Georgia - Transport sector memorandum (Vol. 1 of 2) : Policy note

E N ^1- i . IN~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I o~~~ s - '~I~) 0 0 ; 0 0 0 ? , : E 0- O 0F:, C } :1  CURRENCY UNITS and EQUIVALENTS US$ 1 = 3323 Russian rubles (as of December 9, 1994) US$1 = 0.82 ECU (as of December 9. 1994) WEIGHTS, MEASURES and OTHER UNITS bln billion km nkilometer min million pass passenger km2 square kilometer vpd vehicles per day CONVERSION FACTORS I mile = 1.609 km I kg = 2.205 lbs I US gallon = 3.785 liters GLOSSARY OF ACRONYMS AND ABBREVIATIONS ATC Air Traffic Control CLAU Caucasus Logistics Advisory Unit CMEA Council for Mutual Economic Assitance DC Direct Current DWT Deadweight Tons EBRD European Bank for Reconstruction and Development EC European Community ECU European Currency EMIJ Electric Motorized Unit FSU Former Soviet Union GDI Gross Domestic Investment GDP Gross Domestic Product GSC Georgia Shipping Co. ICAO International Civil Aviation Organization IMF International Monetary Fund LT Long Term MOT Ministry of Transport NGO Non Governmental Organization PHRD Policy and Human Resources Development SITA Societe Internationale de Telecommunications Aeronautiques ST Short Tenn TA Technical Assistance TACIS Teclmical Assistance for Commonwealth of Independent States TDB (United States) Trade and Development Bureau TEU Twenty-foot Equivalent Unit USAID United States Agency for International Development WFP (United Nations) World Food Program  REPUBLIC OF GEORGIA TRANSPORT SECTOR MEMORANDUM POLICY NOTE TABLE OF CONTENTS A. Introduction .....................................i B. The Transport Sector .................................... iii C. The Reformned Transport Sector - A Vision ............................... iv D. How to Get There - A Strategy For Change ................................ v E. The Priority Areas .................................... viii F. The Evolution in the Medium Term .................................... ix G. Assistance Strategy .................................... xii H. World Bank Assistance ..................................... xiv   REPUBLIC OF GEORGIA TRANSPORT SECTOR MEMORANDUM POLICY NOTE A. INTRODUCTION 1. This report gives a snapshot of the current situation of Georgia's transport sector, follows with a vision of a reformed transport sector in a market economy, and suggests the steps necessary to transition. It is based on the findings and recommendations of two transport sector recotnnaissance missions that visited Georgia in 1993 and 1994. It shows: (a) the extreme seriousness and tluiditv of the situation, and the need to stabilize and resolve internal conflict and macro economic imbalances; (b) the still limited macroeconomic policy framework and growth of the informal economy, and (c; transport flows which reflect the contraction of trade and economic activity in Georgia, and economic implosion in the Caucasus region. Hyperinflation, i.e., inflation rates of up to 70% per month until the second half of 1994, and a contraction of employment in the civil service have made it extremely difficult to obtain up to date and meaningful information. Inflation rates in 1995 slowed down to about 3% pel month. The Economy 2. The economic recession of Georgia's state controlled sector is so serioLIs that major strucmtial changes are taking place spontaneously, without any explicit policy intent on the part of thie Govenin-met. Salient examples are the slow disappearance of functions traditionally performed by the civil service. partly as a result of reductions in real public expenditures, and the corresponding significant growth of a private, unrecorded, economy with transactions denominated in foreign currency. The Government has so far adopted a "laissez faire" response to these changes. although it has proposed new measures on foreign exchange transactions and foreign investments. Some privatization of trucking is underway. iad first steps towards commercialization of ports have occurred. 3. Contraction of the Civil Service. Apart from an intended reduction in slate employmnew levels, this is also the result of a rapid loss in the purchasing power of governmental salaries. Employees of ministries, agencies, and enterprises are reportedly abandoning their posts without even attempting to collect severance packages. Those who can find something more remunerative to do move on1, with the predictable result that institutional capacity is being reduced in a haphazard and disruptive fashion, faster than the level of Government employment. This trend is already affecting railway operations, where skilled workers have left to join the budding private sector. The decision to dismantle the MVinistry of Transport has affected the prospects for leadership in policy reform in the sector. In recognition of this fact, the Government has recently proposed to reestablish the Ministry. 4. Growth of an Unrecorded Economy. The drop in the supply of goods and services hy the public sector, has prompted the informal private sector to respond. Georgians have lolg had an entrepreneurial tradition and such response is rooted in ancient history. For example, European Non Governmental Organizations (NGO's) report wheat productioni by small plots of 450,000 tolls per yerr.  ii Policy Note Prior to 1991, there was no significant wheat production in Georgia. The wheat is traded informally within Georgia and across its borders. The case of fuel is another relevant example. Fuel at controlled prices is not available. At the same time fuel sold directly from "importing" trucks is widely available at a market price quoted in hard currency for foreigners and in Russian rubles for the local population. The price of a gallon of gasoline approaches world prices: in June 1994 and May 1995, it was comparable to the price of gasoline in Washington D.C. at that time. The same entrepreneurial response is evident throughout the economy, with small shops, bakeries, garages, car rental services appearing spontaneously, despite difficult conditions and against all odds. Major Issues 5. Lack of Policy Framework. The macroeconomic policy framework is still being developed. So far, this has encouraged the growth of an economy outside the established legal structures. This situation increases costs to producers and traders while forcing economic activity underground. It also leads to de facto tax evasion with a short fall in state revenues. In the case of transport, it has slowed down the removal of price controls, the inception of adequate cost recovery, and has delayed privatization in the sector. 