Report No. 12934-UZ Uzbekistan Economic Memorandum Subsidies and Transfers (In Two Volumes) Volume l: Main Report June 20, 1994 Country Operations Division I Country Department IlIl Europe and Central Asia Region FOR OFFICIAL USE ONLY ;-- , . Document of the World Bank This document has a restricted distribution and may be used by recipients cnly in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization ABBREVNIATIONS CIS Coimmonwealth cf Independent States CIT Corporate Income Tax CBR Central Bank of Russia CBU Central Bank of Uzbekistan CMEA Council for Mutual Economic Assistance EC European Community EBRD European Bank for Reconstruction and Development FDI Foreign Direct Investment FSU Formner Soviet Union GDP Gross Domestic Product GNP Gross National Product Gosplan State Planning Committee IBRI) International Bank for Reconstruction and Development I FC International Finance Cooperation IMF International Monetary Fund MOA Ministry of Agriculture MOI: Ministry of Finances NMP Net Material Product OECD Organization for Economic Cooperation and Development SOE State Owned En.erprises STF Structural Transformation Faciiitv VAI Value Added Tax FOR OFFICIAL USE ONLY PREFACE This report is based on the findings of a mission to Uzbekistan in November 1993 led by Helga Muller. The report was discussed with the authorities in Mav 1994. The World Bank wishes to thank the authorities in Uzbekistan for their support a&d cooperation in providinig information and data on the Uzbek economy. The Economic Report was prepared by Helga Muller (main author), Douglas Adkins (Bodgetary Issues), Anthony Aylward (Macroeconomics), Lawrence Bouton (Financial Sector), Richard Browning (Energy), John Cameron (Agriculture), Jeny Klugman (Consumer Subsidies and the System of Social Protection), and Ekaterina Samnsonova (Statistics). Valuable coniments were provided by Isabel Guerrero, Jorge Garcia-Garcia, Parvez Hasan, Kathie Krumn', Michael Levitsky, Costas Michalopoulos, Branko Milanovic, Marcelo Selowsky, Silvina Vatnick and Laura Tuck. The report was processed by Robert Elings and Cielito Pelegrin. The work was carried out under the general supervision of Kadir Tanju Yurukoglu, Division Chief, and Russell J. Cheetham, Director. Since the mission was undertaken, several policy steps have been undertaken by the Government. The report has been updated according to these developments. The quantitative analysis especially in the chapter on the agriculture and energy sector is based on data obtained during the mission and has not been modified fully. However, in the discussion of the various reform components the recommendations are still vaild and the path of policy change has been updated. This document has a restricted distribution and may be used by recipienw- nnly in the performance of their official duties. Its contents may not otherwise be disclosed without V 'ord Bz.. 'c authorization. TABLE OF CONTENTS EXECUTI 'E SUMMARY ...... I............. ... ...... ....... CHAPIER 1: Economic Reforms and Prospects ....... ............. ...... An Outline for Reforn ......... ............ ........ 3 Economic Prospects. 9 CHAPTER 2: Subsidies, Transfers and the Governmezt's Budget ................. 15 Subsidies and Their Budgetary Impact ...................... 17 Unbudgeted Subsidies ...................... ......... 21 CHAPTER 3: Consumer Subsidies and the System of Social Protection .... ......... 25 Overview of Recent Developments in Uzbekistan ............... 25 The Economic Cost of Conswaier Subsidies in Uzbekistan .... ..... 28 The Impact and Incidence of Consumer Subsidies ............... 31 Recommnendations ................................... 33 CHAPTER 4: Interest Rate Subsidies and Directed Credits ...................... 35 Quasi-Fiscal Activities of the Central Bank ................... 35 The Impact of CBU Credit Policies on the Enterprise sector .... .... 40 Recommendations ................................... 40 CHAPTER 5: Subsidies and Implicit Taxes in Agriculture ...................... 43 Subsidies to the Agricultural Sector ............... I I ...... 43 The Implicit Taxation through the Scate Order System .... ........ 45 Net Flows ...................................... 47 Recommendations .............................. 48 CHAPTER 6: Subsidies in EnerFy ....................................... J1 Energy Price and Subsidy Reform ........................ 52 Energy Pricing and Taxation Principles ..................... 55 CONCLUSION: Short and Mediwn-Term Actions ............................ 57 Text Boxes 1.1 Economic Developments in 1993 and the First Quarter 1994. 2 1.2 The Status of Structural and Sectoral Reforms. 4 1.3 The Government's Economic Agenda for 1994. 7 3.1 The Concept of Free Prices in Uzbekistan .7 Text Tables: 1.1 Macroeconomic Indicators. 1.2 Macroeconomic Simulations, Reform Scenario .10 1.3 External Financing Requirements, Reform Scenario .11 2.1 Subsidies 1993, Estimate .15 2.2 Li :el of Subsidies in Selected Countries .17 2.3 C(;,solidated Budget .18 3.1 Budget Expenditures on Consumer Subsidies, 1992 and first nine months of 1993, as a share of GDP ..... ........... 26 3.2 Comparison of Prices, October 1993 ........ .................... 26 3.3 Selected Food Subsidies, first nine months of 1993 ................... 28 3.4 Subsidy Levels and Retail Price of Different Types of Bread .... ......... 28 3.5 Meal Program by Type and Numbers Covered ...................... 30 3.6 Retail Prices and Wholesale Cost Utilities ....... .................. 31 4.1 Fiscal Costs of CBU Refinance Credits .......................... 38 5.1 Estimate of Agricultural Subsidies for 1993 ............ ........... 44 5.2 Estimate of Cost of Subsidies and Transfers oLt to Government by Sub-sectors . 46 5.3 Estimated Effect of Policy Changes on Farmers' Income and Government Revenue ................ 47 6.1 Implicit Energy Subsidiae ................ 52 EXECUTIVE SUMMARY 1. In 1993, total explicit budgetary and implicit non-budgetary subsidies in Uzbekistan amounted to more than 75 percent of GDP. This exceptionally high level of subsidies is clearly unsustainable since subsidies distort prices, slow adjustment and are the main cause of the lage budget deficit in Uzbekistan. Rationalization of the subsidy system is a pre-corndition for macroeconomic stabilization and restructuring of the financial and enterprise sector. Decisive actions are required in four key areas: consumer subsidies, interest rate subsidies, agricultural subsidies and state orlors and ergy subsidies. The report will focus on these four key areas. Recent Economic Developments 2. Over the two years since the break up of the Union, Uzbekistan experienced a lower drop in total output than most of the other FSU countries. In 1992, the fall in real GDP in Uzbekistan was of the order of 10 percnrt and in 1993 GDP fell by about 3 percent. There are two main factors contributing to this performance. First, I T-bekistan's specialization in the procatction of agricultural and energy commnodities shieldad the economy somewhat froin the collapse in FSU production that was centered in the manufacturing sectors. Oil production increased substantially due to the discovery and opening of a new oil field. Second, Uzbekistan was slower than other FSU countries in removing state orders and subsidies. The continued controls helped temp'orarily in preventing drastic declines in Uzbekistan's economy; but they also disguised the need for funidamental adjustment and laid the ground for prolonged economic stagnation. Recent economic developments suggest that previous policies are unsustainable. 3. Because of both the loss of transfers from the Union budget and increasing domestic subsidies, national fiscal autonomy has been accompanied by a growing budget deficit. The narrowly defined budget deficit amounted, to 2.5 percent of GDP in 1993. But the consolidated public sector deficit (including the many extra-budgetary funds) was 16 percent of GDP. While an accurate picture of the overall balance of payments is difficult to obLain owing to statistical and methodological problems, some trends are evident. The overall current account deficit, measured in US dollars at quarterly average official exchange rates, increased from a deficit of US$240 million in 1992 to US$417 million in 1993 due to the collapse in the payments framework for interreprublican trade. The increasing deficit in the balance of FSU trade more than offset a surplus on the balance of trade with non-FSU countries. The main reason for the improvements on the balance of hard currency trade were significant gold sales in 1993 which were not reported in the balance of payments in previous years. 4. Money supply grew rapidly in 1993 as a result of the rapid expansion of Central Bank credit. In July 1993, the ruble zone was effectively dismantled as a common currency area for the FSU. In November, the Uzbek authorities introduced the Sum-Coupon as an additional medium of exchange with the intention of becoming the Uzbek national currency. Retail price inflation averaged around 1300 percent in 1993, up from 850 percent in 1992. Real wages may have fallen by 5 percent in 1993. Uzbekistan's Reform Prcgram 5. Following the dissolution of the Union, the Government of Uzbekistan adopted a very gradual approach to reforn. Prices were partially liberalized, some new taxes imposed and import tariffs Executiv. Sumunary ii removed. Some privatization occurred in the agriculture. distribution and residential housing sectors. New laws on banking, propeaty and foreign investment were enacted. But structural reforms have also been slower than in other FSU countries. While most housing and small scale enterprises were privatized, little was done in medium scale privatization. Furthermore, state orders, the key policy instrunent of the centralized economy, remnained largely intact for important commrodities like cotton. 6. Since Decemt er 1993, the Governrment has issued several statements and decrees outlining a inore substantial reform. program for 1994 and beyond. These statements may serve as a starting point for a blueprint of the comprehensive set of detailed policy initiatives necessary to transforn the economy. But to do so, conLsiderable development of ihe stated policy agenda is needed. Much of the timing and sequencing cf the policy implementation remains to be worked out, along withi the detailed program specification, budgetarv analysis and costing. Also, areas of both complementarity and conflict need to be identified. An area which needs special attention is the scope, approach, scale and timetable of the privatization program. Subsidies .rd Transfers 7. The subsidy system currently in place in Uzbekistan is still characteristic of the old Soviet system. It makes the economy highly non-transparent and inefficient by implicitly transferring resources from one sector of the economy to another. The industrial sector is subsidized through large credit and input subsidies. Consumers are subsidized through low food, utility, housing, and energy prices whereby tl"e subsidies are not targeted and show very little reference to the actual need of the consumers. A p,rtion of the subsidies is paid for by the agricultural sector which is implicitly -- through the state order system -- heavily taxed and penalized. Moreover, the rapid inflation undermines any redistributive objective of social policies by creating ..rbitrary transfers of real wealth and pu.chasing power within the economy. 8. The Government pf Uzbekistan is starting to realize that the current subsidy and transfer system is unsustainable. Given the increasing budgetary pressure, some subsidies are already being cut. The Government has expressed its commitment to further reducing consumer subsidies on services, and subsidies and transfers to enterprises in industry and agriculture. Gradual liberalization of prices of utilities, communication services and energy products is also planned for 1994. 9. While the Government statements suggest an acceleration in reforms, policy slippage has occurred in many areas. More generally, much of the timing and sequencing of the policy implementation remains to be worked out, along with detailed program specification, buagetary analysis and costing. Also, the adjustment of administered prices continues to lag behind inflation in wholesa!e prices; the Government must cover growing gaps between the purchase price and the final sale price of goods. 10. A rough accounting of the level of subsidies shows that tota! budgetary subsidies are very large. Budgetary subsidies (including consumer subsidies and credits to enterprises) amounted to at least 21 percent of GDP in 1993. If all the import subsidies, financed through cotton sales, were included in the budget, the total amount would be even his,' sr. In addition, implicit energy subsidies and directed credits accounted for another 23 percent and 32 . ercent of GDP respectively, bringing total implicit and explicit subsidie- to more than 75 percent of GD? in 1993. iii Executive Summary 11. Subsidies and Resource Allocatior:. The subsidies hide the underlying structure of relative prices in the economy, thereby slowing down the push for adjustment. Incorrect price signals result in a lower growth rate of output than would be the case if relative prices reflected the real value of resources. If market forces are allowed to determine levels of production and consumption, agriculture and industry could produce more efficiently. 