Uzbekistan - Social and structural policy review

Report No 19626 Uzbekistan Social and Structural Policy Review August 25, 1999 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region Document of the World Bank  CURRENCY AND EQUIVALENT UNITS Currency Unit = Soum US$1 = 117.81 (at official exchange rate) ACRONYMS AND ABBREVIATIONS CBU Central Bank Of Uzbekistan MOF Ministry of Finance CSWCM Center for Study of World MFER Ministry of Foreign Economic Commodity Markets Relations CIB Credit Information Bureau MOL Ministry of Labor CPI Consumer Price Index NBU National Bank of Uzbekistan DALY Disease-Adjusted Living Years OECD Organization for Economic EBRD European Bank for Reconstruction Cooperation and Development and Development PAYG Pay-As-You-Go ERP Effective Rate of Protection PF Pension Fund FAO Food and Agricultural Organization PIF Privatization Investment Fund FBS Family Budget Survey PIP Public Investment Program FDI Foreign Direct Investment RCMCP Republican Commission on FSU Former Soviet Union Monetary and Credit Policies GDP Gross Domestic Product SOE State-Owned Enterprise GKI State Committee on Privatization SSPR Social and Structural Policy Review and Support of Entrepreneurship STF Systemic Transforrnation Facility HDR Human Development Report TIN Taxpayer Identification Number IMR Infant Mortality Rate TRSE Tashkent Republican Stock Exchange IMF International Monetary Fund UNDP United Nations Development Program JSC Joint Stock Company URCE Uzbekistan Republican Currency Exchange MMR Maternal Mortality Rate VAT Value-Added Tax MMS Ministry of Macroeconomics and WDR World Development Report Statistics WHO World Health Organization FISCAL YEAR January 1 to December 31 Vice President: Johannes Linn Country Director: Ishrat Husain Sector Director: Pradeep Mitra Sector Leader: Ataman Aksoy Team Leader: Asad Alam  TABLE OF CONTENTS PREFACE .....................................................i EXECUTIVE SUMMARY ..................................................... ii INTRODUCTION ......................................................1 SECTION I ECONOMIC POLICIES AND MACROECONOMIC PERFORMANCE .3 CHAPTER 1 ECONOMIC POLICIES AND PERFORMANCE .4 Initial Conditions and Adoption of a Gradual Approach .4 Period of Slow and Limited Reforms (1992-93) .5 Period of Reform Acceleration (1 994-Q3 1996) .7 Period of Mixed Progress (from Q4 1996 to the present) .9 Macroeconomic and Transition Performance Compared .11 Sustainability of Macroeconomic Performance .13 Conclusions .14 SECTION II INCENTIVES FOR PRIVATE SECTOR GROWTH ............................................. 16 CHAPTER 2 FOREIGN EXCHANGE ARRANGEMENT .17 Structure of the Foreign Exchange Market .17 Rationale for the Current Arrangement .19 Experience with the Current Arrangement .19 Implications for the Rest of the Economy .22 Currency Convertibility and Structural Reform .24 Conclusions .24 CHAPTER 3 TRADE REGIME .25 Overview of the Trade Regime .25 Recent Trade Developments .26 Key Objectives, Policies, and Outcomes .29 A Strategy for Export Promotion .31 Conclusions .32 CHAPTER 4 FINANCIAL SECTOR .33 Structure of the Banking System .34 Prudential Regulations .36 Payments System .38 Banking Sector Restructuring, Privatization, and Liberalization .39 Interest Rate Regime .42 Non-Bank Financial Sector .43 Conclusions .43 CHAPTER 5 AGRICULTURE SECTOR .44 Overview of the Agriculture Sector .44 Key Objectives and Outcomes .49 Inconsistencies in Polices .54  A Strategy for Reform ........................................................... 54 Conclusions ........................................................... 56 CHAPTER 6 ENTERPRISE PRIVATIZATION ........................................................... 58 Overview of Privatization ........................................................... 58 The Privatization Investment Funds (PIF) Program ...................................................... 59 Privatization of Large-Sized Enterprises ........................................................... 61 Legal and Regulatory Framework ........................................................... 62 Leading Indicators of the Quality of the Privatization Program ................................... 62 Conclusions ........................................................... 65 SECTION m PUBLIC SECTOR MANAGEMENT AND INSTITUTIONAL QUALITY .67 CHAPTER 7 PUBLIC SECTOR MANAGEMENT-AN INSTITUTIONAL PERSPECTIVE ...... 68 Aggregate Fiscal Discipline ........................................................... 68 Expenditure Prioritization ........................................................... 70 Technical Efficiency ........................................................... 72 Corruption ........................................................... 73 Accountability and Transparency ........................................................... 73 Private Sector Perceptions of the Credibility of the State ............................................. 74 Conclusions ............................................................ 76 SECTION IV SOCIAL DIMNSIONS .77 CHAPTER 8 LIVING STANDARDS AND SOCIAL PROTECTION ........................................ 78 Living Standards ........................................ 78 Social Protection ........................................ 83 Pensions ........................................ 86 Conclusions ........................................ 88 CHAPTER 9 HEALTH AND EDUCATION ........................................ 90 Health ......................................... 90 Education ........................................ 93 Conclusions ........................................ 101 SECTION V CONCLUSIONS .103 CHAPTER 10 CONCLUSIONS .104 An Agenda for Key Policy Reforms .105 LIST OF TEXT TABLES Table 1.1 Selected Indicators of Macroeconomic Policies and Performance, 1992-97. 6 Table 1.2 Uzbekistan and Other FSU Countries: Transition Perfornance Compared .. Table 2.1 Structure of the Foreign Exchange Market .18 Table 2.2 Estimated Redistribution of Income through the Official Segments of the Foreign Exchange Market, 1997 .20 Table 2.3 Effective Rates of Protection, 1997 .21 Table 3.1 Composition of Foreign Trade, 1993-98 ............................ 27  Table 3.2 Summary of Import Duties ........................ ................................................... 28 Table 3.3 Number of Tariff Line Items ......................... ................................................. 28 Table 3.4 Revenues from Trade Taxes, 1992-98 .......................................................................... 29 Table 3.5 Selected Indicators of Export Perforrnance, 1993-98 .......................................................... 30 Table 4.1 Banking System Concentration Ratios-Selected Countries (as % of assets) .................... 35 Table 5.1 Agricultural Area, Production and Yield, 1991-98 .............................................................. 45 Table 5.2 Net Resource Transfers in Agriculture .......................................................................... 52 Table 6.1 Quantitative Indicators of Enterprise Privatization, 1995-98 .59 Table 6.2 Indicators of PIFs Performance, 1997-98 .60 Table 6.3 Distribution of PIF Shares in Enterprises, 1998 .64 Table 6.4 Ex Ante Use of Privatization Proceeds, 1995-98 .65 Table 7.1 Selected Budgetary Expenditures, 1992-97 .71 Table 8.1 Public Health Spending, 1994-98 .81 Table 8.2 Rankings of Living Standards Indicators by Region ............................ .................. 82 Table 8.3 Regional Distribution of Social and Children's Allowances .84 Table 8.4 Nominal and Real Average and Minimum Pensions, 1995-97 .87 Table 8.5 Projection of Pension Fund Balance under Different Scenarios, 1997-2006 .88 Table 9.1 Comparative Health Indicators for Uzbekistan (selected years) .90 Table 9.2 Education Outcome Indicators, 1996 .94 Table 9.3 Enrollment Trends by Age Group/Level, 1992-96 .94 Table 9.4 Pattern of Education Spending, 1995-97 .96 Table 10.1 Summary and Recommendations ........................................... ............................... 108 LIST OF TEXT FIGURES Figure 1.1 Index of the Real Official Exchange Rate and Curb Market Premium, 1993-99 .................. 