productive employment or migrates to unemployment or subsistence activities.

when the investment climate is conducive to entry, new enterprises compete with the old sector, rapidly increasing their share in employment and typically attracting the most qualified individuals.

a threshold of about 40 percent for the shares of small enterprises in employment and value added needs to be crossed for new enterprises to absorb the resources released by the old sector and contribute to sustainable growth.

Simply having a small number of highly productive small enterprises is not enough. Unless it is combined with rapid growth in the share of employment, the small sector will not develop the critical mass to lead aggregate economic growth

. The empirical investigation of new enterprises and their interaction with old enterprises suggests the following:

A sharp and early decline in aggregate employment precedes the rapid growth of new enterprises. With the former as an indicator of the fast dismantling of old industries, the rapid demise of the old sector seems necessary but not sufficient for the growth of new enterprises.

Countries that reached the trough of the transition recession sooner had faster growth in the new sector. The observationssuggest a sequence where hard budget constraints are imposed and the old sector declines before the new sector can grow.

While disciplining the old and encouraging the new appear to be complementary, the old sector has generally, though not invariably, proved unable to survive even where budget constraints have been soft and the new sector has not emerged.

In such cases, mainly in the CIS, agriculture and low productivity services have served as “shock absorbers” for those forced to leave old industries.

Can We Have It Both Ways, That Is,Protecting Old Inherited Enterprises and

Encouraging New Enterprises?

The economic argument seeing discipline and encouragement as complementary goes as follows.

Continued resource transfers for nonviable state-owned enterprises, other things being equal, either require the consolidated government to loosen its fiscal stance, raise taxes elsewhere in the economy, or engage in off-budget activity.

A looser fiscal stance can weaken the credibility of the government’s stabilization program and, by increasing market perception of risk, raise domestic interest rates, thus crowding out the new private sector.

Intensifying taxation of the potentially more efficient emerging private sector can start a vicious cycle that pushes enterprises into the informal sector, thus lowering tax revenue and further increasing tax rates.

Off-budget activities include issuing loan guarantees, establishing insurance schemes, and providing explicit or implicit cover generally for politically motivated activities that tend to benefit incumbents.

These outcomes end up protecting state enterprises and collective farms and discouraging new enterprises. However, the relationship does not run simply from the costs of propping upunviable enterprises (protection) to discouraging the new private sector.

Further evidence on how protection of the old sector discourages the new sector comes from the following examples.

The first is protection through the banking sector. Small enterprises have grown less in such CSB countries as Bulgaria and Romania, where the banking sector was a major conduit for loans to the old state-owned enterprises and farm collectives.

The second example is protection through special allocation of inputs. In Belarus and Uzbekistan the old industrial sector has remained protected through favorable foreign exchange regimes,directed credit, and high trade protection. Specific large foreign investments have also been favored. As a result new smaller enterprises face the residual of these allocations in the market.

The third example is protection through tax and utility arrears. Nonpayments by enterprises to the main utilities in the energy sector remain a major source of subsidization, particularly in Russiaand Ukraine, but also in Georgia, the Kyrgyz Republic, and Moldova. This has delayed restructuring of energy-intensive industries and shedding of assets that smaller new enterprises could use.

New, more energy-efficient enterprises are charged more to compensate for the revenue losses from the old, less energy-efficient enterprises.

The softer the budget constraint andthus the stronger the barriers to exit, the lowerthe contribution of small enterprises to employment