12. The reform of the subsidy system and price controls is a prerequisite for the successful restructuring of enterprises and the financial system. The subsidies and price controls, currently in place, distort the structure of relative prices and make a meaningful cost-benefit analysis impossible. Without a clear signal on prices, investors and producers cannot determine the potential value of privatizeAl assets. Only the eliminiation of the subsidies -- especially the substantial implicit subsidies provided through the large negative real interest rates charged on enterprise loans -- will reveal the financial condition of enterprises. 13. Impact on the Government's Budget. Subsidies are clearly one of the major causes of the budget deficit. Therefore, any credible stabilization program has to address this issue. So far, the Government's attempts to reduce subsidies have focussed mainly on the narrowly defined budget. But the costs of many subsidies are off-budget. i4. Monetary, price and exchange rate stabilization will only be possible if budget imbalance is reduced. In the absence of any significant mobilization of savings by the financial sector, public sector deficits will have to be financed by foreign borrowing and will be accompanied by external deficits of similar magnitude. These deficits will deplete the scarce ctocks of international reserves. On the other hand, there may be also limits on how much the rest of the world may be willing to finance the deficit. 15. Reform of the Subsidy System Reforms of the subsidy system should aim first at eliminating subsidies that have the largest impact on budgetary resources and those that have large distortionary effects on the incentive structure. Many of these are implicit subsidies which arise when domestic prices are set below the wiorld prices for a particular commodity. For example, this is the case in the energy sector, w.,ere price regulation has resulted in energy being supplied below world prices. Domestic prices were about 20 to 40 percent of world prices in October 1993. Impli.it subsidies also arise in the financial sector, where credits are provided at negative interest rates: when the loan is paid back, it is worth much less than when it was contracted. For example, with an annual inflation rate of 700 percent, an enterprise that received a loan iwith an interest rate of 45 percent per annum would, after one yezr, have to repay in real terms the equivalent of 18 per..ent of the initial loan amount. The grant element in these credits represents a sigiiificant subsidy from the Goverilment to the benefiJaries. If some r these subsidies have to be maintained during the transition they should be made directly through the buiget. Direct subsidies are preferable to implicit subsidies since they are transparent and therefore far e,.sier to control. Cons:umer Subsidies, Import Subsidies and Price Controls. 16. Explicit consumer subsidies cost the Government about 9 percent of GDP in 1993. Direct budgetary food subsidies account for the largest proportion of consumer subsidies amounting to 5 percent of GDP in that :s Large budgetary payments are also made for housing, utilities, and public transport. The rL ! u e share of housirg and util ities subsie ies increased from just under 10 percent of consumer subsidy expenditure in 1992, to over 20 percent in the first three quarters of 1993. The share of public traiispit ', ubsidies also doubled during the same period. Executive Sunmmary iv 17. This explicit subsidy component is indeed large by any standard. Yet, it understates the full amount of the gap between the world and the domestic sale price. With the proceeds of the sale of cotton and other products for hard currencies, the Government buys imported grain, meat, milk and pharmaceuticals. The domestic sale of these imports is subsidized at prices far below their respective world market prices. However, since the exchange rate, at which hard currency imports are costed in the budget, is below the market rate, only part of these subsidies are recognized as a component of expenditure in the state budget. 18. In the transition to a market-oriented economy, there will be a fundamental shift in the forms of compensation made to labor. Under the command economy, money wages were low. Hence, there was the need to have low administered prices for consumer goods and services. Low administered prices were considered a basic form of social protection. It was available to all regardless of need. Husing was also highly subsidized by enterprises and the state. In effect, a significant part of labor compensation accrued as benefits in-kind. Money wages will rise as the significance of in-kind compensation is diminished. This does not exclude the posFibility of some in-kind compensation. Even in market economies, employers and employees may still prefer that some part of the real wage accrue in kind (e.g. health insurance). However, in the transition to a market economy, it will be necessary to scale back the number of goods that are subsidized, while at the same time, new targeted measures are introd,uced to protect the poor. 19. Recommendations. The Government's best option is to move away from the system of universal subsidies as quickly as possible, and introduce targeted forTris of transfers to the poor. This course of action would eliminate both rent seeking behavior and unsu6tainable pressures in the budget. Ir. the short term, howev.er, the absence of adequate compensatory mechanisms for the poor preclude immediate large increases in the prices of basic goods and services. For the time being subsidy reforn will have to be done in stages. The appropriate pace of reformn will depend upon the design and implementation of alternative forms of transfers to poor people. This can be done by building on existing programs, in particular family allowances, or implementing a new cash social assistance betnefit for the poor. 20. It is reconmmended that the Government of Uzbekistan immediately consider the implementation of the following measures to increat, Lhe efficiency of the system of social protection: (i) remove the remaining subsid;-s on food, except for bread and flour, which are well-targeted .o the poor; (ii) reduce and eventually :nate import subsidies and, in the interim, incorporate re- aining import subsidies in the budget, (iii) abolish the remaining price controls on "free" prices ii - .junction with the development of a system of anti-monopo!y regulation, (iv) continue to improve cost recovery for housing maintenance: and (v) Lefine a timetable for reduction of subsidies on housing operations and maintenance, with temporary compensation for poor families. Credit Subsidies. 21. The use of subsidized credits provided by the Central Bank of U.bekistan (CBU) has had a serious impact on financial flows in Uzbekistan. Since credits are granted at substantial!v negative real interest rates, they constitute grants to the enterprise sector. CBU refinance credits have undat-mined the ability of the financial system to impose discipline on the enterprise sector, delaying the restructuring of industry. Ir addition, the "turnover fund" of the Ministry of Finance which is unmatche~d by any revenues has provided loans of at least 12 percent of GDP to enterprises on concessional terms. A significant proportion of total central bank credit is channelled through this fund. v Executive Summary 22. Recommendations. The Government and the CBU should move away from the central allocation of credit. The CBU should begin to grant credits on the basis of a market determined credit auction system. All credits should be channelled through the banking system, where credit is allocated according to standard assessments of enterprise credit risk and ability to service debt. Furthermore, the banking sector should rely on domestic financial savings, as opposed to CBU refinance credits. 23. In addition to phasing out the existing directed credit practices of the CBU all current credit programs of the central bank need to be reviewed and the largest recipients of directed credit should be identified. In the near future, however, the banking system will continue to rely heavily on central bank credit. The share of the credits auctioned should be rapidly increased and any interest ...te margins on commercial bank lending of these credits should be removed. Only those banks which meet regulatory standards should be allowed to have access to the auction. 24. Budget consolidation would subject the "turnover fund" to the same detailed examination as the main republican budget. Expenditures from this fund would then need to be classified as social sectot expenditures, expenditures in other budget categories, or support to enterprises. Although this consolidation does not have a direct economic impact, it adds transparency and explicit scrutiny to the budgetary process. 25. Any implicit subsidies for credits going to certain sensitive areas or not yet privatized enterprises during the transition period should be replaced by direct grants financed through the budget, strictly limited and eventually phased out. The main advantages of this arrangement would be to: (i) improve the government's monitoring of its actual expenditures; (ii) increase the accountability of enterprises with respect to these subsidies: and (iii) allow the financial system to perform its proper role of financial intermediation. Subsidies and Transfers in Agriculture. 26. The large distortions in Uzbekistan's agriculture are caused by price controls, subsidies, and transfers. The Government subsidizes agricultural inputs heavily, providing them for free, or at prices far below those it would receive if they were sold on the world market. However, there are also large taxes on agriculture through the state order system which more than offset the input subsidies. The state order system requires farmers to sell a predetermined quota to the Government at fixed prices significantly lower than the international price for these conmmodities. This imposes an implicit tax on agriculture and penalizes farmeis. In 1993, the total implicit tax through the state-order system was about US$1.6 billion for the four major crops cotton, wheat, maize, and rice. The implicit tax on cotton alone amounted to about US$1.36 billion. 27. The current agricultural production and marketing systems do not provide incentives for farmers to improve crop yields, increase quality or save in the use of inputs. Crop yields in Uzbekistan are therefore low; illput usage is highl and the quality of produce is often inferior when compared to that of Uzbekistan's competitors. Farmers are removed from market signals by the state order system and input subsidies. Their decisions on crop selection and the use of inputs are taken over by the State and economic returns are not be maximized. Even provisions which al!ow a portion of the crop to be sold on the free markt are inadequate because distribution systems are controlled by the Government. l his is particularl.r -, -iant for cotton, as the free portion of a farmer's crop must be sold through a Government aewn'.y if it is to be exported. Executive Summary vi 28. Recommendatons. The Governrnent should phase out the state order system and the production quota. State orders for cotton could be gradually reduced to about 60 percent in 1995, and in subsequent years to 40 percent, 20 percent and then eliminated completely. In the meantime, the prices fanners receive for the cotton procured under state order should be raised closer to world market levels. The Government should also gradually phase out input subsidies and rrovide farmers with the freedom to export any or all of their produc!s. Subsidies for key items such as fertilizer and water should be withdrawn to reduce waste and the over-usage of inputs. Furthermore, a taxation and revenue collection system for the agricultural sector should be introduced to include land rental and water charges. A scheme for the introduction of water charges should be designed by December, 1994. While the removal of the state order system would significantly reduce the Government's revenue base, it would be offset by lower subsidies and the introductior' of user charges and a new agricultural taxation system. Energy Subsidies. 29. There are different types of subsidies in the energy sector in Uzbekistan. Explicit subsidies are directly financed by the Government and a ise if the domestic price or the export price are lower than domestic production cost. In this case, the Government has to compensate the enterprise for its losses equal to the difft ence between domestic cost and prices. In Uzbekistan reported domestic costs are lower than domestic prices, indicating that there is no efplicit subsidy. However, the reported production costs understate the full costs of production significantly. If estimated at free market production costs, domestic prices are below cost and this implies a subsidy. 