Uzbekistan - An agenda for economic reform

Report No. 11683-UZ Uzbekistan An Agenda for Economic Reform August 30, 1993 Country Operations Department FOR OFFICIAL USE ONLY Document of the World Bank This document has as restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization  CURRENCY EQUIVALENTS CURRENCY UNIT = RUBLE Exchange Rates" 1992 January 121 February 121 March 139 April 139 May 139 June 139 July 159 August 182 September 232 October 339 November 452 December 452 1993 January 600 February 715 March 778 April 878 May 1156 June 1141 1/ End of perid, selling rates Source: National Bank of Foreign Activities of Uzbekistan  FOR OFFICIAL USE ONLY ABBREVIATIONS ADB - Asian Development Bank BOP - Balance of payments CBR - Central Bank of Russia CBU - Central Bank of Uzbekistan CGSSP - Committee for Governing State Property and Privatization CIF - Cost, insurance and freight CIS - Commonwealth of Independent States CMEA - Council for Mutual Economic Assistance CPI - Consumer Price Index EAU - External Assistance Unit EBRD - European Bank for Reconstruction and Development ECAs - Export credit agencies EEC - European Economic Community EF - Employment Fund EIA - Environmental impact assessment ES - Employment Service FDI - Foreign Direct Investment FSU - Former Soviet Union G-7 - Group of Seven Industrial Nations GDP - Gross Domestic Product GNP - Gross National Product GOU - Government of Uzbekistan Goskompriroda - State Committee for Environmental Protection Goskomprognostat - State Committee of Forecasting and Statistics IBRD - International Bank for Reconstruction and Development IFC - International Finance Corporation IFIs - International Financial Institutions IMF - International Monetary Fund MFER - Ministry of Foreign Economic Relations MLRWR - Ministry of Land Reclamation and Water Resources MMWM - Ministry of Melioration and Water Management MOA - Ministry of Agriculture MOE - Ministry of Education MOF - Ministry of Finance MOH - Ministry of Health NGOs - Non-governmental organizations NMP - Net Material Product OECD - Organization for Economic Cooperation and Development QRs - Quantitative restrictions ROW - Rest of the world SANIIRI -Central Asian Scientific Research Institute of Irrigation SOEs - State Owned Enterprises UNDP - United Nations Development Program UNEP - United Nations Environment Programme UNICEF -'United Nations Children's Fund USAID - United States Agency for International Development Uzbekzoloto - Uzbek Gold (gold enterprise) VAT - Value-Added Tax WHO - World Health Organization WPI - Wholesale Price Index This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   Preface Uzbekistan became a member of the World Bank on September 21, 1992. This report is based on the findings of two economic missions to Uzbekistan in June and September/October 1992 led by Silvina Vatnick. The report was discussed with the Government in July 1993. These missions would like to express their gratitude to the authorities of Uzbekistan for their hospitality and cooperation and for their involvement in and excellent organization for the discussion of the report. The report was prepared by a team led by Silvina Vatnick (main author), comprising Suzanne Barnes, Jeremy Berkoff, James Cowie, Jean-Charles Crochet, Asli Demirguc-Kunt, Sunita Gandhi, Jorge Garcia-Garcia, Felix Remy, Ralph Romain, Joseph Saba, Hong Wei, and Charles Cameron, Harold Cole, David Falcon, Sen Gupta, Alistair McAuley (consultants). Valuable contributions to the report were made by Ziad Alahdad, Homayoon Ansari, Michel Cramer, Cevdet Denizer, Haindy Eisa, Alexander Fleming, Peter Hopcraft, Gordon Hughes, Luciano Janelli, Ruth Klinov, Richard Lacroix, Guy Lemoigne, Walter Ochs, Salem Ouahes, Maurice Schiff, and Elton Thigpen. John Holsen provided very helpful insights for the preparation of the macroeconomic framework. Alan Gelb, and James Hanson (Peer Reviewers), Isabel Guerrero, Parvez Hasan and Costas Michalopoulos provided very useful comments. Tamara Kanterman was responsible for document preparation.   COUNTRY DATA: UZBEKISTAN GNP per capita in US $ (1992) 860" General Area (1,000 sq kIn) 447 Population (1992, million) 21.7 Growth rate (1980-92, percent) 2.6 Density 21991, per sq km) 49 Social indicators Crude birth rate (percent) 3.5 Crude death rate (percent) 0.6 Health Infant morality rate(1991, per 1000 live) 35.5 Population per physician (1990) 297. Life expectancy at birth 69.5 Gross Domestic Product (billion rubles, at current prices) 1990 1991 1992 GDP at market prices 32.4 61.5 416.9 Real growth rate (percent) 1.6 -0.5 -9.6 Total Consumption 28.1 48.9 Private consumption 19.9 37.3 Government consumption 8.2 11.7 Gross domestic investment 10.4 15.8 Resource balance -6.1 -3.3 Output by sector (billion rubles) 1991 1992 Agriculture 22.1 149.5 Industry 17.3 119 Construction 5.4 54.4 Services 16.7 94 Total 61.5 416.9 Government Budget (billion rubles) 1990 1991 1992 Total revenues 14.6 28 142.7 Union transfers 6.3 12 0 Total expenditures 14.9 31.1 188.4 Overall balance -0.3 -3.1 -45.7 Prices 1991 1992 Retail price index (annual percent change) 83 7902 Wholesale price index (annual percent change) 147 27002 Source: Goskomprognostat and Bank Staff Calculations I/ Pfr.inky a ,w abjec w rvsm 2/ FPt D=_ie w Dwci*.   UZBEKISTAN AN AGENDA FOR ECONOMIC REFORM Contents Executive Summary ......................................................... i Section I: THE NEED FOR REFORM AND MEDIUM-TERM OUTLOOK Chapter 1: The Legacy of the Past .................................. 1 Chapter 2: The Need for Reform ................................... 11 Chapter 3: Macroeconomic Policy Framework and the Reform Program .... ...... 27 Chapter 4: External Financing .................................... 45 Section II: AGENDA FOR STRUCTURAL REFORM Chapter 5: The Governance of Reform ............................... 53 Chapter 6: Reforming State-Owned Enterprises and Developing the Private Sector ................................................ 61 Chapter 7: The Financial Sector ................................... 83 Chapter 8: The Framework for Social Protection ......................... 97 Section III: AGENDA FOR SECTORAL REFORM Chapter 9: Agriculture . ....................................... 115 Chapter 10: Energy . .......................................... 137 Chapter 11: Mining . .......................................... 158 Chapter 12: The Infrastructure for Production: Transport and Telecommunications ........................................... 169 Chapter 13: Health, Education and Training ........................... 187 Chapter 14: Environment ........................................ 219 Annex 1: Government of Uzbekistan - Organizational Structure ............... 229 Annex 2: Issues Associated with the Industrial Sector ...................... 231 Annex 3: Aral Sea Issues ........................................ 243 STATISTICAL APPENDIX . ..................................... 249 Glossary ...................... ........................ 307 References ................................................. 311  List of Tables, Figures and Boxes Tables Table 1I.1 Mineral and Energy Production ....................................... 5 Table 1.2 Main Macroeconomic Indicators for 1988-1991 ............................. 7 Table 1.3 Structure of Employment ........................................... 8 Table 1.4 Structure of Production and Expenditures ................................. 9 Table 2.1 Output Decline in FSU Economies ..................................... 13 Table 2.2 1992-93 Macroeconomic Indicators ..................................... 14 Table 2.3 Price Behavior in 1992, Monthly ...................................... 15 Table 2.4 Federal Revenue and Expenditures ..................................... 16 Table 2.5 Monetary Indicators .............................................. 20 Table 2.6 Composition of Foreign Trade ........................................ 24 Table 2.7 Balance of Payments 1992 .......................................... 25 Table 3.1 Sequencing of Key Structural and Sectoral Reforms ........................... 35 Table 3.2 Key Macroeconomic Projections - Reform Scenario ........................... 37 Table 3.3 Key Macroeconomic Projections - Muddle Through Scenario ..................... 40 Table 4.1 Composition of Resource Balance ...................................... 45 Table 4.2 Medium-term Projections: 1993 External Financing Requirements Under the Reform Scenario 46 Table 4.3 Medium-term Projections: 1994-2002 External Financing Requirements Under Reform Scenario .47 Table 4.4 Medium-Termn Projections: 1993-2002 External Financing Requirements Under Muddle-Through Scenario . ......................................... 50 Table 4.5 Creditworthiness - Degree of Concessionality .............................. 51 Table 6.1 Uzbekistan's Industrial Structure in 1991 ................................. 62 Table 6.2 Privatization in Uzbekistan . ......................................... 75 Table 7.1 Monetary Indicators .............................................. 87 Table 8.1 Income Distribution .............................................. 98 Table 8.2 The Evolution of Real Wages, Monthly ................................. 104 Table 8.3 The Structure of Income and Expenditure, 1991-1992 ........................ 105 Table 8.4 Changes in the Consumption of Foodstuffs, 1990-1992 ........................ 106 Table 8.5 Budgetary Cost of Selected Subsidies, 1991-1992 ........................... 107 Table 8.6 Expenditures on Social Protection, 1980-1992 ............................. 108 Table 8.7 Levels of Social Expenditure: Uzbekistan and OECD Countries .................. 109 Table 9.1 Ratio of Market to State Prices, 1989-1992 ............................... 122 Table 9.2 The Decline in Profitability of Selected Agricultural Products ................... 123 Table 9.3 Ratio of Domestic to International Prices ................................ 124 Table 9.4 Input Use in Agriculture and Subsidies Received ........................... 125  Table 9.5 Taxation (-) of Agricultural Production, 1992 ........ . . . . . . . . . . . . . . . . . . . . . 125 Table 9.6 Developmental Expenditures and Expansion of Irrigated Areas ...... . . . . . . . . . . . . . 129 Table 9.7 Water Use by Major Region in 1991 .......... .. . .. . .. .. . .. . .. . .. . .. . . . 