8 Figure 1.2 Uzbekistan and Other FSU Countries: Macroeconomic Performance During Transition Compared .......................................................................... 12 Figure 2.1 International Liquidity, 1993-98 .22 Figure 4.1 Selected Countries: Level of Financial Intermediation, 1992-98 .34 Figure 4.2 Nominal and Real Interest Rates, 1996-99 .43 Figure 7.1 Fiscal Out-turns, 1992-98 .69 Figure 7.2 Private Sector Assessment of the State's Credibility ................................................ 74 Figure 7.3 Uzbek Firms' Leading 10 obstacles to doing Business ................................................ 75 Figure 8.1 Index of Real Wages, 1991-1997 .81 LIST OF TEXT BOXES Box 1.1 Why Inflation and Growth Estimates Differ .10 Box 1.2 Macroeconomic Impact of the Global Financial Crises on Uzbekistan .11 Box 7.1 The Role of the State .70 Box 8.1 The Mahalla: A Key Pillar of Uzbekistan's Social Protection System .85 Box 9.1 Teacher Compensation .98 Box 9.2 Manpower Planning: Problems and New Approaches .101  LIST OF ANNEXES Annex 1. Estimating the Amounts of Transactions at the Curb Market Exchange Rates ................................................................. 113 Annex 2. Calculating the Weighted Arithmetic Average Exchange Rate for the Soum, 1997 ................................................................. 113 Annex 3. Estimating Redistribution of Income through the Auction and the Commercial Bank Market in 1997 ................................................................. 114 Table A. Estimated Sources of Foreign Exchange Sold at the URCE, 1997 ................................................................. 114 Table B. Estimated Uses of Foreign Exchange Sold at the URCE, 1997 .................................................................. 114 Table C. Estimated Sources of Foreign Exchange Sold in the Commercial Bank Market, 1997 ................................................................. 115 Table D. Estimated Uses of Foreign Exchange Sold in the Commercial Bank Market, 1997 ................................................................. 115 Annex 4. Effective Rates of Protection ................................................................. 116 Table A. Effective Rates of Protection for Imports, 1997 ................................................ 116 Table B. Effective Rates of Protection for Exports, 1997 ................................................ 116 Annex 5. Relationship between the CPI and Exchange Rates .......................................................... 117 Annex 6. Net Resource Transfers in Agriculture-A Technical Note ................................................ 118 Table A. Redistribution of Revenues from Marketing of Cotton ..................................... 119 Table B. Redistribution of Revues from Productions and Marketing of Wheat ......... ..... 120 Table C. Explanations for Direct and Indirect Subsidies for Agriculture ........................ 121 Annex 7. Selected Performance Indicators ..................... ............................................ 122 REFERENCES .124 MAP ..................................................................................................................................... .127  PREFACE This report was produced by a Bank team composed ofAsadAlam (Team Leader, ECSPE,) Karen Brooks (ECSRE), Yuri Dikhanov (DECDG), Bahodir Ganiev, Alexander Kim (ECCUZ), Philip O'Keefe (ECSHD), Ronald Hood (PSDBE), Sandeep Mahajan (ECSPE), and Anand Chandavarkar (Consultant). Valuable comments and suggestions were provided by John D. Nash (ECSRE), Malcolm Holmes (PRMEP), John Nellis (PSDEN), Simeon Djankov (FSPE U), Cevdet Den izer (IFC), David Pearce (ECCUZ), Nicolas Mathieu (ECCOI), Itzhak Goldberg (ECSPF), Pedro Alba, Peter Fallon, Helcio Tokeshi (PRMEP), Christoph Rosenberg, John Wakeman-L inn, Robert Christiansen (IMF), and various members of the Uzbekistan Country Team. Homi Kharas (PRMEP), Daniel Kauflnann (EDIRP), and Silvina Vatnick (ECCRU) provided guidance as Peer Reviewers. Ishrat Husain, (Country Director, ECCOI), Robert J: Anderson, Wafik Grais, and Ataman Aksoy (Sector Leaders, ECSPE), provided strong sponsorship and intellectual inputs into the design and analysis contained in the report. The Task Team also acknowledges its debt to PREMAnchor for making additional financial resources available for the report. Miranda Cookson, Lorie Henson (ECSPE) and Raikhona Atakhodjaeva (ECCUZ) provided capable team support. The report was prepared withparticipationfrom the Government at key stages from concept through to final draft. Early drafts of the report were shared with the Government and the final draft was discussed with them. Comments receivedfrom the Government are reflected in this report. The Task Team is grateful to Mr. Bahtiyor Hamidov, Deputy Prime Minister and Minister for Macroeconomics and Statistics, for setting up a high-level multi-sectoral Working Group to facilitate the work for this report, and to the members of the Working Group for their cooperation. The Task Team is also thankful to Mr. Nariman Mannapbekov, Chief, Division for Cooperation with International Financial Institutions of the Cabinet of Ministers, and his stafffor assisting with the activities of the mission and the coordination of comments from various Government agencies. SCHEDULE OF KEY STEPS Concept Paper Review Meeting :May 6, 1998 Main Mission :May 11-29, 1998 Ist Set of Draft Chapters to Government :August 1998 2nd Set of Draft Chapters to Government :November 1998 Discussions With Government (I) :November 9-26, 1998 Written Comments from Government :Sep.-Dec. 1998 Country Team Circulation :December 17, 1998 Decision Draft Meeting :January 20, 1999 Final Draft to Government :March 1, 1999 Discussions with Government (II) :March 17-24, 1999 Additional Written Comments from Government :April 1999 Report to Government for Clearance for Board :June 1999 Distribution to the Board: :July 1999 i  UZBEKISTAN: SOCIAL AND STRUCTURAL POLICY REVIEW -AN ECONOMIC REPORT- EXECUTIVE SUMMARY i. This report-the first Social and Structural Policy Review (SSPR) for Uzbekistan-takes the stated objectives that the Government of Uzbekistan has given and provides a broad-based assessment of the success that the Government has obtained in achieving its objectives through its policies. The report develops broad recommendations where policy changes or institutional strengthening is required.' Where lessons from the experience of other countries appear relevant to the challenges that Uzbekistan faces, these lessons are drawn out. ii. There are at least three important areas of economic activity where the policy environment has decelerated economic growth. First, in agriculture, prospects for faster growth and improvement in living standards are being undermined by a massive transfer of resources out of the agriculture sector in support of the Government's import-substitution program. Second, the adoption of import-substitution policies have biased incentives against exports, and undermined the growth of competitive export-oriented industries and services. Although import-competing industries are growing, this has been achieved at high cost to the other sectors and by foregoing opportunities for developing robust export activities. Third, deficiencies in the institutional arrangements for fiscal management are leading to the perpetuation of inefficiencies in the banking system as well as in the allocation of scarce budgetary resources. While tax collection is being achieved by using the banking system, this use of banks comes at the cost of undermining the proper role of banks. At the same time, the absence of a modem treasury, and weaknesses in public expenditure planning, budgeting, and execution undermine efficient fiscal management. Achieving and Sustaining Macroeconomic Stability iii. The Government has achieved a measure of macroeconomic stability in 1998, with inflation having been reduced to under 30 percent (from a four-digit level in 1994), the budget deficit to 2 percent of GDP, the current account deficit to less than 2 percent of GDP, and real GDP having grown for three consecutive years. Several economic factors have contributed to