6. Growth Prospects. A significant reversal of the economic downturn experienced by Georgia is not likely in the near term. In 1992, the economy contracted by 40% and in 1993 by 30%. Continuing contraction of the Russian economy, disruption of trade, and political instability are the main reasons for this difficult economic situation. The Government recognizes that the key to economic recovery will be the implementation of a comprehensive program of reform combining stabilization policies, structural adjustment and privatization. Such a program already started with World Bank, IMF and other external support. Since such measures will take some time in taking hold, the demand for transport is expected to remain significantly depressed (e.g., below 1990 levels) at least in the near future. 7. Agenda for change. The program of reforms still under preparation would emanate from four basic premises: (i) consolidation of a new role for the State with a reduced Government size; (ii) creation of an enabling environment for the development of competitive markets; (iii) attainment of macroeconomic stabilization; and (iv) divestiture of state owned means of production - privatization. 8. Role of the State and Government Size. A major change is planned to take place in the role of the State throughout the economy, and in particular, the transport sector. The State would renounce its current role as the only significant owner and decision maker in most economic activities, and would assume a subsidiary role instead. This implies that the State would not run businesses or services, hold monopoly positions, or participate directly in productive activities. Furthermore, micro-management of behavior of economic agents in an attempt to determine final outcomes would be avoided. The new role of the State is to implement the policies necessary to: (i) assure transparency in markets for goods and services; (ii) allow price flexibility as a response to market signals; (iii) ensure freedom of entry and exit from markets; (iv) divestiture of State monopolies; and (v) carry out the allocation of State assets by means of bidding of limited rights over scarce public resources, e.g., radio frequencies, urban rights of way. 9. Creation of an Enabling Environment. An enabling environment provides the measures to allow entrepreneurs the perception of fairness, openness and freedom from intervention. It does not include assurances of profitability. The subsidiary role of the State is a necessary condition, but it is not sufficient. In addition, the following elements need to be present: (i) open, de-regulated capital markets;  Policy Note iii (ii) availability of foreign exchange at or close to its opportunity cost; (iii) non-confiscatory tax systems; (iv) clear property rights; (v) no distinction between "national" and "foreign" private sectors, vis-a-vis all relevant legislation; and (vi) the perception of an unwavering purpose to implement and uphold (i) through (v) above on the part of the public authorities. 10. Economic Stabilization. The necessary steps for macro economic stabilization are: (i) rigorous management of public finance and the balance of payments; (ii) reforming the state to support a market economy and reorienting government spending; and (iii) improving public sector management and performance. 11. Privatization. This is the transfer of production responsibilities from the public to the private sector. For this to be done, the State needs to renounce ownership of the productive undertakings it currently possesses by selling them to the private sector. This transfer can take various forms, depending on the circumstances, the amounts involved, how quickly it is to be effected, and the entity concerned. Increasingly, the State should act by omission as it is already happening. If it is absent from the scene, the private sector can take shape, grow and develop. Active State presence will tend to inhibit, weaken and, in most cases, prevent the private sector from functioning as it should. B. THE TRANSPORT SECTOR 12. The transport sector shows significantly reduced traffic flows in all modes compared with those of only a few years ago. About one fourth of 1990 levels were observed in 1993. Little, if any, maintenance (even basic routine maintenance) was being done. The impression is that the transport system is "existing on its capital stock". The asset base is eroding and may, within the next five years, deteriorate to the point at which maintenance and rehabilitation are no longer possible. If this occurs, the only option will be costly and complete reconstruction. Worsening the picture, the conflict in Abkhazia severely damaged road and particularly railway infrastructure: several bridges were blown on the critical link between the Black Sea ports and eastern Georgia; railway electric wires were vandalized and the signalization system was destroyed. The effects of this deterioration of the transport system would be felt by other economic sectors that rely upon it. 13. The sector, with the exception of the aviation sub-sector, still operates under the organizational and policy structures of earlier days. Pervasive in the sector is the absence of meaningful cost recovery and resource mobilization, with the inevitable consequence of unfunded operating entities, poor service and a degradation of infrastructure and equipment. The sector itself is in disarray: four modes report directly to a Deputy Prime Minister responsible for the infrastructure sectors, and a fifth, (the road infrastructure sub-sector) reports to the Council of Ministers. There is no reliable, consistent information base, and transport statistics are not being collected any longer. Since there is no Ministry of Transport, there is no sectoral focus at the policy making level. 