131 Table 10.1 Energy Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Table 10.2 Total Final Consumption (MTOE) ........... . .. .. . .. .. . .. .. . .. .. . .. . . 139 Table 10.3 Projected Domestic Energy Consumption 140 Table 10.4 Natural Gas Trade .................... .... .... .... .... .... .... . . 141 Table 10.5 Energy Prices ............................ ...... ...... ...... .. . 145 Table 10.6 Energy Outlook - Scenario A ............. .. .. ... .. .. .. ... .. .. .. ... . . 149 Table 10.6 Energy Outlook - Scenario B ............. .. .. ... .. .. .. ... .. .. .. ... . . 150 Table 13.1 Changes in the Consumption of Foodstuffs ......... . . . . . .. . . . . . . .. . . . . . . . 184 Table 13.2 Sources of Finance for Health Care Delivery ........ . . . . . . . . . . . . . . . . . . . . . 187 Table 13.3 Composition of Health Expenditures (in present) ........ . . . . . . . . . . . . . . . . . . . . 188 Table 13.4 Expenditures for Social, Cultural and Social Safety Net ....... . . . . . . . . . . . . . . . . 189 Table 13.5 Composition of Health Expenditures (as percent of GDP) ....... . . . . . . . . . . . . . . . 189 Table 14.1 Crop Types on Irrigated Lands in the FSU and the New Republics (1987) ..... . . . . . . . 220 Figures Figure 2.1 Inter-republic Exports (1990, at world prices) ........ .. . . . . . . . . . . . . . . .. . . . . 22 Figure 2.2 Inter-republic Imports (1990, at world prices) ........ . .. . . . . . . . . . . . . . .. . . . . 22 Figure 2.3 Foreign Trade - Means of Payment (1992) ......... . . .. . . . .. . . . . .. . . . .. . . . 23 Figure 4.1 Current Account and Fiscal Deficit - Under Reform Scenario ...... . . . . . . . . . . . . . . . 48 Figure 8.1 Composition of Employment 1991 ........... .. .. .. . .. .. .. .. . .. .. .. .. . . 99 Figure 8.2 Sectoral Employment (1990) ............. .. ... .. .. .. ... .. .. .. ... .. . . 100 Figure 8.3 Agricultural Employment (1990) ........... .. .. .. . .. .. .. .. . .. .. .. .. . . 100 Figure 10. 1 Energy Outlook for Oil ................ ... ... ... ... ... ... ... ... .. . 151 Figure 10.2 Energy Outlook for Natural Gas ............ .. .. .. . .. .. .. .. .. .. .. .. .. . 152 Boxes Box 2.1 Cash Versus Credit Rubles ............... ... ... .. ... ... ... .. ... ... . . 21 Box 5.1 Uzbekistan's Constitution-Distribution of Powers ........ . . . . . . . . . . . . . . . . . . . . 55 Box 6.1 Commodity Exchanges .................. .... ... .... .... ... .... .... . 71 Box 6.2 Current Status of Privatization ............. .. .. ... .. .. .. ... .. .. .. ... . . 73 Box 6.3 Leasing or Transfer to Collectives ........... .. .. .................... . 77 Box 6.4 Early Experience in Voucher Schemes ....... . ......... . ........ . ......... 78 Box 7.1 Uzbekistan: Present Financial System ................................. 84 Box 8.1 Statistics on Employment and Unemployment .......................... .. . 101 Box 8.2 Social Protection Policy. . . ............................. 102  Box 9.1 The Agriculture Sector ................. ... ... ... .... ... ... ... ... . 116 Box 9.2 Water Resource Management ............. .. .. .. .. ... .. .. .. ... .. .. . . 127 Box 9.3 Irrigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 Box 9.4 Agricultural Reform in China ............. .. .. .. ... .. .. .. .. ... .. .. . . 135 Box 10.1 Technical Assistance ................... .... .... .... .... .... .... . . 155 Box 11.1 The Muruntau Gold Operation ............ .. .. .......... .. ... .. .. .. . . 158 Box 11.2 Uzbek Copper Production . ..... ... ... .. ............................ 159 Box 11.3 Lead-Zinc Mining in Uzbekistan ........... . . .................... . .. . 160 Box 11 .4 Uzbek Coal Mining ................. . ........................... . 160 Box 11.5 Prices and Allocation of Foreign Exchange for Mineral Products .. . ......... . . . . . 161 Box 11.6 Exploration - Key to Developing the Sector ......... . . ............ . . . . .. . . 162 Box 12.1 Transport - Technical Assistance and Training ........ . . . ......... . .. . . . . . . 172 Box 12.2 Telecommunications - Institutional Structure ........ . .. ......... .. . . . . . . . . 174 Box 12.3 Telecommunications - Existing Service Arrangements ....... .......... . . . . . . . 175 Box 12.4 Telecommunications - Experience in Countries with Similar Backgrounds . ........ . . . 177 Box 12.5 Telecommunications - Technical Assistance ......... . . ............ . . . . .. . . 180 Box 13.1 Telecommunications - Demographics .......... .. . .. .. . .. . .. .. . .. . .. .. . . 182 Box 13.2 Morbidity: Annual Prevalence of Diseases Registered at Health Delivery Facilities (191) . 183 Box 13.3 Coverage of Childhood Vaccinations . . ...................... . 185 Box 13.4 Uzbekistan Pharmaceuticals . ........... . ............. 186 Box 13.5 Organization, Infrastructure, and Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 Box 13.6 Comparison of Selected Health Indicators with Other Countries ... . .......... . . . . 191 Box 13.7 The Educational System ............... . ......................... 198 Box 13.8 New Education Law ............................................. . 199 Box 13.9 The School System ................ . .......................... 201 Box 13.10 Out-of-School Education .............. . .......................... 207 Box 13.11 Costs and Financing of Education ................. ... ... ... .... ... ... . 209 Box 14.1 Environmental Concerns: Land Degradation .......... .. . .. .. . .. . .. .. . .. . . 221 Box 14.2 Environmental Concerns: Water Contamination ......... .. . . .. . . .. . . .. . .. . . 223 Box 14.3 Status of Current Efforts .............................. ........ ... . 225  EXECUTIVE SUMMARY THE SETTING 1. Uzbekistan lies along the famous ancient silk road between Europe and the Far East. Landlocked in the middle of Central Asia, it covers 447,000 square kilometers. Almost three-fifths of its land consists of steppe, desert, and semi-arid terrain and the remainder, fertile valleys that skirt two major rivers--the Amu Darya and Syr Darya. Uzbekistan has the largest population of the four Central Asian republics and is the third most populous republic in the former Soviet Union (FSU). Of its 21 million people, 60 percent live in rural areas and about half the population is under 19 years of age. Thlie majority of the population (about 71 percent) is Uzbek. 2. The country is a major agricultural producer, and about 39 percent of its net material product (NMP) in 1992 was in agriculture. Cotton is the most important crop, accounting for about -() percent of the gross value of agricultural production. Uzbekistan is the world's fourth largest produce, of cotton and its third largest exporter. Uzbekistan is the largest producer of fruits and vegetables ih tbc FSU. Agricultural production has increased rapidly in recent years--by expanding the irrigated area at the expense of reducing the volume of the Aral Sea and creating serious environmental problems. 3. Industrial production (33 percent of NMP) centers on the processing of agriculture-based raw materials. Light industry (including cotton) accounted for about 39 percent of industrial production in 1990, agro/food processing 13 percent. heavy industry 41 percent, with the fuel-energy industrv taking up the remainder. The machinery sector includes many products that are liked to agriculture as production inputs, such as cotton harvesters and textile machinery, and, within the chen1i(!ct manufacturing branch, fertilizer. 4. Uzbekistan is rich in natural resources--primarily gold, oil, natural gas, coal, silver, anld copper. It is the world's seventh largest producer of gold, the third largest producer of natural gas in the FSU, and is among the world's ten largest natural gas suppliers. Its annual gold productionl of about 65 tons is about a third of what the Soviet Union used to produce. In 1992 it produced 42.8 billion cubic meters of natural gas, mostly for domestic consumption, and the export potential is significant. The republic also produced 3.3 million tons of oil in 1992, which is likely to increase substantially in the future as two recently discovered oil fields are developed. Despite this potential, Uzbekistan is one of the poorest countries in the FSU, with a per capita income preliminary estimate of $860 in 1992. RECENT DEVELOPMENTS 5. After the breakup of the Soviet Union, Uzbekistan faced difficulties common to republics of the FSU--production inefficiencies, the breakdown of central planning and interrepublican trade and payments mechanisms, highly monopolistic market structures, falling output, repressed inflation, and the loss of significant budgetary transfers from the Union Government. Moreover, world prices were declining for its two major commodities, cotton and gold, and the Government had to manage its economy in an external environment determined largely by Russia. It decided to follow a relatively cautious and partial approach to reform, at least until an articulated approach to reformii could he  ii developed. The Government implemented several new policies in 1992-93, partially liberalized prices, unified the foreign-exchange market, imposed new taxes, and temporarily removed until January 1994 most import tariffs. It has recently removed price controls on foodstuffs with the exception of bread and flour and increased significantly energy prices for industrial use. It also privatized some small shops and residential housing, and enacted banking, property, and foreign investment legislation. 6. The poor quality and availability of data impose severe limitations on the analyses carried out for this first report on Uzbekistan. Thus, all quantitative estimates of economic indicators should be considered provisional. 7. Economic performance (as measured by output and investment) in Uzbekistan in 1992 appears to have been better than the average of other FSU republics, but still resulted in a substantial decline in economic activity. Real GDP declined by almost 10 percent, following a decline of 0.5 percent in 1991. Consumption and investment levels were also affected. Real investment fell by an estimated 12 percent in 1992. Inflation in wholesale prices was about 2,700 percent in 1992, and the terms-of- trade deteriorated about 10 percent. Despite the decline in output, employment was maintained through a significant downward adjustment of real wages. Conventionally measured average real wages declined by 54 percent in 1992. But this figure probably overstates the actual declines because of the extent to which wages had been channelled into "forced savings" before the January 1992 price liberalization. 