Uzbekistan's relatively good macroeconomic performance during the first seven years of transition. These include the relatively low level of initial industrialization, the program of self-sufficiency in energy products, the production of cotton fiber, and the re-orientation of exports to hard currency markets. Now it is critical to deepen the market-oriented reforrns to sustain and improve upon this macroeconomic performance. International evidence suggests that greater progress in implementing market-oriented reforms leads to superior macroeconomic performance over the medium to long term, even though it may entail some short-term macroeconomic costs. The importance of market-oriented reforms in concert with essential institutional strengthening is also highlighted by the recent global financial crisis. While the coverage is broad, this report does not cover some sectors, which are also important to Uzbekistan's development strategy, reflecting information, data, time, and budget constraints. In particular, the report does not discuss the transport and energy sectors, which are important elements of Uzbekistan's development strategy, or the issues of environment. Other sub-sectoral issues not covered are the implications of the evolution of monopolistic market structures in the industrial sector, regional balance in economic growth, labor market, and various issues of public sector management. These and other areas of knowledge gaps are identified in the report and are proposed as the subject for future inquiry, perhaps jointly with the Uzbek authorities. ii  iv. The narrow export base, declining exports, high-cost import-substitution industries, and stagnant foreign capital flows have accentuated the vulnerabilities of the economy to exogenous shocks. The evidence is clear: in 1998, exports declined by almost 20 percent, imports fell by more than 25 percent, and the external public debt stock increased by 25 percent. Furthermore, net official international reserves are down to less than US$1 billion, the supply of foreign exchange is declining, the black market exchange rate premium is over 250 percent and increasing, and there are expansionary pressures in the budget from the large public investment program implicitly financed through imports at overvalued exchange rates. In addition, the current policy framework is undermining growth in those economic activities that could not only mitigate these risks but also become the engine of growth in Uzbekistan- such as agriculture and agro-processing, new small- and medium-scale businesses, exports, and services. Towards Market Incentives for Private Sector Growth v. The Government of Uzbekistan is committed to promoting private sector development in the country. The recent moves towards reforming and strengthening the financial sector are in the right direction. But an essential ingredient which is missing-and which the Government is fully aware of-is an adequate incentive structure for private sector growth, which can be elaborated in the context of four key areas-agriculture, trade and exchange rates, financial sector, and privatization. vi. Reform and Liberalization of Agriculture. Agriculture accounts for one-third of GDP and employs about 40 percent of the labor force. Accordingly, it is assigned an important role in the development strategy of the country. At the same time, the government seeks to reduce agriculture's share in the economy by stimulating growth in the industrial sector. In order to achieve this, the Government redistributes resources from agriculture to finance industrial development. Despite the priority placed on industrial development, the Government has ambitious objectives for the agriculture sector. Most important among these are growth in cotton production and increase in cotton revenues, attainment of domestic self-sufficiency in wheat, generation of revenues to finance investments in other sectors, and improved rural standards of living and employment. vii. Present policies are not achieving these goals, and are unlikely to do so in the future. Cotton export earnings are in decline as yields and international prices fall. Declining Uzbek yields reflect primarily inadequate price incentives and costly marketing arrangements. These policies lead to an excessive burden of taxation (much of it indirect or implicit), equivalent to over 6 percent of GDP in 1998 or about 60 percent of the international price calculated at a notional market exchange rate. While the explicit tax burden, in the form of excise taxes, has shrunken dramatically from the equivalent of 4.9 percent of GDP in 1994 to zero in 1998, the burden of implicit taxation has increased substantially. The primary implicit tax burden on cotton is from the (i) inefficiencies in the cotton marketing chain, especially from the monopsonistic ginning and the monopolistic external trading arrangement, equivalent in 1998 to 4.0 percent of GDP, and (ii) the overvalued exchange rate at which cotton export revenues have to be surrendered, equivalent in 1998 to 5.2 percent of GDP. Subsidies paid to cotton farmers in 1998, equivalent to about 3.2 percent of GDP, only partly offset the implicit tax burden. viii. Uzbekistan's self-sufficiency in wheat has increased during the period of independence, but the justification for this policy has become weaker as external supply has become more reliable and less expensive. Thus, the continued commitment to increase wheat production interferes with other agricultural activities that could bring higher earnings to rural families. In addition, prohibitions against transactions in land, and the current approaches to farm restructuring and to land reform are not adequate to support a major renewal of rural growth. Growth will require investment, and much of this will have to come from rural households themselves. With the present flow of resources out of agriculture and iii  weak property rights of rural households, farm families have neither the money nor the confidence to invest in agriculture or in the deteriorating state of the irrigation and drainage systems. ix. Agriculture can provide a basis for sustained growth and improvement in living standards, but is unlikely to do so unless, a number of key reforms are undertaken. Among the most important are the elimination of the remaining state orders on cotton and wheat, the liberalization of input and output prices, the freedom of choice to farmers with respect to the cropping patterns, input purchases, and output sales, access to financial services provided by private competitive banks and other institutions, and security of land tenure with rights to conduct transactions in land. In addition, domestic prices for agricultural output and inputs should reflect international prices at market-determined exchange rates. Such an incentive framework will induce farmers to respond with increased productivity and unleash a virtuous cycle of investment, growth, higher incomes and living standards, and social stability. Countries starting with similar initial conditions and institutions such as in Uzbekistan have indeed demonstrated that this virtuous cycle can be attained. x. Adoption of an Export-Oriented Development Strategy. Improvements in market incentives in agriculture will need to go hand in hand with an export-oriented development strategy. The current strategy of import-substitution biases incentives against the export sector and is inconsistent with promoting exports. The exchange rate regime is central to Uzbekistan's import-substitution policy. Uzbekistan still maintains an over-regulated and segmented foreign exchange market with multiple exchange rates. The Government regulates both the demand and supply of foreign exchange as well as its price in the official segments of the market. The excess demand from these segments is then met in the unofficial segments of the market-the so-called curb markets for the cash and non-cash soum. While precise estimates of the volumes of transactions in the curb markets are difficult to obtain, indirect estimates suggest that they accounted for about 28 percent of foreign exchange transactions in 1997. xi. These administrative restrictions in the foreign exchange