30. The second type of eneigy subsidies are implicit and do not have a direct budgetary impact. The most common form of implicit subsidies are those that arise when the world price of an energy commodity exceeds the domestic price. By seliing products on the domestic market at the low domestic price the producer foregoes substantial profits that it would get from selling at world prices. The producer, therefore, implicitly subsidizes domestic consumers by the difference between the world price and the domestic price. 31. Another type of implicit subsidy involves the large cross subsidies f,om the industrial sector to the general population and agriculture. Tariffs for natural gas, electricity and heat are differentiated by consumer. As of June 1994, tariffs for gas to households were, for instance, about 13 times that of industrial consumers. 32. Both explicit and implicit subsidies influmnce the allocation of resources away from what would result in a market economy. Low domestic prices, for example, lead to excess domestic consumption and reduces the level of exports. Low prices also reduce total production, since producers have no incentive to make the additional investments that might be profitable they received the world price. 33. Recommendaiarms, Energy subsidies are the result of the present system of price controls in the energy sector. The best approach to eliminating energy subsidies is to complete the process of price liberalization. Thc path and speed of energy' price liberalization are therefore central to the elimination of all types of energy subsidies. The Government believes in a gradual approach to energy price liberalizationm However, experience from countries that have faced energy price shocks suggests that economic r 1. n.turing has been most successful when the full level of increased energy prices has been passed e in jdustry and final consumers as rapidly as possible. vii Executive Summary 34. As a getneral rule, energy prices should be increased to fully reflect economic costs of production, or, when traded in world markets, the import or export value. For tradeable fuels (crude oil, refined products, and coal) prices can and should be decontrolled rapidly. Producer, wholesale anw retail prices of tradeable fuels should be fully liberalized in conjunction with the abolition of the system of state orders for these commodities. For nat iral monopolies (natural gas, heat, and electricity transmission and distribution) the Government should develop price and tariff structures and regulatory systems for these industries. The substantial differentials that exist betueen household, agricultural and industrial consumers of gas, electricity and heat should be reduced. The final sales price of energy should be allowed to varv regionally in 1995 in an amount which reflects at a minimum the transport and transmission cost differentials. Taxes should be imposed on the wellhead to capture a portion of the windfall gain or "surplus" profit resulting from rising crude oil and natural gas prices. Studiec will be required to assess costs and determine appropriate structures for the prices and tariffs, and regulatory bodies will need to be established. Economic Prospects 35. The decline in output is expected to accelerate in 1994 and 1995, but if reforrns are pursued rigorously they should lead to a stabilization of output and prices iD the medium-term and a significant reductio-! ;n fiscal and external imbalances in the long run. Economic growth will depend on the degree with which Governm,nt implements a strong macroeconomic stabilization program and the extent to which appropriate structural and sectoral reforms can be implemented.' Without macroeconomic stabilization, the uncertainty of the economic environment will make investment by individuals and enterprises more difficult. A major challenge 'or stabilization policy is to restore confidence in the economy. The success of the reform program will ultimately depend on the Governrnent's ability to implement a comprehensive program of structural reform and sectoral reforms (including price liberalization, privatization, reform of the financial sector) and a clear tuinetable for implementing it. Future output growth will, of course, also depend to some extent Oii exogenous factors, such as the future worid prices for Uzbekistan's commodity exports, the development of demand and output growth in neighboring FSU countries, and new discoveries of oil and gas resources. 36. Uzbekistan's pervasive system of subsidies and transfers is the main impediment to further adjustment of relative prices towards market equilibrium levels; i is also the main cause of the budget deficit. A decisive implementation of a privatization pr )gram would accelerate the overall reduction and elimination of subsidies and transfers to the enterprise sector. The reduction of the extensive subsidy system would help prevent a serious fiscal crisis, as well as provide enterprises and individuals with the right institutional and market incentive structure. W'ithout subsidies, efficiency gains will be much higher since market price signals are allowed to direct resource allocation. This should be reflected in an improveinent in productivity and output growth in the medium term. 37. Uzbekistan will need to require substantial medium-term external financing to rover the current account deficit and build international reserves. If the Government displays a more limited commitment to structural reforms, the economy may take longer to stabilize and the amount of available external financing will be lower. 1. The Crnutr. Economic Memorandum "Uzbekistan-An Agenda for Economic Reform', World Bank 1993, provides de :len 1crmmendations on the necessary structural and sectoral reforms. CHAPTER 1 ECONOMIC REFORMS AND PROSPECTS 1.1 Over the two years since the break up of Tabk 1.1 the Union, Uzbekistan Macrooecoo Iflndkators experienced a lower drop in 1989 1990 1991 1992 1993 total output than other countries in the former Soviet Rean GDP 4.5ge p.a.) -2.5 Union (FSU). In 1992, the Retil prices (avg.) 0.7 4.0 105.0 528.0 851.0 fall in real GDP in NMP Implicit price deflatot (avg.) 0.8 4.0 98.2 868.6 1050.1 Uzbekistan was of the order Avcrge monthly wages 6.5 11.1 51.2 612.0 700.0 of 10 percent, compared to (as % of GDP) 19 percent in Russia and 20 Investment experditure 31.7 32.2 25.8 25.6 23.5 percent on average for the Consumer expnditure 78.1 810 75.9 74.4 76.5 FSU. In 1993, GDP fell by Exports 33.2 29.1 33.6 63.5 na about 2.5 percent based on Imports 45.8 44.3 31.6 74.9 na official government data. Current account balance . 20.5 -11.6 na There are two main factors Source Uzgoskomprognostat, World Bank staff estimates and IMF. contributing to this performance. Uzbekistan's specialization in the production of agriculture and energy comnnodities somewhat shielded the economy from the collapse in FSU production centered in the manufacturing sectors. Oil production in particular has increased substantially due to the discovery and opening of a new oil field.' Energy production figures show an increase of about 6 percent, and the decline in GDP is estimated at about 3.5 percent if this figure is taken into account. Furthermore, Uzbekistan was slower than other FSU countries in removing state orders and subsicies. The continued controls helped temporarily in preventing drastic declines in Uzbekistan's economy; but they also disguised the need for fundamental adjustment and laid the ground for prolonged economic stagnation. Recent economic developments suggest that previous policies are unsustainable. 1.2 Since gaining independence from the Soviet Union, macroeconomic imbalances have increased. (For a detailed description see Box 1.1 and Annex 1.). National fiscal autonomy has been accompanied by growing budget deficits as a result of the cessation of transfers from the Union in 1992, and increased expenditures on subsidies and transfers. While an accurate picture of the overall balance of payments is difficult to obtain owing to statistical and methodological problems, some trends are evident. The overall current account deficit, measured in US dollars at quarterly average official exchange rates, increased from a deficit of around US$240 million in 1992 to USS417 million in 1993. A deficit in the balance of trade with FSU countries more than offset a surplus in the balance of non-FSU trade. In Uzbekistan, as elsewhere in the FSU, inflation has undermined the ruble and contributed to a collapse in the payments framework for inter-republican trade. Trade volumes within the FSU declined precipitously. 1. The o(tftild, (a 'ernment figures imply an increase in energy production of about 19 percent which seems to significantly oseitrtc,ma the increase, 2 Chapter I Box 1.1 Economic Developtnents in 1993 and the First Quarter 1994 Outru: In 1993. real GDP fell by a reported 2.5 percent The largest drops in producnon occurred in those sectors most cloely linked to other FSU countries with whonm trade and payments flows have been disrupted for several months Agricultural output expanded, construction output fell by 5 percent, and energy production rose by about 6 percent in 1993. In ' futst quarter of 1994, GDP declined by about / percent (compared to the same period in 1993) This was mainly due to a sh, Cfine in idustrial production (7.5 percent) - especially in heavy industry. Output in light industry increased by about 3 p. ent and agncultuml output remained at the previous year's level. EmDlovment and Income: In the absence of significant restructuring of enterprises and collectivcs, and relatively small declines in output, the unemployment rate remained under I percent in 1993. Also, real incomes among the population and coissumer expenditure have helo up relatively well. Most of the decline in purchasing power occurred in the value of trsasfer payments, the bulk of which were pensions. Tne household savings ratio may have risen to around 12 percent in 1993 and consumer expenditure may have declined by as much as 7 percent. The financial position of the enterprise sector has detenorated markedly since independence, with the consequence that investment expenditures were cut back significantly, by about 10 percent in volumre in 1993. Monetary Developments: The supply of money and credit to the Uzbekistan economy grew ra,iidly in 1993. At the end of September 1993. the total liabilities of the banking system stood at R2,627 billion an increase of over 1000 percent on the level at fte end of 1992. Ibe main factor fueling the monetary expansion in 1993 was the rapid expansion of central bank credit. In the first quarter of 1994, the increase io money supply in real terms was less than in the corresponding period of the previous year. This was mnainly due to the tightening of the Government's credit policy. Prices and Wages: As measured by the implicit price deflators accompanying the national accounts. inflation increased to aund 1100 percent in 1993, up from around 900 percent in 1992. The main factors driving prices were:- (i) the expansionist monetary policies pursued since the breakup of die Union; (ii) consumer subsidies were partially removed, and (iii) the partial liberalization of energy prices in mid-1993. Nominal wages rose at an annual rate of 700 percent over the first three quarters of 1993 and nominal wage inflation in the state sector was above average. Real wages fell by a further 5 percent in 1993 when the inimumtL real wage fell by around 10 percent. However, t,e minimum wage was more than doubled in early January 1994 when it stood at R30,000. In the first quarter of 1994, retail and wholesale prices increased monthly by about 20 pernent. Trade: The acceleration in inflation, the economic instability in Russia and the other FSU countnes, and the breakdown of the payments system have seriously disrupted trade flows in Uzbekistan. Imports of grain shifted from Ukraine to hard currency countries. The volume of exports to the FSU fell by over 20 percent in 1993 because of generally weak condtions for trade in manufactured goods. Import volumes from the FSU fell by an estimated 16 percent in 19934 A surplus of US$158 million was reported on the balance of hard curreno-y' rrade in 1993, following a deficit of USS60 million in 1992 The main reasons for this turs-around were significant gold rules in 1993 which were not reported in the balance of payments in previous years, iower grain imports from hard currency areas which more than offset increased imports of other food items and sharply higher imports of capital goods. In the first quarter of 1994, hard currency exports amounted to USS233 million whereas imports were US$180 million. The increase in exp.rts resulted from a 50 percent increase in conon exports. Imports declined duc to significantly lower food and machinery impors Fiscs' Policy: The Government limited the budget deficit in the narrowly defined ruble budget to 2.5 percent of GDP in 1993. While tax collections have improved, this outcome was also the result of the ming of expenditures to cxtra-budgetary funds. A consolidated budget that accounts for net lending, extrabudgetary funds and fort :, .urrency expenditures and receipt would show a substantially higher deficit. Budgetary control is seriously affected by the use of several extrabudgetary funds This includes 15 foreign exchange funds. The foreign exchange funds are mainly used for the impon of foodstuff and other important goods. 