8. Uzbekistan had an estimated fiscal deficit (defined as a ruble deficit of the central government) of 11 percent of GDP in 1992, and a current account deficit of 17 percent of GDP, financed by arrears with some FSU republics, by borrowing abroad and by using part of its international reserves. During the first three quarters of 1992, the Government tried, through controls and subsidies, to prevent internal prices from rising as rapidly as they did in Russia and elsewhere in the ruble zone. But in the fourth quarter, a major increase in domestic prices for energy products led to a large increase in the general price level. 9. According to preliminary estimates, Uzbekistan may have run a trade deficit in its interrepublican trade of about $200 million in 1992, and a trade deficit with the rest of the world of $60 million. Foreign direct investment flows were only beginning in 1992. About $380 million in bilateral loans and export credits were committed in 1992, of which about $125 million were disbursed. In addition, Uzbekistan signed an agreement with Russia on November 2, 1992, whereby Uzbekistan relinquished all responsibility for the share of the old external debt/assets of the former Soviet Union allocated to it under the Debt Allocation Treaty of Succession on Foreign Debt and Assets of the USSR of December 4, 1991. This agreement on the so-called, "zero-variant" with Russia will help Uzbekistan's overall creditworthiness. THE PROGRAM FOR ECONOMIC REFORM 10. A comprehensive reform program will be needed to accomplish the Government's objectives of: (1) achieving financial stabilization, (2) reversing the decline in output and improving productivity, (3) promoting sustainable development over the medium term, and (4) protecting vulnerable groups. The program will have to cover macroeconomic management, structural reforms, and sectoral reforms--simultaneously--to make the transition to a market-oriented economy. Early attention should be given to the creation of an enabling institutional and legal environment to support the reform program.  iii 11. Changing the role of the state and developing markets. In a market economy, resources should move in response to the signals and incentives provided by prices freely determined by markets. The role of the state will need to change from the detailed management of the command economy to combining satisfactory macroeconomic management, establishing and maintaining the legal and regulatory framework for private activity, providing the necessary social services and economic infrastructure, and maintaining an adequate system of social protection. 12. Phasing out the state order system in all sectors of the economy--along with direct state involvement in both domestic and international trade--is the first step toward increasing resource mobility. This would allow labor, capital, allocation of raw materials, and production and consumption decisions to respond to market prices. The liberalization of the distribution system is essential for the establishment of a market-price-guided incentive system to replace the planned allocation of goods and services. Removing internal trade barriers will allow liberalized prices to work their way through to correct the misallocation of domestic resources and to free up resources for use in the more dynamic activities of the economy. 13. Establishing property rights. Private sector development requires a legal framework to define and ensure property rights. Property rights must be defined clearly, held largely by private owners, freely used and transferred by such owners without unpredictable or arbitrary governmental intervention, but within a predictable regulatory framework, and enforced by a neutral party based on an effective judicial system and modern civil and commercial laws. 14. Enterprise governance. Enterprise governance should be strengthened, for public utilities and for the larger state enterprises that will not be privatized in the near future. Budget constraints need to be tightened, and performance monitoring needs to be introduced. An efficient governance structure for enterprises must provide accountability to the owner (the state), an enterprise body responsible for strategic issues and oversight of management performance, substantial operational autonomy and incentives for the enterprise management, and the imposition of financial discipline. 15. Pro-competition policies. Monopoly power hinders successful reform. The highly concentrated industrial structure in Uzbekistan reduces the competitive pressure for cost minimization and, as a consequence, firms can set higher prices. If productive enterprises are to be forced to behave efficiently, in their resource use and investment policies, they must face competitive pressure in markets with liberalized prices under the discipline of hard budget constraints. International competition, combined with competitive factor markets and competitive markets for nontraded goods, is needed for prices to be effective signals and incentives for economic efficiency. Demonopolization then is an essential element for transforming Uzbekistan into a dynamic market-based economy. Agenda for Macroeconomic Management 16. Stabilization can be accomplished after a period of adjustment, which must encompass reform of the economic system and movement toward a market-based economy. The macroeconomic policy measures that would allow the Government to access an IMF Systemic Transformation Facility or a Stand-By arrangement would help the Government establish the fundamental elements of stabilization. As long as Uzbekistan remains in the ruble zone, however, options for macroeconomic policy will be limited. Both monetary and exchange-rate policies will have to follow zone parameters, and success will depend critically on stabilization in Russia. Fiscal discipline is the most critical determinant of stabilization. The challenge to the Government will be to generate revenue efficiently,  iv vhile continuing to compress expenditures enough to shrink the deficit in the near future. A stringent fiscal policy will have to be accompanied either by close coordination of monetary policies with other zone members or by Uzbekistan's issuing its own currency, and thereby establishing independent monetary and exchange-rate policies. 17. Subsidies. Subsidies, at the core of the fiscal deficit and macroeconomic imbalances, have important implications for the efficiency of the economy. To cushion the impact of the economic events of 1992, Uzbekistan maintained most of the direct and indirect subsidies and price controls that are the legacy of the Soviet Union. These subsidies impose a severe burden on fiscal policy. Moreover, relative prices depend heavily on subsidies, creating a severely distorted incentive structure. Input and credit subsidies to agricultural and industrial producers, in addition to their fiscal costs, lead to a tremendous waste of resources. For example, the low domestic price of energy inputs and the absence of water charges for irrigation hamper conservation efforts and induce rationing. Moreover, the systematic underpricing of energy relative to other goods has led to substantially higher consumption of energy per unit of output than in market-based economies. 183. Social protection expenditures. Priority should be given to restructuring and reallocating social expenditures--particularly to reducing universal subsidies and increasing targeted assistance. Spending on social protection policies (including consumer subsidies) will have to be reduced from today's high level which is higher than in countries with the same per capita income and similar to the level in low-inconme OECD countries. Funded from both budgetary and off-budgetary sources, spending oni social protection (including pensions) represents about 24 percent of GDP, of which almost half is for conlsumer subsidies. By phasing out all consumer subsidies except those on bread--and adjusting wages and pensions to accommodate higher food prices--the Government could save up to 8 percent of GDP in 1993. As part of the move to a system of direct payments based on need, the Government could also unify the family allowances and switch to a flat-rate allowance per child. 19. Taxation. The taxation system should be strengthened to enhance revenue, with the tax base widened as much as possible. Special tax exemptions at both the federal and local levels should be reduced. Enterprise profits should be calculated according to revised accounting methods consistent with n110derni comminiercial accounting practices and the number of exemptions included in the tax code should be reduced and simplified. 2(. The consolidated public sector budget. Overall budgetary management must be strengthened. All public-sector revenue and expenditures, budgetary and off-budgetary, should be idenitified to help assess the overall level of Government spending and its financing. As part of the assessimienit, a consolidated analysis of the entire public sector including public sector enterprises and subsidized credits through the banking system should be undertaken. 21. Trade policy. Trade policy to open Uzbekistan up fully to the rest of the world and encourage competition in all sectors will accompany both stabilization and structural reform. It will need to have two objectives: achieving efficiency in the economy (in production and consumption) and increasinig Government revenue. Quantitative trade restrictions should be eliminated. The medium-term obljective should be to work toward treating both FSU and foreign trade equally. A temporary ad valorem export tax could replace differential prices and confiscatory export taxes now in place. The tax on foreign exchange proceeds should be abandoned in favor of a low uniform duty on exports (with a higher rate on minerals and cotton as appropriate).  