market have a major impact on the economy as a whole. The discretionary and administrative foreign exchange allocations are, in fact, redistributing large amounts of income from the export-oriented sectors, such as agriculture, to import- substituting sectors, such as car manufacturing, electronics, and the production of tobacco and soft drinks. In addition, the arrangement insulates the import-substituting industries from international competition. As a result, effective rates of protection for some of these import-substituting industries are very high and positive even though the nominal tariff protection is small. At the same time, the effective rates of protection of export-oriented industries are negative and large. Such an arrangement is therefore dampening incentives for exports and undermining the Government's avowed objective of export promotion. xii. Nor are other Government objectives being achieved. While over-valued exchange rates reduce expenditures on external debt service and capital imports for the public investment program, it also makes the budget forego possible tax and dividend income from those public sector entities that sell foreign exchange at below market rates thereby incurring losses. While prices of some essential consumer goods imports-such as flour, bread, cooking oil, and sugar-can be justifiably subsidized for targeted groups of low income and vulnerable population, the current method of subsidization through the foreign exchange regime is benefiting high and middle income families also. In addition, econometric work suggests that the aggregate consumer price level is actually higher than it would have been under a more liberal regime. xiii. The adoption of an export-oriented strategy is critical to IJzbekistan's growth prospects. Export- oriented sectors both in agriculture and industry will also stimulate the growth of small and medium private enterprises, which are relatively labor-intensive, and promote employment and growth. Backward iv  and forward linkages to a dynamic agriculture sector will also help improve inter-regional income inequalities. Key elements of such a strategy would include the maintenance of a stable macroeconomic environment to reflect not only low, stable, and predictable inflation, but also a competitive and stable real exchange rate through the adoption of a market-determined system. It would also include the elimination of quantitative restrictions and licensing requirements for imports and exports, unrestricted automatic duty free access to imported inputs, the development of export facilitation infrastructure, and other measures such as greater flexibility in the labor markets. International experience has clearly shown that an outward-oriented, export promotion strategy leads to improved economic performance-in terms of higher growth rates of GDP, domestic savings, exports, manufacturing output and employment, lower inflation, and higher investment efficiency -than inward-oriented, import-substitution strategies. xiv. Reform and Liberalization of the Financial Sector. For higher private sector growth to take place, the financial sector has to play an efficient role in mobilizing and allocating savings. This in turn requires a competitive and healthy financial sector. In accordance with its gradualist approach to economic reforms, the Government of Uzbekistan has followed a cautious and gradual approach to financial sector reform. Until recently, the focus has been on creating an adequate legal and regulatory framework for financial intermediation, and developing the sector's technical and institutional capacity. The legal foundation has been largely developed, prudential regulations and banking supervision strengthened, an electronic payments system introduced, and internationally-accepted accounting standards for banks adopted. The Tashkent Stock Exchange and National Depository were established in 1994. xv. Financial sector liberalization, bank restructuring and privatization have started only recently and are now gaining momentum. Therefore, the financial system is still marked by lack of openness, relatively high degrees of banking concentration, segmentation, and cross-ownership, and presence of non-performing loans. Real interest rates remain mostly negative despite the reduction in inflation. Over 90 percent of the banking assets are accounted for by the 5 largest banks, with a single bank-the National Bank of Uzbekistan-accounting for the overwhelming share of them. Other policy restrictions also impede the emergence of a market-oriented banking sector. Banks continue to act as tax collectors and tax inspectors. While such an arrangement may have helped Uzbekistan maintain tax collection rates, it undermines the trust and confidentiality of the banking system, which in turn leads to low level of financial intermediation, investment, and growth. Perhaps the most egregious policy is the limitation on the use of cash transactions by enterprises only for wage, pensions, and travel payments. This also imposes transactions costs on enterprises, stimulates informal finance outside the banking system, creates a two-tiered pricing structure which distinguishes between cash and non-cash payments, and undermines the circulation of the national legal tender currency. Another obstacle in the form of single account restriction in now scheduled to be phased out by June 1, 2000, in the recognition that these increase the transaction cost of doing business and preclude inter-bank competition for customers. Bank restructuring and privatization efforts are beginning with support from donors including the World Bank. xvi. While some of these policy restrictions may have helped insulate Uzbekistan's domestic financial market from the negative implications of the global financial crises, they have also undermined the ability of the system to mobilize and allocate savings efficiently, necessary conditions for achieving rapid and sustainable economic development. To further unshackle the banking system, significant policy reforms are needed. These reforms should include a strategy for the speedy divestiture of the tax collection and inspection function of banks, the abolition of the cash and non-cash distinction, the enhancement of the competitiveness of the banking sector by privatization and entry of new adequately capitalized and professionally managed banks, the freedom of domestic enterprises to open and maintain multiple bank accounts, the adoption of a policy of maintaining positive real interest rates, and adoption of a high degree of financial transparency. v  xvii. Privatization of State Enterprises. The Government's program of privatization is central to the reform of state enterprises. This has proceeded along a three-phased gradual process. In the first phase, the program of privatization of small-sized enterprises was largely completed in 1995 though small-sized enterprise restructuring has faced obstacles primarily due to an adverse domestic market environment, in particular, since the introduction of foreign exchange restrictions in 1996. The second phase involved medium-sized enterprise privatization for which the Government opted for an innovative route of Privatization Investment Funds (PIFs) to avoid the perceived problems of mass privatization programs, which may fail to provide efficiency enhancements. However, frequent and adverse changes to the legal and regulatory environment have undermined the confidence of market participants and the prospects for improved corporate governance. Limited outside ownership, deficiencies in the enabling market environment, and the lack of transparency on the use of privatization proceeds raise questions about the quality of the privatization program. The principal concern is that although the management of the corporatized and privatized enterprises is dejure independent of the state, the prevailing ownership patterns and the current regulatory regime leave wide scope for direct administrative interventions by the state. The efficiency gains from privatization will accrue only if the privatized enterprises are allowed to be restructured financially, in the choice of product mix, and in internal