1.3 Prices generally rose at a faster rate in 1993 than in the previous year. Wholesale price inflation averaged about 1100 percent in 1993 and retail prices increased by 1300 percent. The supply of money and credit grew rapidly in 1993 mainly bczause of the rapid expansion of Central Bank credit. In July 1993. the ruble zone was effectively disbanded as a common currency for the FSU and in November, the I 'zhek authorities introduced the Sum-Coupon as an additional medium of exchange with the intention thal i; wil! become the Uzbek national currency. Economic Reforms and Prospects 3 An Outline for Reform 1.4 The Go%ernment of U,Jzbekistan's preference for a gradual approach to reform was confirmed by the various policy initiatives implemenited in 1993. Prices were partially liberalized; new taxes imposed; import tariffs removfcd, small shops and residential housing privatized; and new laws on banking, property and foreign investment enacted. However, reforms in most of these areas proceeded slowly (see Box 1.2). 1.5 A gradualist reform program may accomplish the eventual transformation of the economy to a more efficient and equitable social-market system. but it will probably be more difficult to implement. A partial reform program poses the risk of getting the worst of two worlds. The persistence of the price distortions of the centralized economy hinder the movement of resources to new economic activities. In turn, the failure to fully stabil.ze the economy and successfully establish market institutions may have adverse consequences for the distribution of income and social welfare. The Governument's Reform Program for 1994 and Beyond 1.6 Starting in December 1993, the Government issued several statements and decrees describing the reform program (See Box 1.3). These documents indicate sigi.ificant progress in the Government's conception of economiiic reform. In particular, they szress the importance of achieving the stability of a national currency and implementing structural reforms, both fundamental to the success of the program. The statements also include commitments to: liberalize nrices; limit the budget deficit; remove credit subsidies and tighten credit policies, abolish the foreign exchange tax, create a market in foreign exchange; strengthlenl the Central Bank and ihe banking system; extend the privatization program to the sale of medium and large enterprises; and, target social assistance and define the poverty line. All of these are positive steps that woulo contribute to structural reform. Furthermore, the IMF is currently preparing a Systemic Tranisformation Facility (STF) program which would support the reform program of the Government and calls for wide-ranging reforms during the program period. 1.7 The Presidential decree of January 22, 1994 provides in part for the strengthening of property rights, the promotion of privatization in the industrial and construction sectors, and increased public participation in privatization through open joint-stock companies and the sale of shares through a stock exchange. The decree reduces the number ot goods subject to export licensing requirements, establishes uniform treatmienit for FSU and non-FSU trade, and eliminates import tariffs until July 1995. It also calls for specific measures to make the new currency convertible and to open up the capital account of the balance ot paynments. 1.8 The Sequencinc of Reforms. The agenda for reform may serve as the basis for a blueprint of the coi iprehen.si;ve set of detailed and self-consistent policy initiatives required. The program the Government intends to implement covers key areas of reform (See Box 1.3). But development of the stated policy agenda is needed. More generally, much of the timing and sequencing of the policy implementation remains to be worked out, along with the detailed program specification, budgetary analysis and costing. Also, areas of both complementarity and conflict need to be identified. An area which needs special attention is the scope, approach, scale and timetable of the privatization program. 4 Chapter 1 Box 1.2 The Status of Structural and Sectoral Reforms The State Order. State order quotas in agriculture and industry were only marginally reduced in 1993. The Presidential decree of January 21, 1994 called for the elimination of the system of state orders. The implementation of this intention has begun: state purchases are to be limited to coton, grain, meat, poultry. milk, petrol, diesel, coal, and a small number of consumer items for distribution in hospitals, schools and special shops in 1994. For die items to remnain under state ordeT, there has been a decrease in the proportion of total output represented by state purchases, and further decreases are planned. Uzcontractorg (the largest domestic distribution monopoly and primary responsible for mnanagement of state orders) has been dismantled per a March 1, 1994 decree. External Trade Reform. Bilateral trade agreements encompass about 80 percent of FSU and non-FSU trade. This brings about the need for considerable use of administrative controls such as quotas, licenses and Government controlled distribution. Some steps, however, have been taken to liberalize external trade flows. The number of commodities subject to export licenses fell from 176 in 1991 to less than half in 1993. In February 1994, the number of goods subject to licenses according to fixed quotas was reduced from 80 to 26. Private barter trade agreements within the FSU (which avoided export tax liability) were made officially illegal from July 1, 1993 and international trade agreements are now based on international prices. AlthLugh licenses apply to both irnports and exports, imports are essentially free of licensing. Gnly 6 product categories require an import license. Customs control has been transferred to the taxation committee. On April 15, 1994 the tax on foreign currency earnings was eliminated and the surrender requirement increased to 30 percent and was extended to centralized exports. Price Controls. Direct price controls on many food and consumer goods were removed duriiig 1993, although price controls were maintained in connection with rations of allocations quotas for some items. Privatization. The first privatization auctior. took place on March 4, 1994 in Namagan. The Uzbek Committee on Privatization reports that by November 1993 (14 months into the privatization program), about 40,000 SOEs had been privatized. While most of the privatization was of small-scale SOEs, several hundred medium-scale SOEs and some large-scale SOEs have been sold. For example in internal trade, more than 9.000 of Uzbeksavdo's (Ministry of Domestic Trade) 11,000 shops are reported to have been privatized individually or by local groups. However, the eight large national wholesalers are still under Government ownership. In consumer services, all but 400 of about 12,000 enterprises have been privatized. In addition, privatization of larger enterprises has proceeded on a discretionary basis and sectoral privatization programs have been initiated elsewhere in the economy. The main criticism of the privatization program Lr that transfers are exclusively to staff at below-market prices. Experience in other countries suggests that exclusive sales to SOE staff invariably ends up generating less growth and employment in the medium term than other more open forms of privatization. The main reasons are that current staff are unable to supply all the enterprises future needs for management expertise and capital. Privatization has also started in agriculture where the Government has distributed an estimated 450.000 hectares of land to rural households. This amounts to a little over 10 percent of the total land area under irrigation in Uzbekistan. Over 10,000 small agricultural enterprises have been sold. Average family plot sizes are 2000m2 and the land reform is expected to contribute to improved productivity in agriculture, and an easing in the fiscal cost of the social safety net as required outlays on food subsidies decline. The Government wants to modify the land leasing program and introduce privatization. Housine privatization has moved quickly. In December 1993, titles to about 95 percent of the state-owned dwellings in Tashkent and 85 percent in the rest of Uzbekistan had been transferred to their occupants, mostly in return for a nominal fee. These transactions, however, have not reduced the housing subsidy burden, nor altered the management of the state-owned housing nor led to the development of as; active market in real estate. In 1993, 70 percent of the actual operations and maintenance outlays were from the budget. Privatization fees are being used to complete residential construction projects that had been stopped because of increased pressure on budget resources. Economic Reforms and Prospects 5 Box 1.2 (cont.) Entererise Governance. Coordination of supply chains has shifted from ministries to concerns, associations and unions of SOEs in an attempt to dismantle vertical integration of industrial combinates and move enterprises closer to suppliers and customers. A concern is an industry holding company that coordinates the allocation of inputs and credit and directs production acti-ity among SOEs in the industry. Concerns are responsible for the management of their SOEs state orders. At the evel of the SOE. however, activity continues to revolve around the fulfillment of the state order with little regard to profiLs or financial management. Financial Sector Reform. Financial institutions in Uzbekistan are not currently in a position to support the privatization and restructuring of existing enterprises. In 1993, an interbank credit market for th^ trading of excess commercial bank credit was developed and interest rate margins were eliminated, but the interest rates at which these credits are extended are still very low. The extremely negative real interest rates on deposits are discouraging private deposits in the banking system, expropriating financial savings and redistributing wealth in the economy away from savers towards borrowers. Consequently, the sector does not f, Ifill its major function of intermediating the flow of savings between borrowers and lenders. The Central Bank of Uzbekistan continues to direct the overwhelming portion of its credit to the economy to specific purposes and enterprises ti accordance with directives framed by Uzgoskomprognostat and approved by the Cabinet of Ministers. These directed credits carry interest rates that in the current inflationary environment effectively transform the credits into capital grants. Thus far, the high rate of inflation has eroded tie real value of banking system assets and liabilities and increased the dependency of the comnmercial banks on the credit resources of the Central Bank of Uzbekistan. 1.9 Policy Complemenitarities. The major initiatives intended to stabilize the economy are in large part mutually reinforcing. Stabilization policy is the key to building credibility in the Government's programii. Monetary and fiscal policies should stabilize prices, output, the public sector deficit and the external trade imbalance over the medium-term. Without macroeconomic stabilization, uncertainty concerning the econiomiiic environment will make it increasingly difficult for individuals and enterprises to conduct economic relations. The economy will be more susceptible to budgetary or financial crises and the cost of transition could then be higher than necessary. I .10 Reform of the fiscal system is central to macroeconomic stabilization. The overall fiscal deficit (including extrabudgetary funds and net lending) was about 16 percent of GDP in 1993 and substantially larger than the deficit in the narrowly defined ruble budget. Macroeconomic stability will only be possible if this deficit is substantially reduced. In the absence of private savings, public sector deficits would otherwise he monetized and accompanied by external deficits which would deplete international reserves and undermine the currency. The successful introduction of the national currency - - the Sum -- will require that supportive economic policies be put in place, notably in the form of anti- inflationary monetary arid fiscal policies. I . I Fiscal dliscipline can only be restored if reductions are made in subsidies. transfers and net lending. Uzbeki'.tan's pervasive system of subsidies and transfers is the rnain impediment to further adjustment of relative prices towards market equilibrium levels. it is also the main cause of the budget deficit. The Governt-iTe1t should cut subsidies and transfers both in the ruble budget and off-budget funds. This include ( U5sihlCc through directed credit programs, low interest rates, and energy prices. All these indirect SUIJi rc larger than budgeted subsidies, and are growing fast. For price liberalization to proceed it) . t and service sector, consumer subsidies in these sectors must be reduced accorditi' . i,,iled analysis of the subsidy and transfer system is undertal .is report. 