14. The disappearance of the Ministry of Transport needs to be seen in the context of a needed contraction in the civil service, with more and more responsibilities concentrated in fewer and fewer hands. However, this trend carried to an extreme has adversely affected the policy-makers' ability to formulate sector policy, carry out reforms and adjust to new realities. Since the restoration of the Soviet- style civil service would not be advisable, this presents a unique opportunity to organize reforms and privatize the sector.  iv Policy Note t5. The sector needs to move toward privatization and much greater use of the market mechanism than previously. In this regard, the recent reorganization of the aviation sub-sector is demonstrative of how such a program of reforms leads to greater efficiency, availability of finance, new investments and improved maintenance. The present lack of economic activity provides a convenient window in which to effect the institutional changes necessary. The time available before the economy recovers may be limited, and the sector may need to be restructured and market-oriented to be able to perform under increasing traffic volumes. There are indications that officials are beginning to accept the logic and the inevitability of the changes that will be needed. There is also evidence that they also realize the extent to which their roles and responsibilities will be altered. 16. Thzere is only one chloice to improve efficiency, wvhich is to operate commercially across transport modes. In addition, the Government of Georgia does not have the resources to operate the transport sector. 77Te size of the Governmnent is likely to remain limited and this, in turn, implies that regulatory conttrols and ownership would be relinquished. At an initial stage, the process of privatizing the sector could be vested in ministries im7plementitng the economic reform program. C. THIE REFORMED TRANSPORT SECTOR - A VISION 17. The future transport sector of Georgia is likely to rest on the privatization of all transport services. Public provision of infrastructure such as roads, airports, and navigation aids for sea and air transport would take place on the basis of full cost recovery. The transformations that would take place in the transport sector would respond to the changing role of the State, the opening of the economy, and the recovery of economic activity. The number of operators, clients and, more generally, decision makers will grow. Initial beneficiaries of the opening and expansion of the sector will be its users, operators and specialized commerce and financial intermediators. 18. The transport sector will continue to be an incubator of entrepreneurial activity. Small enterprises will be launched, and significant amounts of labor will be absorbed. The main areas of expansion are going to be in trucking and bus transport, freight forwarding, regional aviation (8 independent airlines already operate in Georgia) and, to a lesser extent railways and shipping. Recurrent maintenance and rehabilitationi will represent a new market for the local civil works contracting industry. This activity, as the beneficiary of the application of cost recovery flows, would not be dependent on the central government budget. 19. The successful commercial operation of the sector calls for a financial framework suitable to sustain operations in a market economy and mobilize resources. The allocation of private investment resources would take place within this framework. The allocation of public investments being a part of the public expenditure would require different mechanisms. 20. Financial Framework. An acceptable financial framework for the transport sector would be compatible with the goal of privatizing services and achieving a current net public revenue position for the sector as a whole. Under such a financial framework, the transport sector would be able to expand in concert with the economy, and would cease being a drain of scarce public resources. Key aspects of the financial framework are the following:  Policy Note v (a) Realistic valuation and periodic adjustments of the foreign exchange rate; (b) Reduction and uniformity of custom duties; (c) Elimination of foreign exchange controls and freedom to buy (and sell) foreign exchange from the banking system at the prevailing commercial rate: (d) Liberalization of commercial banking: (e) Managerial freedom to purchase necessary equipment, software and technical assistance, subject only to the financial constraints of a market economy; (f) Elimination of State subsidies; (g) Freedom to set levels of service, and select routes and frequencies of service: (h) Liberalization of prices; (i) Unrestricted entry for private investors into the transport markets; and (j) Recovery of the cost of public infrastructure. 