governance structures. The third phase of large-sized enterprise privatization is only just beginning. The recent Government decision to involve foreign investors, and to open up strategic sectors of the economy-such as oil and gas-which were erstwhile closed to foreign participation, are positive steps. However, the current domestic economic environment will limit the potential for foreign investment inflows and for successful enterprise restructuring and performance. xviii. The innovative PIF program is central to the privatization program and there are at least three ways, in which the Government can boost it. First, the quality of enterprises offered to PIFs needs to be improved. Second, the legal framework needs to be strengthened. In particular, it is imperative for the Government to modify the adverse provisions relating to corporate governance contained in recent resolutions in order to restore the confidence of market participants and increase prospects for improved corporate governance. The legal framework should ensure a "second round" of auctions where prices are allowed to decrease and shares are sold at whatever prices they fetch. The legal framework should also confirm that enterprise shares owned by PIFs and the PIFs shares are fully transferable. Third, the overall success of the program will depend crucially on the restraint of the Government from interfering unnecessarily in the operations of the PIFs and their relations to their shareholders. Confidence in the program will depend on the Government exercising responsible oversight, while fully respecting the role of PIFs as independent financial institutions. Public Sector Management xix. An initial institutional perspective on the performance of the central government along three dimensions-aggregate fiscal discipline, the strategic prioritization of expenditures across programs and projects, and technical efficiency in the mobilization and use of budgeted resources-reveals serious inadequacies. While progress has been made to achieve aggregate fiscal discipline through the consolidation of the budget, and the increase in coverage of central government accounts, sustainable institutional arrangements are lacking without which the sustainability of fiscal outcomes is at risk. These include the lack of openness of financial markets, financial pressures from an ambitious public investment program, continued recourse to inflationary central bank financing of the budget, and the unknown size and extent of contingent fiscal liabilities, particularly from state guarantees of debt of loss- making state enterprises to domestic banks, and inter-enterprise arrears. vi  xx. Expenditure prioritization remains a daunting challenge in the presence of extensive state involvement in the economy. While the overall budget is established with due consideration of its macroeconomic impact, the determination of the overall framework does not involve an adequate discussion of the policy tradeoffs, or of the tradeoffs between expenditures on new projects and expenditures on ongoing projects, or between expenditures on investment outlays and expenditures for operations and maintenance. Lack of systems to provide data on the functional classification of expenditures precludes the discussion of inter-sectoral tradeoffs. Improvements in technical efficiency are hampered by the lack of a modem Treasury, which would improve the execution and monitoring of the budget, a modern system of tax administration, which could take over from the banks the functions of tax collection and inspection, and an efficient public service. Recognizing the growth in numbers of employment in the public service, and the lack of incentives for performance, the Government has recently adopted measures to reduce the size of the service by 20-25 percent and to provide financial incentives to public servants from the resources saved therefrom. xxi. There is evidence to suggest that good governance-a key objective of the Government-is being undermined by the opportunities for corruption inherent in the system of licensing, controls, regulation, and extensive state involvement in the micro-management of the economy. While better monitoring and sanctions of recalcitrant behavior-as demonstrated recently by the Government with a series of sanctions of high level officials on charges of corruption-are necessary to fight corruption, the primary mechanism for reducing corruption lies in addressing the fundamental sources, which provide for the opportunities for such activity. This means moving away from an economic system of controls with discretionary authority, towards an open, transparent, and rules-based system. This, in turn, requires a major thrust to move towards policies that reduce controls on foreign exchange and trade, remove entry barriers for private industry, simplify tax and investment policies, and adopt a national procurement law and set of regulations which will provide the institutional framework for competitive procurement and contracting. Social Investments xxii. Social policy issues are being addressed by the Government as a priority, and the Government deserves commendation for its policy stance in this area. The Government has successfully introduced innovative schemes such as the mahalla system, which are playing a key role in the social protection system. The mahalla system is particularly unique in empowering local communities to decide upon the allocation of benefits, combining a rules-based process with discretionary allocation, being responsive to changing family needs, and having low "inclusion error" in targeting. On pensions, an inter-ministerial working group has developed important proposals for pension reform which, if adopted, would put the existing pay-as-you-go system on a sustainable footing in the long-term, allow for cautious introduction of further reforms which would more closely link contributions and pension benefits, and better protect the poor and the vulnerable. xxiii. While data inadequacies seriously hamper a complete assessment of social and living standards in Uzbekistan, anthropometric data, and health and education outcomes-low prevalence of stunting and wasting, average life expectancy of over 70 years, infant mortality of 30 per 1000 live births, maternal mortality of 12 per 100,000 births, literacy rates of almost 100 percent, high enrollments, and little gender differentials in schooling-are good and compare quite favorably with other countries with comparable income levels. However, 1995 household survey data from three regions suggest high and variable poverty, and significant differences in living standards between the rural and urban areas; other correlates of living standards also indicate inter-regional disparities in living standards. vii  xxiv. While the impressive social indicators were in large part inherited from the former Soviet Union, the further development of the human potential is a key priority of the government in both health and education. Health and education expenditures have been protected in relative terms in the face of acute budgetary constrictions. Policy reforms in health are designed to restructure the health sector, moving away from the Soviet model to a model based on more cost-effective primary and outpatient care. The focus currently is on the rural areas, with an emphasis on building and rehabilitating primary care clinics. A number of challenges remain, including the rationalization and restructuring of delivery systems in urban areas, and the development of an appropriate mix of public and private provision of care. Sustained decentralization of management and allocation mechanisms can reinforce and accelerate these changes. The sector has a significant level of "catching-up" to do on human resource-related training for physicians and nurses, and the introduction of new treatment protocols similar to those found in OECD countries. xxv. In education, the reform agenda of the Government has many desirable elements. A major strength is acknowledging the fundamental changes necessary in education to respond to the needs of a newly independent country with a market economy. However, in order to translate this goal into