v Agenda for Structural Reform 22. The Government has indicated that it wants to follow a gradual process of economic transformation. Such a pace is thought to result in fewer social and economic disruptions. However, it is likely to involve the preservation of significant inefficiencies in the allocation of resources which will undermine the Government's capacity to stimulate sustainable long-term growth. Whatever the pace of reform chosen, the success of the reform program will depend on the Government's ability to implement a comprehensive program of structural reform according to a clear timetable. This reform package should cover four priority areas: * Establishing the legal basis for developing a market-oriented economy and the private sector, especially property rights and contract laws. * Enterprise reform to restructure and privatize state-owned enterprises in the public sector, improve governance of those remaining as SOEs, and encourage new private sector activities. * Implementing financial-sector reform so that lending is on a purely commercial basis. * Providing a social safety net to protect the most vulnerable groups. 23. Legal and regulatory framework. Uzbekistan would benefit from a thorough reconsideration of legislation necessary for reforming enterprises and developing the private sector. To put in place the minimum requirements for the private sector, new laws (or significant amendments to existing legislation) are required in the following areas: (1) a civil code or new laws governing property (real, personal, and intellectual), contracts (including leases) and secured transactions, (2) company law, (3) accounting standards, with particular attention to standards applicable to SOEs, (4) foreign investment legislation, (5) bankruptcy law, and (6) resolution of commercial disputes. A regulatory framework adequate to encourage and support private-sector development will also require action to rationalize and harmonize existing legislative and legal reform measures and to greatly simplify licenses, permits, and approvals. 24. Enterprise reform. Enterprise reform lies at the core of the necessary structural reform. At the end of 1991, the SOE sector accounted for 85 percent of GDP and 80 percent of employment in Uzbekistan. Moreover, through its links with the budget and the banking system, the sector controlled most of the country's financial resources. To promote competition, the restructuring accompanying privatization should include both demonopolization and reductions in vertical integration. The change in ownership would thus be accompanied by a consequent change in the size distribution of enterprises. 25. Despite some legislative initiatives, the Government has not yet developed clear ownership and governance rules for the enterprises that will remain under state ownership in the near future. Nor has it developed a comprehensive privatization program for the SOEs. At present, privatization in Uzbekistan is based on the following principles: privatizing smaller firms and those in trade, catering, services and local industry initially; limiting the dislocation of labor, with employees playing a major role in corporate governance after privatization; leasing or selling firms cheaply to the workforce (often as a collective), rather than auctioning or giving away through a voucher system; placing restrictions on changing lines of business for long periods; and maintaining the previous control structures and continuing "voluntary" associations into concerns.  vi 26. The 1991 Privatization Law and the implementing regulations need to be revised in three main ways. (1) The priority given to enterprise staff, particularly collectives, must be de-emphasized. Shares should be given to individuals, not to collectives, and ought to be fully transferable. (2) Competitive sale of enterprises should be the norm, and leases should only be a fall-back solution. Prior to sale, however, all large enterprises should become stock companies, and monopolies should be broken up. (3) There should be no restrictions imposed on the enterprises' line of business subsequent to privatization. 27. Financial sector reforms. To sustain enterprise restructuring and privatization and develop the private sector, the banking system must provide a mechanism for mobilizing savings and efficiently allocating resources. Financial institutions in Uzbekistan are not in a position to fulfill this role, or to support the privatization and revitalization of enterprises. Negative real interest rates on deposits are discouraging private bank deposits, so that the financial sector cannot fulfill its primary function of mediating between savers and investors. 28. The infrastructure of Uzbekistan's financial system must be strengthened as a matter of urgency. This would include the revision of accounting, auditing, and reporting standards, and the adoption of procedures for financial market regulation and supervision. The payment system needs to be replaced by modern clearing and settlement mechanisms, to ensure fast processing of financial transactions. A strong and independent Central Bank, focused on the conduct of monetary policy and on bank regulation and supervision, is the core of any stable, efficient financial system. Separating the Central Bank's commercial and central banking functions is necessary to avoid conflicts of interest and interference in the conduct of monetary policy. Thus, the Central Bank should no longer funnel 70 percent of deposits in the Savings Bank to the banking system. 29. As reform progresses, the Government should restructure and possibly privatize some sectoral banks. One option is to create a specialized financial institution that could assist the Government in financing large loss-making SOEs before their privatization, restructuring, or liquidation. Such an institution would lend to SOEs under less stringent criteria than a commercial bank, work closely with the Government and be funded partly (if not wholly) through the budget. Instead of isolating the bad loans in one institution, another option is to adopt strict accounting and regulatory frameworks to ensure that bad loans within each bank will be contained during the transition. To strengthen its commercial banks the Government should enforce prudential regulations (such as limits on loan exposure to owners) and, to reduce risk, it should require diversification of loan portfolios. There is also a need to develop financial institutions and markets to provide term financing and risk capital for the private sector. In the longer term, Uzbekistan also needs to develop other financial institutions, such as a securities market, life insurance companies, and pension funds. Preparing the legal framework and establishing regulatory and supervisory bodies for this purpose could be considered. 30. Labor mobility. Labor deserves special consideration when discussing reallocation of production factors. Thus far, unemployment in Uzbekistan has remained very low, but this is deceptive, since most enterprises are probably retaining idle workers and many have cut their work week to four days or even three. In the near term, some public enterprises may need to be liquidated and others forced to reduce greatly their employment levels in order to become profitable. As labor in public enterprises is shed, specific measures will be needed to enhance the flexibility of the labor market, such as reducing internal restrictions on mobility and expanding job placement centers. The approval of the Employment Act in 1991, and the beginning of the process of establishing over 100 employment centers around the country, signal some progress in this area. But the perpetuation of residence permit requirements, along  vii with extensive housing shortages, means that labor mobility in Uzbekistan is still very low. The rise in unemployment, combined with an expected increase in wage differentials, could lead to a less equitable income distribution, which would reinforce the need for a stronger social safety net. 31. The social safety net. The social dimensions of stabilization and enterprise restructuring require great attention to the social safety net, which the Government is committed to maintaining. But the fiscal situation may not support a safety net strong enough to protect against significant unemployment. Priorities will have to be fixed, and resources will need to be used efficiently. In this context, the Government should consider (1) offering income support to those who would otherwise fall below the poverty line (such as children in large families and the elderly), (2) extending assistance to those who are affected adversely by the transition, particularly the newly unemployed, and (3) targeting scarce resources to those most in need, rather than providing support indiscriminately. Agenda for Sectoral Reform 32. Agriculture. Because yields are relatively low while input use and spoilage rates are high, the productivity gains possible in Uzbekistan agriculture appear to be large. The key to realizing these gains will be to establish the necessary incentives for generating and adopting new technologies in line with Uzbekistan's comparative advantage. The Government has already initiated this process of reform. In the short term, further reforms should focus on providing greater freedom to produce, sell, and trade at prices determined in an increasingly free and competitive market. This will require Government actions to: (1) liberalize prices and markets, (2) phase out compulsory deliveries at below market prices under the state order system, (3) create a competitive and responsive marketing system, and (4) establish the initial conditions for encouraging more efficient land and water use. A full-fledged land leasing program could be implemented without major delays. For the longer term, programs must address two issues: increasing the efficiency of water use in a manner consistent with environmental concerns (for example, through irrigation modernization and water pricing) and supporting sustained growth in land productivity (for example, through land reform, varietal development, and the promotion of improved on-farm practices). 