21. Allocation Mechanisms. Private Investments. For private investments, market forces, prices, costs and access to commercial credit will influence the flow of resources to the transport sub-sectors of Georgia. Global "allocation" of private investment would follow the pace of de-regulation, liberalization and privatization of the economy. The stronger the pace of change, the stronger the response from the private sector. In the end, there is little for policy makers to do to assign private sector flows because the price system, once liberalized, becomes the allocation mechanism. Each private activity in the sector will have a return resulting from the difference between the cost of production and the prices charged for the output. If prices are not fixed and there is no interference with what can be produced or who can produce it, the supply of goods and services will tend to grow and will attract investment until all unsatisfied demand has been met. 22. Public Investments. The case of direct government expenditure or public debt guarantees is different. A choice amongst sectors is required first, followed by an allocation to possible uses within that sector. This requires a thorough evaluation of all possible uses for these resources against their benefits. It is necessary to determine the social and economic returns for each option, followed by a descending ranking according to the contribution of each to development. The cut-off rate (i.e., the rate of return below which projects will become ineligible for government support), will be given by the level of resources available. It is the rate of return of the last project which can be financed prior to exhausting the resources available . Only projects showing a return in excess of the cut-off rate of return will become candidates for direct government investment or benefit from debt guarantees. D. HOW TO GET THERE - A STRATEGY FOR CHANGE 23. The strategy for recovery in the transport sector includes the following elements: * Privatization of transportation services. * Deregulation and price liberalization. * Cost recovery on public investments to ensure financial sustainability. * Removal of bottlenecks for an immediate development response.  vi Policy Note The Private Sector Role - Actions on Privatization 24. Initially, services that can be provided by one or a small group of individuals should be transferred first to the private sector (both operating and ownership rights). This would affect large and small buses, taxis, light trucks, related auxiliary services, and maintenance in the road and rail sectors. 25. Services which are simple to provide and do not require large capital sums, sophisticated technology, or major investments should follow. This would include specialized transport services (e.g., for schoolchildren, tourists, personnel, valuables, mail, etc.) and those of a certain size providing auxiliary services (e.g., airline caterers, ship chandlers, cleaning/maintenance/repair firms). 26. Subsequent phases would focus on enterprises and/or services that utilize advanced technology and require heavy investment and whose promoters must have the financial capacity to cover both. In this group would be companies that: provide stevedoring and cargo-handling services at ports and airports; offer locomotive, ship and aircraft maintenance and repair services; hold concessions to provide port and rail services; and own (or hold shares in) airlines, trucking companies and shipping lines. 27. The transfer of enterprises from the State to the private sector would take place by any of the following methods: (a) Sale of assets. Since the individual assets are sold separately there can be a number of small purchasers. (b) Sale on a turnkey basis. The enterprise is sold as a whole, with all its assets and liabilities. In this case, the sale should be by public auction, on realistic and well publicized conditions published sufficiently in advance to attract the maximum number of potential buyers. Enterprises that are not sold at or over reserve after more than one attempt can be knocked down to the highest bidder. (c) Liquidation. The state enterprise disappears, making way for its replacement through efforts by private entrepreneurs. (d) Partial sales. Where large enterprises have ancillary activities (such as inputs they provide themselves, maintenance and repair shops, vehicle fleets) these can be sold off first, leaving basic activities to be sold at a later stage. (e) Conversion into a stock company with sale of shares. One way of selling large enterprises is to first convert them into stock companies and then to sell blocks of shares that will enable the new stockholders to familiarize themselves with the enterprise and to then participate in its management. (f) Sale for cash or on credit. This relates to the method of payment for the enterprise sold. In the case of enterprises where the workers' skills and expertise are important, this makes them desirable to potential buyers and sale on credit may enable the workers themselves to obtain ownership. (g) Auctioning of supervisory or control functions. The State would still have certain control functions in the fulfillment of its public duties. These functions themselves could be the subject of contracts with the private sector. An example is compliance with rules  Policy Note vii on pollution control. In such cases, bids would be sought from contractors to perform such control functions. DeregulationlRegulation 28. The areas where deregulation under consideration would assist the development of the transport sector are the following: (a) Decontrolling of prices. Georgia's de facto price freedom needs to be formalized. The alternative, i.e., the power to fix prices, entails: subsidies; support for and shoring up of inefficient industries and/or producers; shortages; black markets; and prevents prices from assisting in resource allocation. (b) Free foreign exchange and financial services markets. The price of foreign exchange should be based on the amount of foreign exchange held by the economy and access to it generalized. (c) Opening of foreign trade. With the price of foreign exchange set at its real value, there would not be any need to protect foreign exchange saving activities. Informal trade and smuggling would be reintegrated into