a more concrete set of objectives and reform measures, it will be important to avoid overly-deterministic approaches to education planning, which in turn reflect ideas of a labor market that may be too rigid for a market economy. The ongoing refinement and implementation of educational reforms also needs to be done with a close awareness of fiscal constraints, the financial capacity of different sectors of society, the equity of treatment and access so that commitments are not made which either can not be fulfilled, or can only be fulfilled at the expense of basic education for all children in Uzbekistan. Conclusions xxvi. To promote sustainable economic growth and improvement in living standards, the Government urgently needs to re-assess its current policies in the problem areas identified and develop a comprehensive, coherent, and internally consistent program for economic liberalization. Key policy reforms are needed particularly in agriculture, trade and exchange rate regime, and fiscal management. These are the areas where the greatest economic gains are to be achieved, and which provide the win-win policies conducive to economic growth and improvement in living standards. These key reforms will also need to be supported by complementary policies, particularly with respect to liberalizing the financial sector, privatizing state enterprises, maintaining tight fiscal and monetary policies, strengthening the social safety net, improving governance, and further strengthening health and education sectors. The pace and sequencing of these reforms can be chosen to suit the political and social imperatives faced by the Government, but it is important that the direction and the path are clearly laid out and that the internal inconsistencies and constraints in implementation are removed. xxvii. In some areas, reforms can be implemented on a gradual, pilot basis, as envisaged in the Bank's Country Assistance Strategy-so as to demonstrate the benefits from the reforms, provide for opportunities for learning by doing, and enable the management and containment of risks-and subsequently replicated in the economy. However, gradualism requires the credibility of the reforms to be established and maintained throughout the process. Credibility requires that the objectives and the agenda for reforms are clear and coherent, that the reforms are broad in coverage as well as deep in substance, that they draw from the international lessons learned regarding what policies work and what do not, and that there is a clear publicly announced commitment to a timetable for reforms with monitorable performance benchmarks against which implementation performance can be assessed. viii  I INTRODUCTION A. Uzbekistan's path of transition to the market economy is guided by five principles:2 These principles are strongly held by the Government as the basis for maintaining social and political stability which, in turn, are pre-requisites for growth. These guiding principles are: (i) the de-ideologization and de-politicization of reforms; (ii) the maintenance of the role of the state as the developer and implementor of reforms, particularly as a "collective entrepreneur", "production regulator", and investor in priority sectors of the economy; (iii) the establishment of a legal foundation as the basis for reforms; (iv) the development of a strong social policy with guarantee of social protection; and (v) the adoption of a gradual, evolutionary process of reforms. B. The gradual, stage-by-stage, path of reforms is the officially stated characteristic of Uzbekistan's reform program and is defended on economic, social and historical grounds-(i) to take account of national and historical factors such as communal structure, traditional values, resistance to change and aspirations for social equality; (ii) to take account of the initial conditions at the time of independence with poverty, in particular, being below the average for the former Soviet Union, which would make the high social cost of 'shock therapy' unacceptable; (iii) to protect the vulnerable given the young demographic profile wherein 45 percent are under the age of 15; (iv) to protect the ethnic diversity of the nation with about 70 percent of Uzbek origin and the rest from a wide variety of ethnic backgrounds; and (v) to overcome the deeply-entrenched public psychology of dependency arising from the lack of ownership and the dependence on a totalitarian state over the years. C. These guiding principles have led the policymakers to develop their own model for transition which focuses on developing a socially-oriented market economy-an economy which "combines fully the features of a market economy and a social economy in order to merge the efficiency of economic advancement with social guarantees and justice". Major elements of this model are: (i) a balanced program that will stabilize the economy and maximize job creation and macroeconomic growth, and which is socially oriented; (ii) departure from direct state management of production through privatization, development of a level playing field for businesses, and support to private activity; (iii) preservation of the state's active role in choosing investment policy priorities, attracting foreign capital, and in regulating the economy; (iv) strong social policy which guarantees the protection of the socially vulnerable-children, pensioners, invalids, and the young; (v) development of the market infrastructure including market institutions and regulatory frameworks. D. Achieving broad-based growth and improvement in living standards, consistent with the maintenance of social stability, is central to the Government's objective. This report-the first Social and Structural Policy Review (SSPR) for Uzbekistan-takes the stated Government's objectives as given and provides a broad-based assessment of the success that the Government has obtained in achieving its 2 The following discussion is based on Karimnov, 1. (1993).  2 objectives through its policies. The report develops recommendations where policy changes or institutional strengthening is required, and develops an alternative set of internally consistent policies and instruments, which can deliver the Government's objectives at lower cost. Specific recommendation on the pace and sequencing of the specific reform measures can be developed, if so desired by the government, as a sequel to this report. The report also develops a set of performance indicators for future tracking of economic performance and for comparative assessment, but does not provide comparative international benchmarks for performance, which would be a more ambitious exercise. E. While this report provides a general stock-taking of the economy and has a broad coverage, key sectors are not covered-or are addressed in a limited way-reflecting information, data, time, and budget constraints. In particular, the report does not discuss the transport and energy sectors, which are important elements of Uzbekistan's development strategy or the issues of environment. Among the areas covered in this report, some issues such as the implications of the evolution of monopolistic market structures in the industrial sector, regional balance in economic growth, and various issues of public sector management and labor market are not addressed. These and other areas of knowledge gaps are identified in the report and are proposed as the subject for future enquiry, perhaps jointly with the Uzbek authorities. F. This report is divided into five sections. Section I provides an assessment of Uzbekistan's overall policy and performance record since Independence in a comparative context. It also provides a brief presentation of the potential areas of vulnerability in the economy following the global financial crises. Section II looks at the incentives for private sector growth. The main areas of examination are the trade and exchange rate regime, the financial sector, the agriculture sector, and enterprise privatization. Section III provides a preliminary institutional perspective on the role of the state while Section IV looks at social dimensions, particularly living standards, inequality, and health and education. Finally, Section V integrates the results and recommendations of the report into coherent conclusions.  