33. Energy. Provided substantial reforms are undertaken, the medium-term outlook in the energy sector is promising and Uzbekistan could become a significant energy exporter in the longer term. Apart from developing its oil potential, the greatest challenge in the medium to long term is to secure export markets for excess natural gas supplies. The volume of natural gas available for export in the medium term may be much greater than the Government now envisions--domestic consumption could be reduced by raising prices to international levels and promoting greater efficiency in use. If the potential economic benefits from the energy sector are to be fully realized, three policy measures must be implemented in the next 18 months. First, energy pricing and taxation must be reformed. In addition to improving the fiscal situation, this would provide the incentives for resource conservation and more efficient use. Second, an investment framework must be developed to attract outside investment into the petroleum sector and to design petroleum legislation and taxation. Third, institutional reform in the energy sector is necessary--to restructure energy enterprises and enhance their economic efficiency and development potential. 34. Mining. The medium-term outlook for the mining sector also appears promising, particularly the gold and copper industries. The sector's success depends on the enactment of a regulatory framework that provides the basis for opening the sector to private investment in exploration - -the most critical phase of the mining cycle. Current mining sector policies--state procurement, lack of  viii access of mineral producers to international markets, exploration reserved to the state--will probably not lead to a strong internationally competitive mining industry. Pricing policies for mineral products distort incentives and resource allocation. Investment decisions are made not on the likely rate of return from a pnr)ject hut on whether a specit'ic conmnodity is "needed" or whether a geographic region is strategically iiilmpotanit. A critical assessmenit of the competitiveness and productivity of the different subsectors of' the milning industry is needed to determine which mines can become competitive in a market-based economv. 35. In light of the need for modern management expertise and for improved minling techniologies, the bulk of the effort to stimulate and maintain growth in the mining sector should come t'ronil foreigin private investors. To encourage such investment, the Government must adopt a policv and institutiknal structure that supports stable and transparent regulations to govern the rights and obligations o)f the invcstor and the Government, a competitive and well-structured fiscal regimile. access to foreign excliangee at imarket rates, anid well-organiizedi institutionis to monitor and assist the producers effectively. 36. Franisport and telecommunications. The cornerstone of any market-based economlyr is anl et'fticienit systeml tfor supplying inputs to producers and distributing the output to customers. Uzbekistan's transport systemi is well adapted to its geography, but the sector's need for the rehabilitation and replacemilenit of assets is significant. As in the other sectors of the economy, regulatory controls andc distorted price anid incentive structures create inefficiencies. An improved institutional structure for formulating policy, regulations, and operations effectively is needed. 37. The maini challenige in the telecommunications sector is to take advantage of new technical opportunlities to meet the demanids of customers for new and improved international, long distance, atid local services. Meetling this challenige will require major financing and funding decisions--and a range of' planning and operationial strategies, appropriate tariff policies, and cost-effective approaches to moderinization. The institutional structure of the sector must be reorganized so that the Governiment can create a framiiework for encouraging service improvemilents, privatizing sectoral entcrprises. conimerivaliziing the sector, and upgradinig existing facilities. Only when a stronig institutioInal structure is created will the sector attract investment. 38. 1Iealth. Ilealth status indicators in Uzbekistan are not encouraging. Many rural poor. w'ith large f;amiilies, suffer f'rom acute infectious diseases, such as enteric illnesses. The interval between hirths is less than two years for 80 percent of women, maternal and infant mortality are relatively higih, and chllildhood vaccination coverage is dropping in some regions. Poor drinking water, lack of sanitatioll, and improper clilical management add to the problems. The population now views health care as a right, hut fiscal realities are rapidly eroding this belief. Health services face severe problems: ( I ) the administration of the Ministry of' Health, which manages all aspects of the health sector, is weak, (2) tilere is an unstable financial base, and (3) there are shortages of vaccines, medical supplies, and equipmlielnt. 39. In the short term, consideration should be given to priority setting and development of a sustainlahle health finance system. A successful prevention program will reduce demand for expensive curative services. Preventive measures such as childhood immunization, diarrhoeal control (clean water and provision of oral rehydration salts), and targeted nutritional supplements for some pregnanit women and infanits (e.g., dried milk) would save lives, eliminate many expensive in-patient stays, and reduce the need for staff. It should also be possible to eliminate some unnecessary services and increase efficienicy in the use (df inputs, and there should be a rationalization of drug use and an alignment of service  ix protocols with international standards. Developing a sustainable health finance system impllies the introduction of some charges and fees. There are also needs to empower the Ministry of fHealth and clarify the roles of other organizations--and to develop a coherent women's health strategy. 40. Education. The education and training system faces three difficult challenges. First, nationhood has demanded new language policies, focusing learning around circumstances in tJzbekistan and promoting new international links in education. Second, a market-based economy requires changes in the content and purpose of schools and in out-of-school education and training programs. Third. declines in output complicate the reform process by limiting the scope and pace of change and prompting economizing measures that are not necessarily in the best long-term interests of education The Government should consider (1) reintegrating the management of the sector under one ministry for economy and efficiency; (2) undertaking as early as possible the preparation of a long-term plani (and related short-term programs) for the development of the school system, including both quantitative and qualitative concerns, and the evolution of the management of the system and its staff developmenit needs; (3) assessing the scale of investments needed in the system, establishing priorities and improving coordination; (4) rationalizing the teacher training system; (5) developing selected higher education institutions as centers of excellence in specific disciplines; and (6) undertaking a cost recovery system for higher education. 41. Environment. The main environmental issues in Uzbekistan derive from the problenms of the Aral Sea--land degradation due to high levels of salinity. The expansion of irrigated cotton production has been associated with serious environmental degradation and an erosion of the country's resource base. The most dramatic effect of this has been the shrinking of the Aral Sea--which has led directly to the abandonment of substantial transport, fisheries, and related infrastructure. Since 1960, the Aral Sea has shrunk significantly because of a nearly total cutoff of inflows from the Amu and Syr Rivers for irrigation. The issues relating to the Aral Sea Basin include the reduction of the sea, the destruction of its aquatic ecosystem, the lowering of soil quality in the Aral Sea Basin, the pollutioni of the surface water and groundwater of the delta draining into the Aral Sea, and the adverse health impact on the population because of lack of potable water and inadequate sanitation. The World Bank is supporting the development of a regional program for promoting sustainable development and use of the basin's land and water resources. 42. Other environmental issues include: (1) disposal of solid and hazardous waste, particularly where pesticide use is concerned, (2) water contamination from municipal and industrial sources, (3) industrial pollution, particularly in the Fergana Valley, and (4) the impact of mining activities (gold, uranium, lead) on workers' health and safety, on air pollution, and on water quality. Particular consideration should be given to environmental issues while assessing the economic viability of Uzbekistan's industrial sector. Environmental standards in the country seem to be strict but are not observed. Any serious attempt to comply fully with them would be inordinately expensive, so the need is urgent to develop more realistic environmental standards that could be met at a reasonable cost, and then to enforce those standards.  x MEDIUM-TERM OUTLOOK 43. A major reform program will inevitably affect short-term growth, since the agricultural, industrial, and financial sectors have to be substantially restructured. If a reform program along the lines suggested in the report had been initiated in early 1993, GDP may have continued to decline in this year, but at a somewhat lower rate than in 1992--possibly by about 6 percent. The disruption associated with any period of major adjustment and restructuring is also likely to generate a temporary but substantial increase in unemployment. The extent of unemployment will depend on two factors: the pace of enterprise reform in all productive sectors, and the opening of new opportunities in the private sector. A slower pace of enterprise reform and restructuring would imply a lower amount of open unemployment, but continued employment in low productivity activities which would need to be supported by continued subsidies. If the Government were to start implementing a comprehensive reform program in late 1993, benefits would be felt only in 1994. 44. The reform program in the agricultural sector must proceed at full speed since it is likely to yield the quickest positive growth response to the proposed new incentive structure. The potential for increasing yields without increasing inputs and for reducing waste, in both the agriculture sector and in the agro-processing industries, could be realized relatively easily. But if reform of the agriculture sector is delayed, the recovery of output and consumption might also be delayed, undermining support for the reform program. 