the formal economy, and intensive production would be undertaken in areas of comparative advantage to be able to buy those goods that cannot be produced efficiently. (d) Free access to economic activities. One of the real prerequisites for a free economy is the removal of those barriers which prevent citizens from producing what they want. Existing regulation not being enforced would be abolished. Applications, permits, studies, demanded under cover of the argument that there has to be "order" in the activities concerned amount to artificial barriers and additional costs . (e) Elimination of economic controls. Another source of distortions and efficiency losses is needless controls. It can be argued that the best control known is that exercised by consumers and the checks and balances produced by competing interests. The only regulations expected to remain or be developed relate to international safety and environmental standards. This applies, for instance, to the current fuel distribution and retailing system wvhich, although liberalized, does not operate under strictly enforced safety and environmental regulations. Cost Recovery of Public Investments 29. A combination of user charges such as fuel taxes, licenses and direct usage charges would be established to recover the costs of developing, maintaining and rehabilitating public investments in the sector. This would be the case of roads, railroad trackage, and navigation aids for air and sea transport. Such a system would be necessary to address significant issues currently faced by Georgia which are common to most FSU countries. They are the following: the risk of loss of valuable infrastructure and mounting rehabilitation needs; accelerating de-capitalization from maintenance backlogs; obsolete equipment; and shortage of spare parts. Georgian roads and railway tracks have not been maintained in the last 4 years. Port dredging at Poti, delayed for several years, is only now being partially addressed, at a much higher cost than the one of periodic maintenance.  viii Policy Note Removal of Bottlenecks 30. A short term minimal rehabilitation phase could be seen as a launching platform to the implementation of the strategy. Removing transport bottlenecks would give the leverage to bring back into use unusable or inaccessible infrastructure. The priority is to be given not to massive reconstruction or rehabilitation of complete road, port or rail infrastructure, but to the minimum investments required to allow through traffic. This would be done independently of whether a full cost recovery system for public investments is operational. It would focus on roads or railways where traffic is constrained, and where the likelihood of overloads is strong once the traffic starts developing. This short-term minimal rehabilitation phase could end as soon as in 1996, when most of the economic transformation of the sector would be well underway and when a road user charge system would be implemented. 31. Regarding overloading of vehicles, the most advisable approach is to initially set road user charges on the premise that overloading will take place (this is already the case with Turkish trucks going to or transiting through Georgia), and that an additional infrastructure cost needs to be collected. The reason for this approach lies in the fact that axle loads limits are, by and large, unenforceable, and the marginal revenue to the transporter is likely to remain far higher than the marginal cost he might face. In fact it may be in the interest of economic development that some initial overload takes place, provided that the cost of the earlier rehabilitation of the road is recovered from the commercial users. E. THE PRIORITY AREAS 32. The priority areas are road transport (both passengers andfreight), ports and road infrastructure. Trucking needs to be privatized as soon as possible to bring into operation the existing fleet and support the emerging private economy; the thrust for this reform is not likely to come from the state owned enterprises themselves. The reform should be placed in the short term divestiture of State property under the proposed strategy, combined with liberalization of entry and tariffs, and the elimination of Government subsidies, direct or indirect. This would put all operators at the same footing and, inter alia, eliminate official prices for fuel. Passenger transport would be privatized and liberalized at the same time and under the same conditions as freight. It would include urban transport which would be auctioned off or liquidated at the same time that tariffs are liberalized. 33. The Government has recognized the need for reform in the road transport sub-sector by recently issuing two pieces of legislative action: (i) a decree on privatization including road transport services, which calls for the privatization of road transport entities by October 1995; and (ii) an April 4, 1995 law on road transport which liberalizes road transport and reorganizes the road transport department. The department would become the regulatory body of the sub-sector, dealing with road transport licensing as well as environmental and safety issues. The priority now is the acceleration of this privatization process. 34 Ports (Poti and Batumi) are key to foreign trade and presently represent a high cost Government monopoly. Their reorganization would include separation into independent port authorities, commercially operated and with ownership vested in regional or national governments, with optional privatization at a later stage. All port services would be privatized, and the ports allowed to compete among themselves. Port specialization, if any, would become an outcome of successful competition and physical advantages of port sites, as opposed to the result of good planning decisions. Today, there exists excess port capacity.  