6 Chapter 1 1.12 Successful macroeconomic stabilization cannot by itself establish the basis for reviving growth, generating sources of employment as the economy is restructured, and enccuraging development. The success of the reform program will ultimately depend on the Government's ability to implement a comprehensive program of structural reform and sectoral reforms (including price liberalization, privatization, reform of the financial sector) and a clear timetable for implementing it.2 Structural reforms will improve the incentive system for efficiency, innovation, and growth. The reform program should seek to increase resource mobility thus allowing production and consumption decisions to respond to market prices. 1.13 However, rationalization of the subsidy and pricing system is a pre-condition for restructuring of the financial. enterprise, agricultural and energv sector. Price reform is essential to provik the right signals to consumers and investors. One of the priorities for reform should be to minimize domestic distortions and to improve the relative price structure. The subsidies and price controls, currently in place, distort the structure of relative prices and make a meaningful cost-benefit analysis impossible. Without a clear signal on prices, investors and producers cannot determine the potential value of privatized assets. 1.14 A key priority should be the re-orientation of enterprise activity towards the objective of profit maximization and away from output maximization. Profits and prices have to play a significant role in the SOE's activities. However, at the level of the SOEs and farms, management activity continues to revolve around the fulfillment of the state order with little or no regard to profits, prices and financial management. The subsidy and transfer system does not provide any economic incentives to cut production costs. Furtherimiore, the state order systemn completely bypasses any reference to market price signals as a guide to resource allocation and also undeimines the efficacy of the trading system. Privatization of SOEs does not remove the obligation these enterprises have to meet the production targets contained in the state order - it simpl) tranisfers the problem to the private sector. The state order system should therefore be dismantled entirely. 1.15 The elimination of the substantial implicit subsidies provided through the negative real interest rates charged on enterprise loans will reveal the difficult financial situation of many SOE's through increased losses. This issue needs to be prcactively managed by the Government, leading to the recapitalization of eniterprises and banks and/or the write-off of enterprise debts and its substitution in the books of the banks by Government bonds. Some viable enterprises will need to have their debt rescheduled. 1.16 Internal trade reform would be incomplete and distortionary in the absence of external trade reform. Moving towkards international prices during the transition is necessary to give the correct signals to domestic producers and consumers, thereby leading to greater production and welfare. International competiiotn, combined with competitive factor markets and competitive markets for nontraded goods. is needed for prices to be effective signals and incentives for economic efficiency. An effective trade policy would seek to reduce the state involvement in trade, remove import subsidies, limit export quotas and export licenses, and reduce tax distortions. 2. sIe recommendations on the necessary structural and sectoral reform-s can he found in the report Uzbekistan - An Ageri. .,i 1-nnmic Reform". World Bank, 1993. Economic Reforms and Prospects 7 Box 1.3 The Government's Economic Reform Agenda for 1994/95 Obiecives. Successful stabilization policies are seen as prerequisite to the implementation of a comprehensive set of reforms aimed at transforming the economy into a socially oriented market based system. The program will reduce the role of the state through initiation of a privatization program and elimination ot direct controls and subsidies. Coordination and Control. The Cabinet of Ministers will exercise direction over the reform program, in coasultation with Goskomprognostat, the Ministry of Finance, the Central Bank and other economic agencies and ministries. The institutional basis has been strengthened and the Ministry of Finance has been put under direct control of a Deputy Prime Minister. The Government's information flow will be improved through a restructuring of the statistical system. In 1994, a standard system of national income accounting will be established. Balance of payments, banking and financial statistics will be upgraded and the system of economic indicators will be improved. Stabilization Policies Fiscal Policy. Priorities in 1994 will be: (i) limiting the consolidated budget deficit to an estimated 8 percent of GDP; (ii) supporting attempts to stabilize the price level; and, (iii) providing a stimulus to production and investment activities. Spending Policy. Government expenditures will be reduced by a number of means. These include: (i) rationalizing the current wage system; (ii) targeting social assistance to those most in need: (iii) lowering consumer subsidies on services; and, (iv) lowering subsidies and t.ansfers to enterprises especially extrabudgetary spending and lending (directed credits). Budget financing will be improved in 1994 through the creation of 3 market in short-term debt certificates. Budgetary management will be made more effective: all existing oft-budgetary funds will be consolidated in an overall state budget and local budgets will assume a greater share of the total to imT\prove accountability. Tax Policy. Tax receipts will be enhanced through widening the tax base of the VAT, enterprise, personal income and land taxes, Excise taxes on some goods will be increased and the VAT and excise taxes will be extended to imported goods. Furthermore, the tax base for the property tax will be narrowed to include only fixed assets rather than fixed assets plus working capital and inventories. Monetary Policy. The Central Bank will maintain direct control over the provs ion of credit until the financial system has evolved to a point where standard monetary policy instruments can be used. Refinancing credits with a maximum maturity of one year will be auctioned among the commercial banks on a competitive basis. Provision of subsidized credits will be discontirnued with the exception of credits granted for the procurement of food and the production of gold and fuel energy. Exchange Rate Policy. The new currency, tle sum, will be introduced in the near future. with the conversion rate of sum coupons to sum at the rate of 1,000 sum equal to one sum. An auction for the sum will be held during the first week of the conversion process. Interventions on the foreign exchange market will be limited and there will be no effort to target an exchange rate. Commercial banks have been authorized to open correspondent accounts with banks in other countries. New foreign currency regulations will be adopted. Systemic Reforms Price Liberalization. Consumer subsidies will remain for bread flour and some medicines. Rations for rice and household soup were eliminated effective March 1, 1994 and rations for other goods will be revised as of lanuary 1, 1995. Gradual liberalization of prices of utilities, communication services, transport and energy products will 8 Chapter I Ros 1.3 (cont.) continue in 1994. Controlled prices and tariffs will be adjusted regularly to reduce the budgetary cost of subsidies. Price controls and nargins will be reviewed by the end of 1994, except on natural monopolies. Privatization and Private Sector Development. Privatization efforts will focus on the sale of medium and large- scale SOEs in the construction, transport and manufacturing sectors during 1994-1995. A new program for large-scale privatization was issued on March 29, 1994. However, the scope, approach and timetable of the privatization program will have to be revised since there are several inconsistencies on bidding criteria, staff discounts, land transfers etc.. It will also have to be opened up to post privatization to outsiders, it has to fragment monopoly positions prior to privatization, it has to limit enterprise staff pre-emption and should rely only on transparent, competitive scales. The Government will review the legal framework for private sector development including property rights and laws governing exit and entry. The Government plans to introduce a law permitting private ownership and transfer co land, including agricultural land, in 1995. A foreign investment company law will be implemented by September '994 and a bankruptcy law by the end of the year. State Order. State purchases are to be limited to cotton, petrol, diesel, coal and a small number to consumer items. Te Government intends to remove state orders on meat, poultry and milk by September 1, 1994 and the state order on grain by January 1995. The Government also plans to reduce the state order for the 1995 cotton crop to 60 percent and will be phased out after 3 years. Housing Privatization. Budgetary support for operations and maintenance of housing will be reduced in 1994 and eliminated in 1995. The Government will issue new regulations to strengthen property rights of owners of privatized housing. Banking System Reform. The requirement that 70 percent of the deposits of the Savings Bank be transferred to the Central Bank will be removed. In 1994, an inter-bank auction market in Government securities will be establisbed. Government securities will be listed on the stock exchange. Commercial bank licensing requirements will become more stringent. Anti-Monopoly Policy. The Government intends to redefine the functions of the Department of Price Setting and Anti-Monopoly Policy of the MOF and convert it into a Competition Department when it begins to revise the anti- monopoly law. That Department will review privatization proposals of medium and large-sized enterprises and those in the monopoly system. Reforms to the External Payments Svstem. New foreign currency regulations will be adopted before the introduction of the new currency. The Government intends to reduce the surrender requirement as foreign exchange availability ..nproves. All gold and foreign exchange reserves held by the Government will be transferred to the Central Bank. External Trade Reform. A unified system of export quotas and licenses might be introduced in 1994 and replaced by an export tax with higher rates for cotton and minerals. The system will conform to GATT standards and will feature competitive bidding for the allocation of export licenses. The goods requiring licenses will be reduced from 26 to 20 by July I, 199a and will be reduced further by December 1, 1994. Centralized procurement of imports will be reduced to a minimum ind import subsidies will be lowered, Trade policy guidelines will be formulated during 1994 and the trading system will be adapted accordingly. The Social Safety Net. New laws will be passed on: (i) the social protection of the population; (ii) the indexation of incomes: and, (iii) minimum subsistence incomes. Social protection will be targeted on those families whose income is less than the subsistence level, Economic Reformns and Prospects 9 1.17 Policy Trade-Offs. Conf.icts will arise in several areas. The implementation of restrictive credit policies to achieve price stabilization, privatization and restructuring of enterprises and the abolition of subsidies might lead to some output contraction and unemployment. The Governrnent's success on this f-ont will depend in large part on the speed with which productive resources can be redeployed and on the Government supporting the private sector and the response of enterprises to the stabilization prograrn. 1.18 The shift to tighter credit conditions and a more austere fiscal policy will be accompanied by a squeeze on liquidity and profits in the enterprise sector. The enterprise bankruptcy rate will rise. The policy on bankruptcy must be clearly defined to facilitate the re-organization of uneconomic production. Persistent loss making enterprises should be closed down. The combination of tight credit and higher credit risk may also have some cost for success of the proposed reforms to develop the commercial banking system. With liquidity at a premium, commercial banks will be reluctant to diversify asset portfolios to incorporate new risks in the private sector; it may be necessary to provide financing for private sector development. 