45. A deepening of structural reform, particularly in the industrial sector, could lead to a further drop in GDP in 1994. However, rapid small-scale privatization, primarily in trade and services, will ensure that at least part of the labor force released by restructuring is absorbed in new activities. Growth of the service sector may also be expected to compensate partially for the decline in economic activity driven by the industrial sector. 46. In the short term, it is assumed that Uzbekistan will not experience any significant deterioration in its terms of trade. Interrepublican trade now seems to be conducted at exchange ratios quite close to world prices. The relative price of natural gas vis-a-vis Uzbekistan's importable goods was unfavorable in 1992, so some actual improvement in the terms of trade is expected in the near future (along with significant exportable balances of natural gas). Otherwise, no sharp changes are foreseen in the world prices of Uzbekistan's raw material exports and imports. 47. Trade will certainly play a critical role in the medium-term outlook for Uzbekistan. Trade with countries outside the FSU is likely to gain in significance but trade and current-account deficits may well be substantial in the next few years. In 10 years, however, exports of natural gas, increase of exports of cotton, potential self-sufficiency in oil production, and potential exports of gold could result in a major improvement in the trade balance. 48. In the absence of comprehensive reform, the few scattered and partial reforms that the Government is implementing would have no major impact. This muddle through scenario would imply that none of the sectors is restructured significantly. This failure to adjust would lead to a supply-led contraction of the level of economic activity, reduction in savings and investment, and unnecessary hardship on the population in the medium term represented by a decline in consumption per capita of not less than 30 percent by 1997. It is very likely that Uzbekistan will not be able to maintain the level of capital inflows that it experienced in 1992. Thus, not even lower current account deficits are likely to be financeable, affecting even further imports, consumption, and output. The only sources of financing  xi would be a probably lower amount of technical credits to be made available by Russia, a relatively modest amount of bilateral loans, and use of Uzbekistan's own international reserves. EXTERNAL FINANCING NEEDS 49. With good prospects for sustainable development after the transition, Uzbekistan should be able to finance its development without difficulty over the long term. But, for the next 10 years, it will have significant external financing needs. If the Government implements a comprehensive reform program, it will be well positioned to obtain access to bilateral, multilateral, and trade credits in the short to medium term. Financing from commercial banks and access to international capital markets will probably not develop until later. 50. Any estimates of Uzbekistan's external financing needs are necessarily preliminary and subject to much uncertainty but they can be useful for assessing the country's prospects under different policy assumptions during the transition. The following analysis should be viewed as scenarios of what may happen under certain policy and other assumptions rather than as projections or forecasts of the future. 51. Assuming major structural reforms are implemented, exports can be expected to grow at 3.0 percent per year and imports at 1.5 percent in the 1993-97 period. These growth rates are significantly higher in current value terms because of the convergence to world prices and exchange rate valuation adjustment. Imports of capital goods for developing the oil fields and sustaining significant exports of natural gas will be particularly important in terms of balance of payments (BOP) implications in 1994-95. Uzbekistan could also maintain significant cotton exports through increased productivity, if efforts are made to improve grading capabilities and deliveries. Uzbekistan can also begin exporting up to 65 tons of gold a year. As net oil imports decline to zero, and gold and gas-related export revenues grow, the trade balance could improve significantly. But gross external financing requirements will remain substantial as a result of debt service and profits remittances. 52. External financing requirements for 1993 could be about $500 million, comprising a non- interest current-account deficit of about $250 million, and interest payments of about $10 million. The balance of about $240 million could be used to build up gross international reserves to back the introduction of a new currency, should the Government decide to withdraw from the ruble zone. For 1994-96, estimated financing needs, to be met by direct foreign investments as well as gross loan disbursements, are $600 to $700 million a year. 53. In the next few years, mobilizing the desired capital inflow will require a major effort by the Government and the international donor and investor communities. Foreign investors are showing interest in mining, agro-processing, textiles, and commercial vehicle manufacturing. Direct foreign investment flows could reach $200 to $250 million a year by 1997, if the legal and institutional frameworks for such investment are strengthened and there is progress in reform. Despite a significant growth of exports, the import growth needed to sustain expansion in output and investment cannot be financed by commercial sources. Substantial official financing may be needed in the next few years to sustain the reform program. A strong program of economic reform will be needed for these flows to be forthcoming. 54. Uzbekistan's creditworthiness in the medium and long terms will depend on successful implementation of the reform program, the development of the country's natural gas potential and  xii recently discovered oil fields, on the timely increase of various commodity exports, as well as on external factors, such as the price of its raw material exports. Weak policies or implementation, and an inability to realize the export potential, could jeopardize creditworthiness. Under these circumstances, Uzbekistan could stagnate. On tlhe other hand, effective reform policies combined with a strong natural resource base m1aV lpermil Iizhekistani to enter a period of sustained growth with increasing access to international capital mlarkets. I)ebt service as a share of total exports could reach only 11 percent by 1999, when amortization becomiies significant, and could fall to about 8 percent by 2002. These projections depend heavily on I zhekistan's ability to sustain export performance and to shift a significant portion of its trade to hard currencv mzarkets. 55. Uzbekistan needs technical assistance to design and implement its reform and restructuring activities. Technical assistance requirements are estimated at about $20 million a year for the near term, ind are expected to be met to some extent by grant financing. Specific technical assistance needs are discussed throughout the report. At the request of the Government of Uzbekistan, the World Bank has started coordinating technical assistance to Uzbekistan through a Pre-Consultative Group in December 1992 and a l ocal Consultative Group in Tashkent in May 1993.  CHAPTER 1 THE LEGACY OF THE PAST 1.1 I*JUzbekistan declared its independence on August 31, 1991. At the time of the breakupI. Uzhekistaii faced not only the difficulties that were commoni to the former Soviet Unioin (FS11)-- productioni inefficiencies, central planning, highly monopolistic market structures, falling output, and repressed intlation--but also its own problems--declining world prices for its two major commlliodities (cottoin andi gold). and the loss of the Union's highest budgetary transfers. A. THE DISINTEGRATION OF THE UNION' 1.2 Hopes for a unified economic reform process in the Soviet Unioni could not be sustained much heyond mid-1990. The first relatively open elections at the local and republican levels of government in the Soviet Union were held in March 1990, one year after the Ulnion Legislature elections. While commllunists gained a majority of seats in many institutionis, republican legislatures enided up with significantly more reformists than in the Union Supreme Soviet. The growing distress in institutional ideology meanit that officials who were more committed to reform began conceiving their policies and programs in a republican, rather than a Union, context. Thus, while the originial intenlt of republic-level legislatures was not to dismantle the Union, the political structure in which they vwere now operating conflicted with the imperatives of the Union Government to retain its power instrumiienits for the very purpose of undertaking reform. The emergence of dual and subsequently multiple "tracks" of reformii was inevitable. 1.3 By September 1990 two competing programs were under active discussion: the Ulnion 'Ryzhkov" Plan (named after the then Union Prime Minister, Nikolai Ryzhkov), and the "SShataliin' Plan (after its primary architect, academician Stanislav Shatalin). On the whole, the Shatalin Plan was a clhallenge by the Russian leadership to the Union authorities' claim to be the arbiters of economiiic reform. The Rvzhkov Plan, formulated shortly thereafter, was the Union's response to that chlallenige. The Shatalin Plan called for giving the republics greater decision-making freedom and, in many ways, for undertakiing more radical reforms than did the Ryzhkov Plan. The Shatalin Plan envisaged a very specitfic timetable of reform--particularly privatization and price liberalization. It also assigned primary taxing authority to the republics, and called for funding the tUnion budget from shares of the republic budgets. The Ryzhkov Plan, by contrast, advocated a slower pace of reform, and did not cede significaint powers to the republics. 