Policy Note ix 35. Road Infrastructure managed by the State Highway concern is of particular importance to the support of local production and distribution. The Highway concern should: (a) develop a program of maintenance and rehabilitation of the core (priority) network; (b) reopen rural links to reopen access to markets for local agriculture; (c) establish a cost recovery system to fund maintenance and rehabilitation works; and (d) develop a program of technical assistance addressing: (i) the reorganization of the concern, by privatizing its construction units and reorienting the institution to financial resource management, and management of work contracts (the programming of works and their supervision is a function which could be itself privatized); (ii) definition of priority maintenance and rehabilitation works; (iii) road user charges; (iv) review and adjustment of technical specifications of road infrastructure including bridges; (v) regulations and training on competitive procurement; and (vi) a sample work program to pilot improvement of local procurement and of the local construction industry. 36. The priorities indicated above correspond to areas of concentration, if exclusive choices were to be faced by the decision makers elaborating the economic reforms. Such choices could be the result of lack of resources, institutional capacity, actual delays in launching preparation work or similar difficulties resulting in nothing else being possibly done. True as this may be, the assignment of priorities is not an advocacy to postpone action on shipping, the railways and aviation, or to give these sub-sectors a status of exception from the adjustment process. The assignment of priorities only reflects the fact that the railways' main role is as a transit service for inland destinations, and as such its level of traffic and ultimate survival is related to the political and economic situation of its neighbors. Similarly, if the ports are operational and exports are reestablished, local shipping's turn to change ownership would come under the privatization initiative. Aviation and its institutions are well in the way towards reform and commercialization and an open skies policy is being followed. F. THE EVOLUTION IN THE MEDIULM TERM 37. This section presents the numerous actions involved in implementing the reform strategy. These actions are best summarized as four concurrent chains of events, and associated processes. They concern the following areas: (i) change in the role of government; (ii) evolution of the legal and regulatory framework; (iii) strengthening of sector institutions; and (iv) private sector participation. Subject to launching by the government of an economic reform program in 1995, the restructuring of the transport sector could be practically completed by 1999, with further refinements and adjustments thereafter. This process over time is structured as a matter of convenient presentation in tranche or phases grouping specific actions according to whether their nature is immediate or preparatory (1995-1996); structural (1996-1997); and consolidating (1998-1999). 38. The measures enumerated below are in no way novel to Georgia. As indicated earlier, a de facto privatization with a reduction of the size of Government is underway and therefore the actions proposed might appear to be superfluous. However, the fact is that the natural responses observed, healthy as they may be, are technically illegal and could be reversed, while Government assets go unused or used inefficiently to a significant extent. Because economic activity is already taking place beyond the limits established by traditional statutes, measures that regularize existing practice or facilitate it further are not likely to be resisted. The opportunity may exist for swift change without major resistances to it. Accordingly, the presentation under time slices of the suggested reforms should be considered only as indicative, i.e., those structural reforms which may be ready for implementation earlier than others (e.g., in the road transport sub-sector) should go forward without delay.  x Policy Note 39. The World Bank's recommendation is that, concurrent with broader economic reforms, resources should be engaged to prepare and carry out the structural reform and privatization of all transport services as follows: PHASE I - Immediate Actions (1995-1996) (i) Evolution of the Government's Role (a) Formal announcement of the intent to move the sector towards a market economy; (b) Periodic adjustments to the foreign exchange rate, to reflect real depreciation of the local currency, and market liberalization' . 2; (c) Public conmmunication of a deficit elimination program in the sector, implementation of its first phase and adjustment of prices and tariffs; (d) Preparation of bid documents for the divestiture of assets by enterprises in the sector2; (e) Announcement of studies to prepare measures under Phase II below; and (f) Simplification of import and export procedures. (ii) Evolution of the Legal and Regulatory Framework (a) Reform of taxation applicable to enterprises generally and to the sector in particular; (b) Simplification and revision of commercial legislation codes; (c) Review and revision of legislation ruling foreign investments; and (d) Announcement of the modifications under consideration for introduction in 1996- 1997. (iii) Strengthening of Sector Institutions (a) Determination of the personnel needs in downsizing the public administration related to the transport sector; (b) Determination of the market conditions under which qualified staff can be attracted and retained; and (c) Liberalization of markets for vocational training. (iv) Private Sector Participation (a) Further expansion of private participation in ownership of transport enterprises and elimination of State monopolies; (b) Initiation of deregulation of routes and levels of services; (c) Measures to expand the availability of financial services; (d) Monitored liberalization of prices; (e) Reduction of Custom duties'; and (f) Simplification of applicable taxation. 