1.19 The need to guarantee social protection of the population will place a constraint on the pace of some economic reforms. Unemployment will inevitably arise for economic adjustment to take place. Therefore, in the near-term, high priority should be given to shifting to a systein of targeted income subsidies as the central instrument of social welfare policy. In considering an appropriate strategy for the future, it is necessary to establish certa:n requirements that labor policies and social safety programs should fulfill. Economic Prospects 1.20 The path of the economy over the next few years will depend on the success of macroeconomic stabilization and the pace and extent to which appropriate structural and sectoral reforms are implemented. Also important are several exogenous factors such as the world prices for Uzbekistan's exports, FSU demand and discoveries of new natural resources. At the present juncture, the economic outlook is particularly uncertain because of the continuing crisis in trade and payments among FSU countries. The following scenario illustrates the impact of gradual but comprehensive reforms on the transformation of the economy. The projected numbers should be viewed as simulations dependent upon assumptions concerning policies that may be implemented, rather .han best estimates of probable outcomes. Reform Scenario 1.21 The reformii scenario assumes that cornprehensive reforms will take place; including liberalization of prices: ending of direct state involvement in trade; phasing out the state order system; and accrleration of privatization efforts. Stabilization policies are assumed to bring down the inflation rate to a moderate level in the mid-to-late-90s. The reduction and eventual elimination of the extensive subsidy system would prevent a fiscal crisis. It would also provide enterprises and individuals with a better institutional and incentive structure. If market price signals are allowed to guide resource allocation. productivity and output growth should improve in the medium term. 1.22 .Jer these assumptions, the decline in output is expected to accelerate in 1994 and then slow down " positive growth would resume in the late 1990s (see Table 1.2). Output falls would 10 Chapter 1 be the steepest in the manufacturing and construction sectors of the economy, but falls in these sectors would be offset to some extent by rising energy production. Increased output in the oil and gas sectors is anticipated when production from several large projects comes on line. A larger increase in energy production could have a significant positive effect on the overall increase in GDP over the medium term. If foreign direct investment and external financing help to develop the potential of the e-onomy especially in the energy secto,, the country could achieve higher growth rates than anticipated in this scenario in the medium term. 1.23 Stabilization measures should compound the autonomous output decline in industry by tightening the budget constraint on enterprises and forcing some enterprises to close down either through bankruptcy or troubled restructuring. Declining real wages and employment should depress consumer spending ever this period, and investment may also continue to decline. 1.24 A s t h e economy would become more Table 1.L integrated into foreign Macroeconomic Sitmulations, Reform icenario markets over the medium- terrn, the trade deficit is 1994 1 995 :996 1997 1998 expected to narrow. Total export growth may average (7% change p.a.. constant 1992 prices) around 2 percent p.a. in Real GDP -7 -4 -1 2 3 volume terms. The most B, Sector: important export commodities Manutacturing -14 -12 5 0 2 would continue to be cottonl, Energy 6 5 2 1 0 gold and natural gas, Construction -15 -10 -6 -3 -I although exports of Agriculture -2 0 1 2 3 manufactured goods are Services -5 -2 - 3 4 expected to grow from a Investment spending -22 -15 -2 6 9 small base. However, there Consumption per capita -5 -6 -2 -1 0 is some uncertainty concerning actual production, Current account (as a % of GDP) -6 -5 -5 -4 -4 fabrication and export levels in the gold sector. Imiport Source: World Ban4 Staff estima' s. volumes are expected to grow and food arid grains would continue to be the most important imports. Eventual self-sufficiency in oil production should improve the trade balance and contribute to a further shift in the pattern of trade away from the countries of the FSU. The positive outlook for the merchandise trade balance would be reflected in a gradual reduction in the overall current a.count deficit from an estimated 6 percent of GDP in 1994 to around 4 percent by 1998. By the late 1990's, the non-interest current account balance may show a moderate surplus, and the overall current balance is expected to be in rough balance. 1.25 Improved budgetary management and fiscal reforms could bring about a medium-term reduction in the consolidated government budget deficit.3 In 1994, it is assumed that net lending (directed credits) throuch thc turnover fur.d of the Ministry of Finance will be substantially reduced, resulting in 3. ifif : '. ,ic tecommendauions on the consolidation of the budget, see Chapter 2. Economic Reforms and Prospects 11 an improved fiscal balance. Expenditures of the Republican ruble budget are assumed to fall substantially with a further decline in 1995. However, government receipts will also be lower in the near-term as falls in GDP over the transition period will result in reduced revenues from tax collection. Growth in expenditures of the Social Insurance Fund are expected to partially offset significant cutbacks in budgeted Wubr dies. Social welfare spending will be increasingly redirected through the Social Insurance Fund; increases in the deficit of the fund may, however, slow down improvement in the consolidated fiscal balance. 1.26 External Financing Reguirements. Access to external finance will depend largely on the success of the Government's reform program. International creditors will want to see a feasible program in place and the required mechanisms to implement the program. If reforms are reversed or arrested, willingness of the international financial community to lend will diminish, and access to required external financing will become more difficult. 1.27 Total external financing requirements should decline from around US$700 million in 1994 to around US$400 million a year by the end of the decade. In 1994, the current account deficit may amount to around US$300 million, an estimated US$150 million would be required to increase international reserves to ensure a minimum adequate level of international liquidity. Provided the reform effort continues, debt service is expected to rise to 10 percent of total exports by 1998-1999. Multilateral credit could bc, an important source of external financing over the medium term. Direct foreign investment flows, export credits and bilateral credit will depend largely on the Govermnent's ability to create a stable economic environment thereby reducing the perceived risks to investment. Table 1.3 Medium Term Projections: External Financing Requirements Under the Reform Scenario' 1994 1996 1998 2000 L U L U L U L U (US$ tihl., lower and upper boundaries of projected ranges) Non-Interest Current Account 299 366 137 167 45 55 -19 -24 Debt Service - Amortization 147 179 182 222 259 316 214 262 Debt Service - Net Interest 44 53 104 127 125 152 139 169 Change in Reserves 131 162 49 60 18 22 19 23 Total Financing Needs 622 760 472 576 446 545 352 430 Direct Foreign Investment 108 i32 112 137 117 143 122 149 Multilateral Financing 134 164 118 144 135 166 136 166 Loans"' 353 431 ?03 249 135 65 24 29 Export Credits 27 33 38 47 59 72 71 86 Total Financing Sources 622 760 472 576 446 545 352 430 Note: The ranges indicated above reflect uncertainties around the midpoint of each the components rather than alterna:,ive policy scenario. Thus, neither the lower or upper bounds can be added up to represent an independent balance of payments scenario. a/ Includcs hil.merai ioans. Sourcc. Wotild Pink Staff estimates 12 Chapter 1 1.28 External Debt Management. A new law on external borrowing was adopted in May 1994. Under the new arrangement, a register of domestic and external debt has been established at the Central Bank of Uzbekistan. The Central Bank will compile monthly statements, starting June 1994, on the status of Uzbekistan's debt. The Government has to ensure that the level and maturity struc.re of external debt is consistent with external viability of the balance-of-payments. Uzbekistan should be able to service future debts according to contractual terms and should therefore develop a track record as a good creditor. This would be a valuable asset in the international capital niarket that would eventually reflected in lower borrowing costs and more favorable terms on international borrowings. However, the country's sustained creditworthiness over the long run will depend on the polices pursued by the Government. Most important would be those polices that ensure the transparency of the financial sector, as well as policies that encourage export oriented economic growth. An Alternate "Muddle-Through" Scenario 1.29 The alternative scenario assumes that the Government follows a partial approach to reforms. This scenario is characterized by limited price liberalization, failure to dismantle the state- orders, and a reluctance to control government expenditure and credit growth -- all leading to adverse macroeconomic outcomes. 'l'he stabilization of prices, output and the fiscal balance would take longer to achieve; acc')rdingly the medium term growth prospects of the economy wouid worsen. Irresolute policy action would amplify uncertainty in the econoniy impedinlg private sector development. 1.30 The near-termii declinie in output may be less than under the comprehensive reform scenario, mainly reflectirig no significant restructuring of economic activity. Economic stagnation would alsc be prolonged and the total cost to the economy -- measured in terms of lost output growth over a number of years -- would be greater than for the reforn scenario. A less favorable assessment of Uzbek economic fundamentals by the international capital markets would also substantially limit thie availability of external financinig. This wonid reduce the flow of essential imports, but, in the near-term, might also lead to a lower current accounit deficit. However, reduced investment would lower export prospects and the longer term outlook for the external balance would be worse than for the reform scenario outlined earlier. External indebtedness and debt-service obligations would tend to rise over time and would eventually exceed the levels projected under the reform scenario. The Major Risks to the Economic Outlook 1.31 Manv risks and uncertainties must be factored into the medium-term outlook for the Uzbek economy. Some risk factors are features of the regional and global economic environment and are beyond the control of the lizbek authorities; others are specific to the present industrial and financial structure of the economy' or to particular policy options now before the Government. Policy makers should attempt to assess the impact of these risks on economic development prospects and adjust policies programs as appropriate External Risks 1.32 () 3 wicrnal risk would appear to be the possibility of supply bottlenecks in the FSU since sonic .itional import links are broken, especially in Russia. The breakdown of the payments ilt t..' i' has reduced essential supplies of imported inputs. If FSU trade experiences Economic Reforns and Prospects 13 significant disruptions beyond 1994, outcomes for growth and the current account would be adversely affected. 1.33 Second, Uzbekistan is vulnerable to relative price shifts in the markets for its major commodity imports and expo.ts. Uzbekistan is particularly exposed to conditions in the world cotton narket because its export base is currently dominated by one commodity -- cotton. The appropriate policy response is twofold. First, the export base must be allowed to diversify to reduce dependence on cotton. Second, the quality of cotton must become premium grade so that Uzbek production becomes less vulnerable to downturns in the world cotton market. 