3 SECTION I ECONOMIC POLICIES AND MACROECONOMIC PERFORMANCE  4 Chapter 1 ECONOMIC POLICIES AND PERFORMANCE 1.1 It has now been more than seven years since Uzbekistan became an independent state in 1991 and initiated market-oriented reforms in early 1992. This chapter seeks to evaluate the initial conditions, under which Uzbekistan started its transition from a centrally planned to a market-based economy, the economic policies its Government have pursued since then, and the outcome of these policies in terms of Uzbekistan's macroeconomic and transition performance compared to that of other former Soviet Union (FSU) countries. Initial Conditions and Adoption of a Gradual Approach 1.2 Uzbekistan initiated market-oriented reforms in conditions, which had mixed implications for its relative macroeconomic performance during transition and strongly influenced its Government's adoption of a gradual approach to market-oriented reforms (see Introduction). On the one hand, the country's relatively rich resource endowment, low degrees of over-industrialization and trade dependence as well as large shares of agriculture in aggregate output and of cotton fiber and other raw materials in total exports implied that, other things being equal, Uzbekistan would show better macroeconomic performance during transition than many other FSU countries.3 On the other hand, significant internal and external macroeconomic imbalances inherited from the FSU, heavy dependence on imports of food and energy products combined with worsening terms of trade implied that Uzbekistan's transition from a centrally planned to a market-based economy would be relatively painful, particularly at its early stages. 1.3 Under those circumstances, the Government of Uzbekistan decided to follow a gradual approach to the transition process. It realized that rapid economic liberalization would have required considerable macroeconomic adjustment, including substantial upward adjustment in consumer prices and significant tightening of financial policies. Giving a heavier weight to maintaining social and political stability in the country-and fearing disruption of essential imports, serious negative impact on already low living standards, and possible social and political unrest-the Government decided to avoid rapid changes in the economic system and to implement market-oriented reforms step by step. 1.4 However, the transformation process in Uzbekistan has been uneven both over time and across its various dimensions. Since early 1992, it has evolved through three phases markedly differing from each other in the stance of macroeconomic policies pursued by the Government, progress made in the implementation of market-oriented reforms, and stability of the macroeconomic situation. The first phase, covering the period of 1992-93, was characterized by the pursuit of loose macroeconomic policies, slow and limited implementation of market-oriented reforms, and further worsening of the macroeconomic imbalances inherited from the FSU. The second phase, covering the period from early 1994 through the third quarter of 1996, was characterized by considerable tightening of financial policies, marked acceleration of market-oriented reforms in many areas, and significant improvement of the macroeconomic situation. The third phase, covering the period from the fourth quarter of 1996 to the present, has been marked with occasional loosening of macroeconomic policies, a reversal of the reform process in several key areas, sustained progress in some other areas, and the intensification of balance of 3 For more detailed discussions of these initial conditions and their implications for Uzbekistan's relative macroeconomic, in particular growth, performance during transition, see De Melo, Denizer, Gelb, and Tenev (1997) and Zettelmeyer (1998).  5 payments pressures. The following three sections of this chapter discuss the Government's economic policies and the country's macroeconomic performance during each of these phases in more detail. Period of Slow and Limited Reforms (1992-93) 1.5 Uzbekistan initiated market-oriented reforms in early 1992, in parallel with similar developments in other FSU countries. And like in many other FSU countries, the transformation process in Uzbekistan was slow and limited during 1992-93 as the Government had to concentrate on managing external shocks resulting from the disruption of the trade and payment mechanisms within the FSU and the worsening of the terms of trade. 1.6 Some progress was made in five reform areas: price liberalization, trade liberalization, small- scale privatization, tax reform, and legal reform. Many prices were liberalized in early 1992; but the Government maintained administrative control over the prices for energy products and a number of consumer goods and services, and introduced a rationing system for basic foodstuffs to mitigate the negative impact of price liberalization on living standards Most import tariffs were temporarily removed and the number of commodities subject to export licensing was reduced. However, the Government maintained overall administrative control over trade. A substantial part of state-owned housing and many small-scale state-owned enterprises operating in retail trade, services, and light industry were transferred into private hands; but most of them were sold to their tenants and employees, respectively, at low prices on a non-competitive case-by-case basis. A number of positive changes were made in the tax system. In particular, turnover and sales taxes were replaced with value-added and excise taxes. The foundation of a legal framework for a market-based economy was laid down with the adoption of laws on property, enterprises, banks and banking activity, privatization, antimonopoly policy, and foreign investment. 1.7 However, little, if any, progress was made along other dimensions of the transformation process, such as liberalization of the foreign exchange arrangements, large-scale privatization, de-monopolization, enterprise restructuring, rural reform, and financial sector reform. Administrative control over the foreign exchange market was further tightened. Most notably, a 100 percent foreign exchange surrender requirement for centralized exports and 60 percent surrender requirement for decentralized exports were introduced in 1992, with the latter being replaced by a 35 percent foreign exchange tax in 1993. Many medium- and large-scale enterprises were transformed into closed joint-stock companies (JSCs) but remained in state ownership. Antimonopoly policy focused largely on price controls rather than promotion of competition. Due to the weak competition and the Government's efforts to prevent decline in output and increase in unemployment by providing state-owned enterprises (SOEs) with subsidized credits, budget constraints in the enterprise sector remained soft. Agricultural reform was limited to distribution of small plots of land to households, transformation of state farms into collective farms, and privatization of livestock farms to their employees. The Government maintained strict control over the production and marketing of major agricultural products. State order on these products ranged from 80 to 50 percent, leaving farms little freedom to choose crops, or input suppliers. 1.8 During 1992-93, the Government pursued relatively loose fiscal policy. The complicated and poorly targeted system of social protection combined with large investments in the energy sector and the subsidized on-lending to the enterprise sector put a heavy burden on the state budget. Budgetary expenditure remained high despite the loss of Union transfers. As a result Uzbekistan ran large fiscal deficits (see Table 1.1).  