1/ Proper valuation of foreign exchange in combination with reduction and simplification of duties are necessary to facilitate the development of the private sector along lines of comparative advantages. 2/ This is already part of the Government Economic Reform Program.  Policy Note xi PHASE II - Structural Refortns (1996-1997) (i) Evolution of the Government's Role (a) Continuation of the deficit elimination program; (b) Announcement and publication of revised bidding and procurement procedures for the State; (c) Call to bids for divestiture of assets by state enterprises in the sector; (d) Publication of Environmental and Safety regulations; (e) Reduction in employment in state enterprises in the sector; (f) Reform and simplification of custom duties; (g) Completion of liberalization of tariffs and routes; and (h) Sale of 50% of shares of state enterprises. (ii) Evolution of the Legal and Regulatory Framework (a) Reform and update Banking legislation and liberalization of Banking services; (b) Legislation on contracting, bidding and procurement by the State; (c) Reform and restructure custom duties; (d) Revocation of the State's authority to set prices; (e) Legislation on capital markets. (iii) Strengthening of Sector Institutions (a) Introduction of investment appraisal for all investments having either public funds or benefiting from a public guarantee; (b) Announcement of the cut-off economic rate of return for the financial year; and (c) All enterprises in the sector operate in a competitive environment. (iv) Private Sector Participation (a) Continuation of Phase I actions to cover remaining sub-sectors and services. PHASE III - Consolidating Actions (1998-1999) (i) Evolution of the Govermnent's Role (a) Complete sale of shares and asset divestiture in sector enterprises; (b) Completion of the deficit elimination program; (c) Publication of reporting obligations of sector enterprises; and (d) Reorganization of the public administration and Ministries related to the sector.  Xii Policy Note (ii) Evolution of the Legal and Regulatory Framework (a) Establishment of appeals mechanisms under the new legal and regulatory framework. (iii) Strengthening of Sector Institutions (a) A program of personnel development for the reorganized public administration related to the sector; and (b) A program of technological innovation to continue the reduction of the public administration of the sector. (iv) Private Sector Participation (a) Completion of substitution of the State by the private sector in transport enterprises; and (b) Investment levels in transport by the private sector in response to demand under market determined prices and subject to financial constraints. G. ASSISTANCE STRATEGY 40. The need for assistance to Georgia's transport sector is substantial. The situation is quite desperate, aggravated by institutional breakdowns, financial imbalances, and stoppage of practically all maintenance work. Were it not for the technical assistance and other grant support from bilateral donors to the ports and railways, emergency assistance to Georgia and neighboring countries would have not reached its destination. 41. There are many obstacles to overcome. The absorptive capacity is limited, debt capacities small, and revenues limited. Technical assistance and training, so far accepted and welcomed by the Government, have an obvious role to play. The continuation of current technical assistance and direct operational support to maintain the flow of humanitarian aid to both Georgia and Armenia may be needed for as long as a more comprehensive approach to the sector is not forthcoming. In addition, any financing made available to the sector would need to be on concessional terms. 42. As the needs to reorganize and rehabilitate the transport sector are extremely large, the priorities are to strengthen the institutional and regulatory framework for the sector and to finance the rehabilitation and maintenance of key infrastructure. It is proposed to structure the donor community's strategy for the transport sector into:  Policy Note xiii (a) A medium-term strategy including: * Sector Institution Building The sector institutions which would be assisted range from the ministries formulating the sector's reform program, to sub-sector entities such as ports, railways, and the Highway Concern. The assistance would cover: legal frameworks; attributions and functions of the sector institutions in a market economy; restructuring of public enterprises in the sector to enable their independent operation in a competitive environment and prepare their privatization, liberalization of transport and of freight forwarding markets; and privatization of road freight and passenger transport. * Privatization or Commercialization of Sector Enterprises The privatization and commercialization of sector operations, and attendant restructuring, will give incentives to the determination of corporate structure and costs of viable transport enterprises. If left untouched, these enterprises would not be credit worthy, would be unable to raise capital to assure their sustainability, and would be candidates to liquidation. * Cost Recovery for Transport Services and Infrastructure Cost recovery by means of restructuring, does not guarantee minimum transport costs. This can only result from competition among suppliers of transport services within and across sub-sectors. The need to ensure competition and have market determined prices leads to the liberalization of entry and prices for transport services. * Rehabilitation of key infrastructure Georgia should start considering investment in new infrastructure only when the existing services are brought back to a