1.34 As a net oil importer Uzbekistan is exposed to changes in world oil prices. The prospective rapid shift to market pricing in Uzbekistan's oil trade with Russia are factored into the projections for 1994 as is a modest strengthening in the world oil price in line with the stronger trend in global industrial activity. Any large variation in energy prices will impact economic performance. In the natural gas sector, the major risks are delays in projects that will expand future gas production and add to the exportable surplus. These risks will in part depend on Government policies. Risks regarding future prices will be influenced by the terimis of project agreements. particularl) the terms covering prices over the medium term. Internal Risks 1.35 In the short-term, the main risk is that policy efforts to stabilize the economy and balance the budget will be insufficient or fail. The clhallenge to reduce inflation, stabilize output, close the budget deficit and maintaini exterinal solvericy should not be underestimated, 1.36 Fui thermore. it is not clear tthat the authorities fully appreciate the systemic transformation required, the magnitude of the required policy' changes. nor the cost of adjustmnents stemming from public expenditure cuts and dislocations of production. T'he reform scenario projects that the standard of living may contract during the transition to a market system. This consideration highlights the urgency of early identification of areas where policy trade offs exist. The costs of significant policy' slippage, inaction or policy reversal on the stabilization front are high. They' entail a high potential for more widespread economic and social disruption. 1.37 Finally, as the range of decisions broadens and the complexity of issues increases, decentralization of authority will be necessary. Timely and effective implementation of the structural and sectoral reform program iwill require a substantial strengthening of institutional capacities. Because the pace of reforms may he :onstrained by the inability of the administration to implement policy measures, training to improve the capacity to implement economic policy, is therefore a high priority. CHAPTER 2 SUBSIDIES, TRANSFERS AND THE GOVERNMENT'S BUDGET 2.1 Subsidies are present throughout Uzbekistan's economy Rationalization of the subsidy and transfer system is a necessary pre-condition for macroeconomic stabilization and restructuring of the financial and enterprise system. Subsidies distort relative prices, slow adjustment, and create large macroeconomic imbalances. Without removing subsidies, prices cannot work properly. Relative prices should influence and guide decisions on levels of production and consumption, such that those goods and services which can be produced most efficiently will be provided. 2.2 T'he Government of Uzbekistan has realized that the current subsidy and transfer system is generating unsustainable budgetary pressure, making cuts in subsidies necessary. However, the budgetary subsidies for heating, transport and medicine are still large. Furthermore, because the Goveurnent must cover the rising gap between the purchase cost of a good and its subsidized final sale price, inflation has substantially increased the budgetary cost of direct consumer and input subsidies. 2.3 In December 1993, the Goverrnent, through its statement on Table 2.1: Subsidies, 1993 - Estimate systemic and macroeconomic policy, Inbins of As % announced that it would reduce expenditures of rubles/sum-coupons GDP by lowering consumer subsidies on services. it would also lower subsidies and transfers to - Food' 229 5A1 enterprises in industry and agriculture. - Non-Food 164 3.7 Gradual liberalization of the prices of utilicies, communication services, transport, and Concess.onal Loans to Enterpnsesb 526'754 12'17 ene;gy products is also planied for 1994. Total Budgetary Subsidies 9191147 21/26 Hlowever, much of the timing and sequencing of the policy implementation remains to be Import Subsidie, Financed worked out, along with detailed program through Cotton Sales' 260 6 specification, budgetary analysi 3, and costing. Fnergy Subsidies 1,00) 23 2.4 The Government's resolve to Directed Credits (CBU)f 1,400 32 reduce subsidies should not only apply to subsidies in the narrowly defined ruble a/ Includes partially import subsidies. budget. This would only partially address the b/ The MOF indicates that concessional loans amounted to R 526 billion. However, the Central Bank. IMF and the budget departnment problem since some subsidies are shifted off- of the MOF estimate the concessional loans at R 754 billion. budget, and more importantly, implicit c/ Partially included in budgetary consumer subsidies. subsidies are increasing. While it is very d/ T'he grant element is calculated under an assumed average interest difficult to quantify the volume of subsidies rate on CBU refinance credit of 40 percent pa. and transfers, the actual level of expenditure on subsidies far exceeds the 9 percent of GDP stated in the Government's ruble budget. There are several off-tudget funds and operations, including the hard-currency Republican Monetary Fund. A rough accounting shows that total budgetary subsidies amounted to at least 21 percent of GDP (See footnote b, table 2.1). If the import subsidies financed through cotton sqtles and the hard currency fund were ful'y included, the total amount of subsidies would be even higher 1Lirthermore, implicit subsidies to energy or through directed credit programs are not channeled throuhgh budgetary accounts and far exceed explicit budgetary payments. Implicit energy 16 Chapter 2 subsidies form the domestic production of crude oil, coal and natural gas may have exceeded 23 percent of GDP in 1993 (See Table 2.1). 2.5 The subsidies can be divided into four categories. The report provides a detailed analysis of each. * Consumer subsidies and price controls (Chapter 3): Direct budgetary food subsidies account for the largest proportion of consumer subsidy expenditure. Imports of grain, meat, milk, and phanriaceuticals are purchased with hard currency proceeds of cotton and other products. The domestic price of these imports are subsidized far below their world prices. While part of these subsidies are recognized in the state budget, the full amount of the gap between the world price and the domestic sale price is understated. Hard currency imports are costed in the budget above the market exchange rate. Large budgetary payments are also made for housing, utilities, and public transport. In addition, Uzbekistan has extensive anti-monopoly price controls. National monopoly enterprises cannot increase prices on about 200 products without approval. And, anti- monopoly price controls, while not requiring direct budgetary subsidies, interfere with the price mechanism and may result in transfers from state-owned enterprises to consumers. - Credit subsidies (Chapter 4): Credits from the Central Bank of Uzbekistan (CBU) carry nominal interest rates that in the current inflationary environment effectively transform these credits into grants. The CBU also refinances credit targeted to agriculture and industry, while providing funds to the Ministry of Finance (MOF) for its turnover fund. This fund becomes a source of net lending from the public sector to the enterprise sector. * Transfers and subsidies in agriculture (Chapter 5): Transfers out of agriculture are much larger than the subsidies received. The Government subsidizes agricultural inputs and provides them below world prices. However, this transfer to farmers is more than offset by the state order system requiring farmers to sell their output at prices much below world prices. * Energy subsidies (Chapter 6): Energy subsidies result from the difference between (i) the cost of production and the domestic price; and, (ii) .he domestic price and the value of energy exports and imports. The G-vernment has implemented significant energy price increases. However, the domestic price of natural gas and electricity, and the retail price of gasoline, are still only a fraction of world prices. 2.6 The high level of subsidies is unsustainable. It distorts resource allocation and is the major source of the huge fiscal imbalance. The deficit, including off-budget funds and directed credits through the MOF, is estimated at 16 percent of GDP for 1993 (See Table 2.3). Given these large macroeconomic imbalances, it is critical to identify these subsidies, contain their magnitude, and target them appropriately. Untargeted subsidies should be removed, as should those which have the largest impact on budgetary resources, and have large distortionary effects on the incentive structure. Budgeted and Unbudgeted Subsidies and Transfers 17 2.7 Currently, the subsidies are financed in four ways: * By borrowing. For 1993, the Government's narrowly defined ruble budget showed a deficit of 'bout 2.5 percent of GDP and has been financed by domestic borrowing. * By imports supplied at below-market prices through bilateral trade agreements in the FSU'. Over 50 percent of Uzbekistan's petroleum consumption is imported. Russia supplies a significant portion of these imports at prires around 53 percent of the world price. * By borrowing against pledges of gold and foreign borrowing. * By state orders in the agricultural sector. Farmers receive a below-market price for the cotton crop they provide through the state-order system. Cotton, wheat, rice, maize, meat and milk must be sold to the Government a: fixed prices significantly lower than the international price for each commodity. The Government uses these large export profits to import consumer goods or energy. Subsidies and their Budgetary Impact The Overall Level of Subsidies 2.8 A rough accounting of the level of subsidies shows that total Table 2.2: Level of Subsidies in Selected Countries consumer subsidies (excluding 1990 GNP Subsidies as 9 concessional loans to enterprises) are very per capita of of large. They amount to 20 percent of (USs) expenditure GDP expenditure in the Republican budget -- Tailand 1,750 3.4 0.5 or 9 percent of GDP. If all the credit Cameroon 820 7.0 1.4 subsidies and import subsidies, financed Turkey 1,950 23.1 5.4 through cotton sales, were included in the Peru 950 21.4 2.5 Philippines 770 3.9 0.7 consolidated ruble budget, the total Bolivia 680 17,7 7,5 amount of subsidies would increase -- Papua New Guinea 950 1.2 0.3 depending on the exchange rate used to Egypt 630 17.7 7.5 calculate these subsidies. This still does Uzekistan 6860 20.0 08 not include import subsidies financed through the hard-currency fund by gold a/ Direct budgetary consumer subsidies, excludes credit subsidies. sales or foreign loans . Source: World Bank Staff estimates. 2.9 Clearly. this high level of subsidies is unsustainable as it distorts resoutce allocation, makes enterprise and financial sector reconstruction impossible and is the major source of the huge fiscal imbalance. In other countries, expenditure on subsidies and transfers account for about 3 percent of GDP 1. Part ot th -,e Ulom imports ar- "artered with cotton at below world market prices which keeps the import price of petroleum verxF~ l,V - ii an artificial construct, since cotton and energy products are both procured at artificially low prices. 18 Chapter 2 (see Table 2.1). It is difficult to compare such expenditures across countries, because they are Table 2.3 one of the most heterogenous categories of ConsoUdated Budget (in billion rubles/sum-coupons) spending. Indeed, the real cost of subsidies and transfers could easily be twice what it is on the 1. Repubic"an Ruble Budget books and in many countries especially since REVENU ES directed credits are not included in tht reported Taxes on Domestic Goods and Services 527 0 Taxes on Trade 76 4 numbers. However, even in countries with high Taxes on Incomes and Profits 528 2 levels of subsidies (like Egypt), they do not Property Tax t0 2 O,ther Taxes/Non-Tax Revenues 599 6 exceed 8 percent of GDP. In Uzbekistan, by Social Security Contributions 731 contrast, the budgeted subsidies in the narrowly Total 1814 5 EXPENDITURE defined ruble budget alone exceed 9 percent of National Economy 260.8 GDP. Social Sectors 760 9 Entitlements and Subsidies 392.7 Public Administration 209 0 2.10 Explicit consumer subsidies for Other Expenditure 81.0 food and non-food items are only one third of the Payments for Precious Metal Production 219 0 Total 1~~~~~~~~~923.4 total budgetary subsidies, or about 9 percent of Surplus (Deficit) Republican Ruble Budget -108 9 GDP. The major item in the off budget funds -- Percent of GDP *2 5 2. Sales of Precious Metals (Gold) accounting for at least 12 percent of GDP -- was Abroad ' 517 7 credit allocated through the turnover fund. The Surplus (Defi ci) Inmc Gold Sales 408 8 Percenti of GDP 9 2 turnover fund was a key feature of credit 3. Concessorsl Loans to Enterprises" 754.0 allocation in Uzbekistan as an instrument to Surplus (Deficit) inml. Gold Sales and Lending -345.2 convey subsidies to the enterprise sector. It Percent of GDP -l7 -8 subsidizes the enterprise sector, or more Revenue 420 0 generally, borrowers. by offering credits at Expendciture 502 0 Surplus (Defiit) mncd Gold Sales, Lending substantially negative interest rates. For a given Ogbudget Funds -4272 subsidized nominal interest rate, the higher the Percent of GDP -9.6 rate of inflation and the longer the maturity of the s5. FoFreisp Currency Fund (Balance) -272.0 rate ofifainadtelne h auiyof the of which payments for food imports 70 8 loan, the larger the grant element. Surplus (Deficit) mtl Gold Sales, Lending Off-Budget Funds and Foreign Currenco -699 2 Percent of GDP .15 8 Budget Consolidation Memorandum Items 2.11 While it is very difficult to GOP(bill rbls) 4428,0 quantify all subsidies and transfers, they are a/ Gold sales were USS559 million are concerted at the average exchange rate. Exchange rates are based on the exchange rate ti Russia, as much larger than stated in the ruble budget determnined by the Moscow Interbank Currency exchange and the Central because of several extrabudgetary ruble and Baik of Russia. bl Data provided by the MOF shows that lending only amounted to R 526 foreign exchange funds (see table 2.3). These billion. include the Pension. Employment, Social c/ Includes Uzbeksavdo Off-budget Fund, Privatization Fund. Social Security, and Uzbeksavdo's Price Regulation and Insurance Fund, Employment Fund Stocks Revaluation Funds, all of which are ruble Source: Ministry of Finance denomrinated and several foreign currency denominated funds, including the Republican Foreign Exchange and local foreign exchange funds. Extrabudgetar% funds cause serious problems for effective budgetary management at the macroeconomic level. These funds reduce the transparency of budgetary operations and complicate assessing 'he lm o.w. f fiscal policy. Extrabudgetary funds function as parallel budgets: they escape conventionai h7; ...' practice, creating loopholes for public sector operations not approved through the proper (bud{ ,-.! hannels. In addition, the presence of multiple "budgets" implies a loss of control Budgeted and Unbudgeted Subsidies and Transfers 19 and information, undermining the use of fiscal policy as a macroeconomic instrument. All legitimate revenue sources and expenditure should be incorporated completely into the regular budget for full accountability of fiscal operations. 