1.4 The Presidential Guidelines that were issued in the fall of 1990 attempted to capture the fairly narrow field of consensus between these two programs. However, consensus was limited only to some generalized goals, and the guidelines failed to specify a timetable for achievinig those goals. In particular, the Guidelines gave the republics considerable freedom to set their own pace for initiatiilg refortl and for formulating fiscal policies--without having specified how or whether policy actions by the republics could be limited when those actions threatened the Union reform program. Meanwhlile, the economic situation in 1990 had been marked by strikes, interethnic strife, the collapse of the Jinioni-wide market in the face of trade barriers created by the republics, and a breakdown of the systemir of state ' This section draws from Chapter I of Russian Economric Reformrl, World Bank Country Study, 1992. It provides useful backgrounid informationi on the chronology of events that led to the breakup of the FSU.  2 Chapter 1 orders. As the party apparatus-the core mechanism of informal coordination and management in a planned economy-began to be weaned deliberately from its central role in the economy, the traditional economic structure began to come apart and output declined for the first time in the peacetime history of the Soviet Union. 1.5 By the latter half of 1990, unrest in the republics, including Uzbekistan, had increased considerably. The crackdown in the Baltics confirmed it, fueling separatist tendencies further. In tune with these political and military measures, the economic policies of the Government took a conservative turn; in October 1990 the Government decreed that all Union enterprise ties were to be frozen. Thus, even as some of the objectives outlined in the Presidential Guidelines of 1990 were passed as laws in 1991, general economic, political, and legal disarray precluded their implementation. Although the legislative and fiscal responsibilities of the Union and the republics for 1991 had been agreed upon in April 1990 (and confirmed in January 1991), the republics circumvented implementing the law, by signing treaties and economic cooperation agreements with each other and by withholding tax revenue from the Union budget. Their actions precipitated the so-called War of Laws, in which republic officials began drafting and enacting legislation in areas that were also the bailiwick of Union legislation. In Russia, the same Shatalin Plan that had ultimately been rejected by the Union legislature had been approved by the republican legislature. More significant was the fact that, in defiance of the tax laws of the Union, the Russian republic and most of the republics including Uzbekistan began issuing independent republican tax regulations. For example, the Union tax law imposed a profit tax rate of 45 percent on enterprises, compared with a lower 38 percent rate imposed by the Russian Federation and Uzbekistan. By 1991 it was clear that the blatant disregard of the Union's attempts to achieve macroeconomic stability were grounded in political desires for independence, not necessarily in differences in economic thinking. 1.6 By April 1991 the Union budget had already reached the deficit level that had been projected for the entire year, and was in effect bankrupt. In response, the "Anti-Crisis" program, formulated with the consensus of nine republics (including Uzbekistan), sought "the unconditional fulfillment of obligations as regards budgets and extra-budgetary funds. It also sought to adopt anti- inflationary monetary policy, to liberalize prices further, to take various measures to halt the decline in output, and to secure the social safety net. The program was implemented in recognition that sustaining economic reform was necessary--both politically and economically. Yet agreement among the nine republics could not be sustained. 1.7 Thus, by the spring of 1991, a crisis of govemance was superseding the economic reform program in the Soviet Union. The Union no longer had clear authority to implement any program of reform. In May, one of the last Union plans for economic reform that acknowledged the crisis in governance by positing the importance of political restabilization was drawn up (the Allison-Yavlinsky Plan). However, the very process of drafting a new political basis for the Union consolidated the opposition of the conservative forces. Their coup attempt in August 1991 succeeded in destroying the very thing the opposition had set out to preserve--the Union. The following two months were marked by enfeebled Union Treaty negotiations and some puzzling inactivity by the Russian leadership. Uzbekistan declared its independence on August 31, 1991. 1.8 In November 1991, the Russian leadership announced the appointment of a new government, and outlined its commitment to radical economic reform. Most of the elements of reform were not implemented, thus finally exacting Russian Government control over the Union Government by withholding the funds necessary to sustain the legitimacy of the Union. The Soviet Union was declared  The Legacy of the Past 3 dissolved on December 8 by the signatories to the Minsk Accord (Belarus, Ukraine, and Russia).2 The dissolution was finalized upon the resignation of Gorbachev as President of the USSR on December 25, 1991. Uzbekistan joined the CIS on December 21, 1991. B. UZBEKISTAN IN PERSPECTIVE 1.9 Uzbekistan covers a land area of 447,000 square kilometers, slightly smaller than France. It is landlocked, situated in the middle of Central Asia. Almost three-fifths of its extension consists of steppe, desert, and semi-arid terrain; the remainder consists of fertile valleys that skirt two major rivers, the Amu Darya and Syr Darya. Rainfall is generally low, and the climate is largely desert continental. The country borders Kazakhstan to the north, Kyrgyzstan and Tajikistan to the east, Afghanistan to the south, and Turkmenistan to the southwest. Part of the northern border between Kazakhstan and Uzbekistan includes the inland Aral Sea. Population and Demographic Characteristics 1.10 Uzbekistan is the largest of the four Central Asian republics of the FSU in terms of population. It is the third most populous republic in the FSU, after Russia and Ukraine, comprising about 7 percent of the total population. It also has a high birth rate (3.5 percent, with about half of the population younger than 19 years of age). In 1991, it had about 20.7 million people, 60 percent of whom were living in rural areas. About 71 percent of the population is Uzbek, and the other major ethnic groups3 include Russians (9 percent), Tajiks and Kazakhs (about 4 percent each), Tatars and Karakalpaks (about 2 percent each), and Koreans, Persians, and Turks (about 1 percent each).4 The Fergana valley is one of the most densely populated regions in Central Asia.5 Uzbekistan's population is largely Sunni Muslim. In terms of administrative structure, Uzbekistan consists of 12 provinces, an independent territory (Karakalpakstan), 123 cities, and 157 agricultural counties. History and Politics 1.11 Uzbekistan lies along the famous ancient silk road between Europe and the Far East. The region was overrun by the Mongols under Genghis Khan in the 13th century. With the breakup of the Mongol empire in the 14th century, a native empire emerged centered around Samarkand. In the 15th century, feudal Muslim states grew up around the cities of Bukhara, Khiva, and Kokland. Trade with Russia developed in the 16th and 17th centuries, and much of the region was annexed to Turkestan in 2 However, the Union legislature has never voted itself out of existence. The debate about whether the Soviet Union was ever officially dissolved was revisited at the Congress of People's Deputies in spring 1992, when it was argued that references to the USSR in the draft Russian Constitution be retained. These figures are reported in the 1989 Census. Russians reside largely in urban areas. The rural population is overwhelmingly Uzbek. However, significant concentrations of other ethnic groups are in villages close to the borders of Tajikistan and Kazakhstan, and a large percentage of Tajiks reside in Samark and Bukhara. I The valley contains more than 300 persons per square kilometer. In the Andhizan oblast, the population density reaches up to 427 persons per square kilometer.  4 Chapter 1 the 19th century. Later, after a brief civil war in 1924, the region was incorporated into the Soviet Union. 1.12 After declaring independence, the former Communist Party was renamed the People's Democratic Party (PDM) in October 1991. Mr. Islam Karimov, former First Secretary of the Party, won the direct presidential elections in December 1991. There are several opposition parties. The largest is the Uzbek Popular Front--Birlik. While the party supports the restoration of the Uzbek national heritage, and a social and educational role for Islam, it opposes the creation of an Islamic state. Rather, the party supports a Western-style democracy, and at its last Congress the party's program called for limiting the powers of the president. 1.13 Two opposition parties were formed by groups that split from Birlik--the Democratic Party--Erk and the Fatherland Progress. Both parties are headed by well-known Uzbek poets. The program of Erk is very similar to that of Birlik, though its orientation is more Western. Its candidate received 12.5 percent of the votes in the recent presidential elections. The Fatherland Progress is a liberal-democratic party advocating parliamentary democracy and a market-based economy. The other remaining party of relevance is the Islamic Renaissance Party, which is the local branch of a party founded originally in the Russian Republic to protect Muslim interests. Thus far, the party has been denied registration given its religious orientation. 