6 Table 1.1 Uzbekistan: Selected Indicators of Macroeconomic Policies and Performance, 1992-98 1992 1993 1994 1995 1996 1997 1998 Growth rate of real GDP -11.1 -2.3 -4.2 -0.9 1.6 5.2 (2.4) 4.4 (3.4) Consumer price inflation End-of-period (inpercent) 910 885 1,281 117 64 28(50) 26 Period average (in percent) 646 534 1,568 305 54 59 (71) 18(29) General government finances (in percent of GDP) Revenue 31.3 36.0 29.2 34.6 34.3 30.1 32.4 Expenditure a/ 43.8 46.4 35.3 38.7 41.6 32.3 34.2 (49.7) Balance -12.5 -10.4 -6.1 -4.1 -7.3 -2.2 -1.8 b/ (-18.4) Domestic bank financing n.a. 16.4 4.8 1.4 6.9 1.3 1.6 Growth rates of monetary aggregates (in percent) Reserve money 857 883 476 194 112 18 40 Broad money 468 785 726 144 113 36 33 Current account balance In million US dollars -236 -429 119 -21 -980 -584 -195 In percent of GDP c/ -11.8 -8.4 0.5 -0.2 -7.2 -4.0 -1.4 Gross official reserves In million US dollars 79 1,022 1,330 1,867 1,907 1,167 1,168 In months of imports 0.6 3.8 5.9 6.9 5.4 3.7 5.0 External debt stock In million US dollars 6.0 1,032 1,244 1,787 2,363 2,761 3,322 d/ In percent of GDP c/ 3.0 20.3 5.2 17.8 17.4 19.0 23.5 External debt service InmillionUSdollars 4.7 29.6 138.0 243.3 291.7 515.9 386.94d In percent of exports 0.3 1.0 4.7 7.0 8.3 14.0 13.4 Notes: IMF estimates are given in parentheses when they considerably differ from official statistics. a/ Excludes foreign-financed expenditures. b/ Includes an increase in the deposits of line ministries equivalent to 1.5 percent of GDP. c/ At the average annual official exchange rate. d/ External public debt only. Sources: Govermnent of Uzbekistan, IMF, World Bank Debt Recording System, and Bank staff calculations. 1.9 Monetary policy during this period was expansionary partly reflecting Uzbekistan's continued participation in the ruble zone along with other FSU countries. The domestic bank financing of the large budget deficits, interest free lending to the extra-budgetary Pension Fund, and provision of subsidized credits-to the enterprise sector to replenish working capital and to the energy sector to invest in expansion of the oil production-led to high rates of credit and monetary expansion. During these two years, reserve money grew on average by 20.8 percent a month, resulting in average monthly growth of 17.7 percent in broad money.  7 1.10 At the same time, the contraction in economic activity was relatively mild. Uzbekistan's real GDP declined by 13.1 percent in 1992-93, as against a non-weighted average decline of 3 5.2 percent for the rest of the FSU. Several factors contributed to this relatively smaller decline including a relatively rich resource endowment, the dominance of agriculture in the economy, dependence on primary exports, a partial approach to reform, diversification of trading markets, and expansion of the domestic production of oil and refined oil products. 1.11 However, Uzbekistan continued suffering from major macroeconomic imbalances. The average monthly rate of inflation at the consumer price level reached 21.3 percent in 1992 and 21.0 percent in 1993, while significant repressed inflation persisted and shortages of essential commodities became commonplace. The curb market for foreign exchange grew rapidly and its premium over the official exchange rate exceeded 300 percent. The current account deficit stood at around 10 percent of GDP and was largely financed through accumulation of payment arrears and external borrowing. Consequently, Uzbekistan's foreign debt stock rose from zero in 1991 to about US$1 billion-equivalent to 20 percent of GDP-in 1993. Period of Reform Acceleration (1994-Q3 1996) 1.12 The withdrawal from the ruble zone at the end of 1993, and the deterioration of the macroeconomic situation, led the Government to change its economic policies at the beginning of 1994. Following the issue of the Presidential Decree on deepening economic reforms in January 1994, market- oriented reforms in Uzbekistan accelerated markedly. 1.13 From early 1994 through to September 1996, considerable progress was made in almost all reform areas. Consumer prices and trade were further liberalized, the rationing system for basic foodstuffs was abolished, and exchange restrictions were relaxed. Small-enterprise privatization was virtually completed, and an innovative program of medium and large enterprise privatization involving privatization investment funds (PIFs) was launched. Limited private ownership on land was introduced. The state orders on all agricultural products, except cotton-fiber and grain, were eliminated, and those on cotton-fiber and grain considerably reduced. Banking supervision and prudential regulations were strengthened. The Uzbekistan Republican Stock Exchange (URSE) and the National Share Depository (NSD) were established. The system of social protection was significantly reformed and became much simpler and better targeted. The Government's program of structural reform received support from the World Bank under the Rehabilitation Loan approved in 1995. 1.14 In contrast to 1992-93, the Government pursued relatively tight fiscal policy. The Government discontinued lending to the enterprise sector, substantially curtailed consumer subsidies, and introduced a number of measures aimed at increasing budgetary revenues and strengthening fiscal management, including further reform of the tax system and first steps to establishing a Treasury. Consequently, the consolidated state budget deficit (excluding privatization revenues) declined to 6.1 percent of GDP in 1994, 4.1 percent of GDP in 1995, and about 3.5 percent of GDP in the first nine months of 1996. To provide non-inflationary financing of the budget deficit, Treasury bill issue was started in March 1996. 1.15 The CBU significantly tightened monetary and credit policies during the period immediately preceding and following the introduction of the national currency-the soum-in July 1994. In particular, it raised the refinancing rate, increased the commercial bank reserve requirement, and discontinued subsidized credits to the enterprise sector, including for wage payments. Domestic bank financing of the budget deficit was contained to 4.8 percent of GDP in 1994 and 1.4 percent of GDP in 1995. As a result, the average annual growth rates of reserve money and broad money fell sharply. In  8 January 1995, the Government's stabilization program began to receive financial support from the IMF under the Systemic Transformation Facility (STF), and the second purchase under the STF and a Stand- By Arrangement were approved by the IMF's Board in December 1995. 1.16 The economic situation in Uzbekistan improved markedly during this period. The decline in real GDP moderated from 4.2 percent in 1994 to 0.9 percent in 1995 and turned into growth in the first half of 1996. Inflation, after surging to 23.2 percent per month in 1994 in response to the price liberalization and adjustments, fell to an average monthly rate of 6.3 percent in 1995 and 4.4 percent in the first nine months of 1996. The curb market premium over the official exchange rate narrowed from more than 750 percent in early 1994 to about 10 percent in mid-1995 (see Figure 1.1). The external current account recorded a surplus equivalent to 2.1 percent of GDP in 1994 and a deficit equivalent to 0.2 percent of GDP in 1995. Official international reserves increased from US$1,330 million (an equivalent of 5.9 months of imports) in end-1994 to US$1,867 million (an equivalent of 6.9 months of imports) in end- 1995 1.17 The reforms also led to a sharp depreciation of the real exchange rate (see Figure 1.1). In the second half of 1994, the real exchange rate depreciated by over 100 percent and the black market premium was reduced ten-fold. This suggests a substantial shift in relative prices towards export-oriented tradable sectors. International evidence suggests that such a shift leads to growth in rural outputs and incomes, redistribution of income from the urban to the rural population (where most of the poor typically live) and hence an improvement in living standards, and in economic efficiency (as "economic rents" from policy interventions, such as trade and exchange controls, fall). However, this favorable development was short-lived as, subsequently, the real exchange rate appreciated to its late- 1993 level and the curb market premium started to rise. Figure 1.1 Uzbekistan: Index of the Real Official Exchange Rate and the Curb Market Premium, 1993-99 (Monthly averages in percent) 250.0 T 900 800 200.0 .700 . g 1150.0 '' o = >100.0 40 X a 50.0 l .-+200 I mr t t r m- 00 0X 00 ~~.. U $ 00 U 1 00 U 001~ U1 C. 01 U o t