2.12 The Cabinet of Ministers has recently directed the Ministry of Finance (MOF) to prepare a consolidated budget for budget management purposes2 and the Governrment has stated its intention to consolidate all extrabudgetary funds. A small start was made with the consolidation of the Pension and Social Insurance Funds at the end of 1993. The net impact of consolidating the budget will be to increase the visible fiscal deficit. However, it is appropriate that the financing requirement of the public sector becomes transparent in the budget, and not hidden in unbudgeted subsidies financed from foreign loans, or in the quasi-fiscal operations of the Central Bank. It will become evident that a reduction of the overall fiscal deficit -- and the rate of inflation -- will require a massive downsizing of the directed credits to enterprises -- since they contribute substantially to the consolidated deficit. A credible stabilization program has to address this issue. The Government has recognized this and stated its intention co reduce these payments substantially. Estimation of the Consolidated Budget 2.13 The main problem in estimating .he consolidated budget is the non-availability of detailed data on the foreign exchange transactions of the Government. For a full understanding of the overall impact of the budget, information on the following is needed: (i) the level and purpose of imports, and (ii) existence and disposition of any offsetting ruble flows. Since these data are currently not available, the approach taken here is to estimate a consolidated ruble budget and then include those hard-currency transactions for which data are available. These estimates will need revision when more detailed information on the hard currency budget is available. The estimates show the impact of subsidy payments on the budgetary accounts. They will most likely underestimate -- not overestimate -- overall subsidies, since a substantial proportion flow through the hard currency funds. 2.14 The deficit in the ruble budget of about 2.5 p ,rcent of GDP underestimates the eonsolidated deficit substantially. In 1993, the consolidated ruole budget ran a deficit of around 16 percent of GDP, compared to 2.5 percent for the Republican budget. More than 80 percent of the conso'idated deficit results from off-budget funds and less than 20 percent from the main Republican Budget. 2.15 Turnover Fund. A large proportion of the consolidated deficit (at least 12 percent of GDP) is caused by payments made through the "turnover fund" at the Ministry of Finance.3 This fund was established to meet the working capital needs of the enterprise sector and provides concessional loans to enterprises. When consolidating the balance sheet of the Central Bank with the Government's budget, this fund can be treated as net lending by the Government. Since the credits are granted at substantially negative real interest rates, they are effectively grants to the enterprise sector. They are, therefore, government expenditures and should be included in the budget. Beginning in March of 1993, the role 2. Cabinet of Vminter". Resolution No. 615. Concept of the Budget of the Republic of Uzbekistan. December 31, 1993: All budget expendtlt .e: m he consclidated by including into it the majority of extra-budgetary funds, all items of foreign economic acti. . t 3. The 'n u rid and its effects are discussed in more detail in chapter 4. 20 Chapter 2 of the turnover fund increased in importance: by September 1993, over 30 percent of CBU credit was directed towards the Ministry of Finance's turnover fund. 2.16 Budget consolidation would subject the turnover fund to the same detailed exarnination as the main republican budget. Expenditures from this fund would then need to be classified as social sector expenditures, expenditures in other budget categories, or credits to enterprises. The latter should be reintegrated into the Central Bank's program of directed credits. Because of the size of the turnover fumd (unmatched by any revenues) this simple action could markedly reduce the formal consolidated deficit of the Government (without changing the macroeconomic reality). Despite this lack of real impact, it is still worthwhile as it would lend integrity to the Government's budget procedures. In general, the Government and the CBU should move away from the central allocation of credit. 2.17 Local Budgets: While the Republican budget includes the local budget, until price liberalization is complete, additional sub-national expenditures that might emerge during the transition could include payments related to subsidies. Many public sector prices, representing potential fee income to sub-national governments, have not been deregulated. Subsidies to these enterprises, and to housing maintenance, will place a heavy burden on local governments. For example, the sub-national government's are responsible for the provision of services in the areas of public transportation and utilities, but prices (and price ceilings) are still determined by the central government. Housing rents may also be set by sub-national governments, but their levels are hostage to national wage policies and levels. 2.18 In general, a rationalization of inter-governmental relations and functions is needed. Some initiatives are planned in the 1994 program that should improve budgetary management. First, the Ministry of Finance has started to consolidate all off-budget funds. Second, the Governrment intends to proceed, as far as possible, with the devolution of government functions from the state level down to the regional level. 2.19 This is a sensible approach, as long as local governments are also assigned sufficient revenues to undertake these expenditures. It is common practice in several countries to assign expenditure responsibilities, especially regarding social expenditures to the local level without giving the local level the appropriate revenues to undertake this expenditure. This leads to "ad hoc" expenditure cuts in localities which might have the greatest needs yet the lowest revenues. 2.20 If budget decentralization is to succeed, the central government should not cover budget deficits automatically at the local level through direct transfers. This would result in limited expenditure responsibility at the local level, and no control of the deficit in the consolidated budget. 2.21 Hard Currency Funds. Table 2.3 compares the Republican budget with an incomplete estimate of the consolidated budget for 1993. Missing from this table is a detailed breakdown of the foreign exchange funds as not enough information on these funds is available. The main foreign exchange fund is the Republican Monetary Fund (RMF). The RMF acts in the following ways: (i) as a budget for hard currency earnings; (ii) as a source for financing the balance of payment; (iii) to pay off external debt; (iv) to finance important imports; (v) to make international payments; and, (vi) to finance the Government's social and economic programs. The accounts are in the National Bank for Foreign Economic Activity. 2.22 ,; important to eliminate the hard currency funds by merging them into a consolidated budget. There .n reason for the Government to maintain separate foreign exchange budgets. On the Budgeted and Unbudgeted Subsidies and Traisfers 21 contrary, the existerce of such budgets harms the Government's ability to monitor the overall budgetary situation and carry out sound fiscal economic policies. All government foreign exchange operations should be concentrated at the Central Bank or in an interbank market. The Government operates the Republican Monetary Fund and other foreign exchange funds in the National Bank outside the purview of the Central Bank. This risks confusing the responsibilities for monetary, fiscal and foreign exchange policies in a potentially harmful way. 2.23 The Government should stop managing the hard currency fund outside the Central Bank. In effect, the Government is directly managing a large part of the country's foreign exchange reserves - - a function which is in market economies reserved for the Central Bank. The Government should purchase foreign exchange for its foreign expenditures and sell its foreign exchange revenues for domestic currency. It could then easily integrate its hard-currency expenditures and revenues into the main budget. The importers would have to purchase foreign exchange in a manner determined by the Central Bank. This would facilitate the management of foreign reserves and the transparency of transactions. 2.24 Cotton Earnings A consolidated budget should also include the large profits from cotton sales and the import subsidies wiiich are financed by these sales. For the production of cotton, wheat, rice, maize, meat and milk in 1993 the state order system requires that farmers sell their quota to the Government at fixed prices which are significantly lower than the international price for these commodities.4 The Government then uses the export revenues to import consumer goods. The use of cotton quotas to finance hard-currency imports constitutes a tax on cotton producers in the amount of the difference between the export price of cotton and the internal price determined by the Government. T his cotton export tax is earmarked by Goskomprognostat for certain importers -- e.g. distributors of essential consumer goods and hospitals -- who realize tax revenues by first paying the internal price for their allocated quota of cotton lint and then receiving the international cotton price in the form of imported goods. These cotton-tax revenues are mainly passed on to consumers as subsidies. 2.25 Like the foreign exchange funds, this cotton-quota system should be consolidated with the main ruble budget. On the revenue side, the large profits from cotton exports procured under the state order system (now effectively appropriated by importing organizations through the cotton quota system) should be entered as revenues in the ruble budget (the state having immediately converted its foreign exchange earnings to rubles). The Government should develop a limited list of import subsidies, to be financed through the budget rather than by cotton quotas, and should be rapidly phased out. in special cases, like imported medicines and medical supplies, the subsidies would become an explicit component of sector policy; appropriate targeting to the most needy could then be incorporated in the construction of the sector budget. The inclusion of the profits from cotton sales, and the import subsidies financed by these sales, would not affect the deficit level. However, it would illuminate more clearly the total level of expenditures and subsidies. Unbudgeted Subsidies 2.26 It is crucial that the Government not limit its efforts to reduce subsidies to those explicitly made through bKdeetary accounts. Indirect subsidies and directed credits, which are larger than the 4 ..
Группа Всемирного банка · Pre-2003 Economic or Sector Report
Uzbekistan - Economic memorandum : subsidies and transfers (Vol. 1 of 2) : Main report
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Pre-2003 Economic or Sector Report
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