1.14 A new Constitution establishing basic principles on civil rights and the division of powers among the executive, legislative, and judiciary branches of the Government was approved by the Parliament on December 8, 1992. Several components of the Constitution are particularly relevant to economic reform because they indicate the enabling institutional structure to support reform in Uzbekistan 6 Econotic Structure 1.15 In 1990, Uzbekistan generated about 3.3 percent of the gross domestic product (GDP) of the FSU. Although the country's estimated per capita income level for 1991 was US$1,350, it has recently been estimated to be about US$860 in 1992. Uzbekistan is one of the poorest countries in the FSU, with a GNP per capita that is lower than that of all other FSU republics except Armenia, Georgia, Kyrgyzstan, and Tajikistan.7 1.16 Nonetheless, Uzbekistan is endowed with substantial natural resources--primarily gold, oil, natural gas, coal, silver, and copper (Table 1.1). Its annual gold production is approximately 70 tons, or one-third of what the entire FSU used to produce. Uzbekistan is the third largest producer of natural gas in the FSU and is among the ten largest natural-gas suppliers in the world. Although most of this production was consumed domestically, and only about 8 percent was exported through a pipeline stretching from Bukhara to the Urals, the export potential of natural gas is significant. A large proportion of local industry uses gas for its energy consumption. In contrast, although oil potential could be significant, current production levels are minor. The republic produced 2.8 million tons of oil in 1991, 6 These are discussed in more detail in Chapter 5, "The Governance of Reform." The structure of the new Constitution is provided in Box 5.1. These are preliminary estimates subject to revision.  The Legacy of the Past 5 and 3.3 million tons in 1992. This is likely to increase substantially as the newly discovered fields in the Namangan and Fergana regions are developed. Table 1.1 Uzbekistan: Mineral and Energy Production (1991) Uzbekistan Central Asian Russia Uzbekistan/ Republics' and Russia Kazakhstan Gold Production (metric tons) 70 250' 28%' Oil Production (mill. m-tons) 2.8 29.2 516.2 0.5% Natural Gas 41.9 92.2 640.6 6.5% Coal (mill. m-tons) 6 131.5 395.4 1.5% Sources: Uzbekistan Statistical and Forecasting Committee (Goskomprognostat). World Bank various Country Economic Memorandums. Notes: i Turkmenistan, Kyrgyzstan, Tajikistan. hi Total gold production of the FSU. c Relative to the total production of the FSU. 1.17 Uzbekistan is a major agricultural producer. Approximately 40 percent of the 1992 net material product (NMP) in Uzbekistan was generated in agriculture, 33 percent in industry, 14 percent in construction, and the rest in services. It is the world's fourth largest producer of cotton and the third largest exporter. Cotton accounts for about 40 percent of the gross value of agricultural production in the country. Uzbekistan is also the largest producer of fruit and vegetables within the CIS. Land used for agriculture comprises over 30 million hectares, two-thirds of which is used for livestock production. The rapid increase in agricultural production in recent years came from an expansion in irrigated areas, which led to reduction in the volume of the Aral Sea and serious environmental problems. At present, the irrigated area is about 4.23 million hectares, about half of which is irrigated by pumping systems. 1.18 Industrial production is based largely on the processing of agriculture-based raw materials. Local processing accounts for 12 percent of raw cotton output, 20 percent of sheepskins, and about 60 percent of silk cocoons. Heavy industry accounted for about 41 percent of the total level of industrial production in 1990, light industry (including cotton) 39 percent, and agro/food processing almost 13 percent, with the fuel-energy industry representing the remainder. The machinery sector includes many products that are linked to agriculture, such as cotton harvesters and textile machinery, and, within the chemical manufacturing branch, fertilizer.  6 Chapter 1 1.19 Production within the state enterprise sector (including agricultural enterprises) is still based primarily on a plan that assigns production quotas to each enterprise. A fixed percentage of the quota is retained by the enterprise, and the rest goes to the Government. However, anything above the quota is the property of the enterprise. 1.20 As in most of the FSU, total trade--but particularly interrepublic trade--represented a substantial proportion of GDP, approximately 67 percent in 1991. In 1991, interrepublic imports accounted for over 83 percent of total imports, almost 29 percent of GDP. Moreover, interrepublic exports amounted to about 89 percent of total exports in 1991. Cotton, machinery, natural gas, and fertilizers are main components in interrepublic exports, amounting to over 70 percent of the total interrepublic exports in 1990. Foreign export represented about 4 percent of GDP in 1991; cotton is the single most significant commodity in foreign export, accounting for about 80 percent in 1992. 1.21 Uzbekistan inherited from the FSU an extensive system of social protection characterized by child allowances, old age pensions, disability benefits, and subsidies on consumer goods and services. In 1989, 44 percent of the population of Uzbekistan were living below the official poverty line, compared with 11. 1 for the USSR. The health status of the population started deteriorating in 1990. Moreover, shortages of vaccines, medical supplies, and equipment indicate that Uzbekistan faces uncertain health risks from environmental influences. Uzbekistan also inherited a high literacy rate and a school system which has suffered prolonged underinvestment in the physical plant, and is isolated from the mainstream of current actual practices in countries outside the FSU. However, it does have a large number of mature and well-educated staff at all levels who have coped well with some of the deficiencies of the system. 1.22 Uzbekistan has a relatively well developed transport system that is adapted to its geography (42,000 km of main roads, 90,000 km of local roads, and 3,500 km of rail lines). However, the economy is unusually transport-intensive, and the needs for rehabilitation and the replacement of assets are significant. Uzbekistan inherited a telecommunications network organized centrally with international routing via Moscow with obsolete equipment and poor-quality service, which is deteriorating further. Economic Performance until the Breakup 1.23 Since 1988, real output growth rates have declined rapidly, and became negative in 1991 (Table 1.2). The substantial decline in output in 1991 preceded any attempt to undertake substantial reform toward a market-based economy and was a response to the breakup of the FSU and a corresponding decline in both the overall terms of trade and the volume of interrepublic trade. 1.24 The share of agriculture in production has been growing steadily to 36 percent in 1991 (see Table 1.3). At the same time, the share of industry declined to 21 percent in 1990 and has recovered thereafter. The shares of construction and services in total GDP dropped sharply in 1991, to 9 percent and 27 percent, respectively. 1.25 The share of agricultural employment has remained constant at approximately 40 percent since 1985,8 while industry's share has grown slightly, representing about 15 percent in 1990. Employment remains heavily skewed toward the state enterprise sector, which accounted for almost 65 1 However, agricultural employment varies within the year owing to temporary seasonal labor.  The Legacy of the Past 7 Table 1.2 Uzbekistan: Main Macroeconomic Indicators for 1988-1991 1988 1989 1990 1991 Output (Real Growth Rates) Gross Domestic Product 10.2 3.7 1.6 -0.5 Net Material Product 9.6 3.1 4.5 -0.91 Trade Balance (as % of GDP) -6.3 -13 -16.4 -3.0 Interrepublic -5.7 -11.4 -11.4 -0.7 Foreign -0.6 -1.6 -5.0 -2.3 Prices and Wages&' (percentage change) NMP implicit deflator -2.2 0.8 4.0 98.2 Retail price 0 0.9 3.8 83.1 Wholesale price NA 2.1 7.2 147.3 Average nominal wage 7.3 6.5 11.2 51.2 Real wage indexb' (1991 =100) 107 113 121 100 Real minimum wage index (1991=100) - - 183.6 100 Source: State Statistical and Forecasting Committee (Goskomprognostat) and Bank staff estimates. i Period averages. bh Deflated by retail prices. percent of total employment in 1991. Employment in cooperatives represented about 18 percent in 1991. The fastest-growing employment sector was self-employment in trade and services, which absorbed part of the drop in the state enterprise share, increasing from 10 percent in 1985 to 17 percent in 1991, although it still represents a comparatively small portion of overall employment (see Table 1.3). 1.26 Since Uzbekistan's per capita income was quite low relative to the average for the Soviet Union as a whole, it led to sizable net budget transfers to the republic, which stopped by the end of 1991. Modest fiscal deficits were recorded in the Government's finances during 1987-90, ranging from 0.3 percent to 1.4 percent of GDP. However, net transfers from the Union rose significantly from about 7 to 9 percent of GDP during 1987-89 to 19 percent of GDP in 1990. The Government deficit rose to about 5 percent of GDP in 1991 in spite of a further increase (up to 19.5 percent of GDP) of Union transfers to Uzbekistan.9 The underlying deterioration in Government finances reflected an increase in expenditures mainly associated with efforts to maintain the living standards of the population through subsidies. 9 Source: Ministry of Finance and IMF estimates. Union transfers may be overestimated because gold transfers from Uzbekistan to the center are not considered. It is estimated that in 1991 they represented about 2 percent of GDP.  8 Chapter 1 1.27 Aggregate expenditures increased Table 1.3 rapidly during the 1987-90 Structure of Employment period. The shares of (in percent) household and government 1985 1990 1991 consumption and investment in GDP all rose. Household Percentage of Population consumption increased from Employed 37 39 40 58 percent of GDP to 61 Retired 11 12 12 percent. During this period, Government consumption Employmentby Sector also increased from 21 Construction 8 9 8 percent of GDP to 26 percent Agriculture 38 39 42 (see Table 1.4). Investment Forestry 4 3 3 grew from 28 percent of Transportation and communication 4 3 3 GDP in 1987 to 32 percent in Trade and related sectors 7 6 6 1990 Other 28 28 27 Employment by Enterprise Type 1.28 The increase State sector 72 66 65 in total expenditures during Cooperatives 18 20 18 this period led to more than a Self-employed 10 15 17 doubling of the republic's- resource imbaae with t Source: State Statistical and Forecasting Committee of Uzbekistan resource Imbalance with the (Goskomprognostat). rest of the FSU, from -8 percent of GDP in 1987 to - 19 percent of GDP in 1990. Although the data for 1991 suggest that the resource balance improved sharply, to -5 percent of GDP, the magnitude of this improvement may not be accurate. It is very likely that the interrepublic trade deficit was underestimated.'