reasonable level of operation and traffic has started flowing again. Today, the humanitarian food aid cargo makes up for most of the port and rail traffic. Such traffic is temporary. Significant transit traffic for the railways and ports such as it once existed is not likely for as long as the Caucasus region remains unsettled. (b) A short-term assistance strategy including: * Initiation of institutional strengthening * Rehabilitation and maintenance of the most critical transport infrastructure bottlenecks  xiv Policy Note H. WORLD BANK ASSISTANCE Short Term Assistance 43. Given the urgent needs to assist the Government of Georgia with the rehabilitation of the transport infrastructure, it is proposed to start with an IDA credit for a Transport Rehabilitation Project. The project would address directly existing bottlenecks and be a catalyst for the adjustment of the sector and restructuring of its institutions. It would have two main components, institution building and investments, as follows: * Institution Building Component, which could include (i) support to teams preparing sector reforms; (ii) assistance for the formulation of technical and legal frameworks necessary to the restructuring, commercialization and privatization of sector entities; and (iii) managerial assistance for public and private transport enterprises. This component could be financed through donor grants. * Investment Component, which could include the financing of selected equipment, spares, and rehabilitation works to remove existing bottlenecks in the transport sector, e.g. critical loading intermodal infrastructure at the ports, the most deteriorated bridges, and critical sections of the railroad and road networks. This component, oriented to restore existing physical capacity to address current needs, would n1ot cov er new inivestments in transport. These actions would amount to a necessary first step, and would lay down the basis on which to develop a program of financial assistance for transport once economic recovery is established. 44. The Transport Rehabilitation Project would be prepared in close collaboration and coordination with USAID, WFP, EU-TACIS and EBRD. Given the severity of current transport dysfunctions, it is also recommended that the short term phase of World Bank assistance be accelerated to the maximum extent possible under the Country Assistance Strategy for Georgia. Medium Term Assistance 45. The rehabilitation, restructuring, and orientation towards a market economy of operations in the sector could be assisted with additional lending over the following five year horizon. The extent of this medium term assistance, would be subject to: (a) the successful implementation of the Transport Rehabilitation Project, (b) economic recovery in neighboring countries and demand for transit services; and (c) increased economic activity and transport demand. Possible World Bank and/or other donors assistance should be targeted as follows: * Rehabilitation of the Core Road Network. Clearance of Georgia's severe backlog of maintenance and rehabilitation of international roads would require initially US$55 million. It would help launch the system of bidding to private construction companies for road works and maintenance, establish cost recovery systems. and would help establish a mechanism for the rehabilitation of rural roads.  Policy Note Xv Restructuring the Railways. Under the current financial conditions, and institutional and organizational structure, the railways will find it difficult to compete in the future market. A corporate strategy addressing privatization needs to be formulated, accounting systems need to be updated, and the fare structure revised for cost recovery and generation of debt capacity to carry out investments. Asset management strategies need to be formulated, including divestiture where applicable. This project would include, in addition to specific technical assistance, training of technical and management staff, and investments for rehabilitation of selected assets. * Restructuring Urban Transport Services. Technical assistance is needed to privatize the urban transport sub-sector. In addition, investment is necessary to renew buses and procure spare parts for the bus fleet on a continuing basis. Implementation of liberalization of fare structures to allow operation by private operators would also be necessary. * Port Rehabilitation and Implementation of Autonomous Port Operations. The implementation of the legal framnework recommnended above would introduce autonomous commercial port operations with participation of the private sector, and competition among ports. This may result in clear specializations along comparative advantages. Investment may be required to rehabilitate, upgrade and even expand some port facilities. Once identified and evaluated, these investments and training necessary would become eligible for financing. * JUpgrading of Air Traffic Control. Carefully selected expenditures now under identification with USAID support, are needed to remove the current isolation of Georgia from the main international overflight routes and improve access. 46. Investments to be undertaken by the public sector over the next five years, should concentrate on rehabilitating the existing infrastructure, rather than on new construction, subject to cost-benefit analysis. Investment by the World Bank would be open to co-financing by other multi- and bilateral organizations. 47. Under the current situation of Georgia, it would seem advisable to postpone consideration of any substantial investments for the trans-Caucasus corridor until transit traffic is reestablished on the existing transport capacity. In so doing the Government and the international finance institutions would be concentrating their energies on the most urgent problems facing Georgia's transport sector.    ~~~ i- ~ 4 4~~~~~~~~~~4