STRUCTURAL REFORM

The EBRD has been systematically tracking the progress of transition and structural reforms since the first Transition Report was published in 1994. Since 2010, its focus has been on transition at the sectoral level, with 18 sectors being assessed in each country in terms of the progress made with the establishment of market structures and market-supporting institutions. The methodology underlying these sector-level scores is currently the subject of a thorough review and may be altered substantially in the coming years. As a result, the Transition Report 2015-16 adopted a “light-touch” approach, which is repeated this year. Rather than carrying out a full update, this section reviews some of the main developments over the last year and flags major changes that could potentially – but will not necessarily – warrant the upgrading or downgrading of those sector-level scores in the future. In a small number of cases, scores have been updated, resulting in upgrades or downgrades, rather than merely being placed on watch. The watch list that has been compiled this year shows a mixed picture of progress and reversals which is discussed in more detail on a sectoral basis in the sections that follow. The online country assessments contain in-depth country-specific analysis of progress and reversals over the last year (see tr-ebrd.com/countries).

This year, Greece has been included in this analysis for the first time. In addition, a new set of transition indicators looking at the financing and development of small and medium-sized enterprises (SMEs) is presented. This assessment reflects the more comprehensive and integrated approach that the EBRD has adopted in recent years in support of SMEs. Rather than focusing purely on the financing of SMEs and supply-side issues, this new assessment also takes account of the role that skills and standards play for such firms, as well as important aspects of the business environment, where shortcomings can have a disproportionate effect on SMEs.

Lastly, this section updates the EBRD’s inclusion scores. The availability of new survey data thanks to the third round of the Life in Transition Survey (LiTS III), which is analysed in detail elsewhere in this report, has resulted in a reassessment of regional inclusion gaps. The youth and gender inclusion scores have also been updated, but they have not changed significantly relative to last year’s report.

Two countries, for instance, that were put on positive watch last year in the roads sector have been upgraded. The first is Belarus, which has moved from 2 to 2+. A key factor in this upgrade is the introduction of an electronic toll system in 2013 and the fact that it has subsequently been extended to cover larger parts of the country’s road network. Similarly, the introduction of a new system for collecting tolls from heavy goods vehicles has resulted in Russia’s score being upgraded from 3- to 3. Slovenia has been put on positive watch in light of the country’s motorway management company Družba za Avtoceste v Republiki Sloveniji (DARS) having awarded a contract for a nationwide system of truck tolling to the consortium of Q-Free and Telekom Slovenije. Croatia, on the other hand, has been taken off positive watch because the privatisation of a major road construction and maintenance company has been delayed, while Poland and Kazakhstan have been removed because delays are affecting the implementation of public-private partnership projects. Lastly, there is one new addition to the watch list for the roads sector, albeit a negative one. In Ukraine, road funding switched in 2015-16 from a dedicated fund to the general state budget. However, a law on the establishment of a new road fund has not yet passed through parliament.

In the railways sector, Croatia and the Slovak Republic have been taken off positive watch, as opening these markets up to the private sector has had only a limited impact on the market structure in the two countries, with the private sector’s market share remaining relatively small. Similarly, last year’s IPO and SPO for freight operator PKP Cargo in Poland represented an important development, but it was not significant enough to lead to an upgrade, given the maturity of the market. Ukraine, on the other hand, is a new addition to the positive watch list on account of its efforts to commercialise and modernise the national railway operator, Ukrzaliznytsia. Positive steps include the corporatisation of the organisation (which was previously an integral part of the Ukrainian Ministry of Transport), the approval of a comprehensive restructuring plan including the separation of cargo and passenger transport, and the appointment of an independent CEO (who is a former head of Polish railway company PKP Cargo).

There have only been a few significant developments in the area of municipal infrastructure. In the urban transport sector, the two countries that were on last year’s positive watch list have been removed. In Hungary, the number of new routes being served by private bus operators has ended up being smaller than expected. In Russia, meanwhile, the introduction of a new parking system in Moscow has not proved significant enough to warrant an upgrade. There are no other new developments to report for this sector.

There is, however, a new entry on the positive watch list for the water and wastewater sector. The introduction in 2015 of a tariff calculation methodology for Kazakhstan’s utilities sector which includes an element of profit represents a positive development. As a result, a number of water companies have secured six-year tariffs with approved annual tariff increases that are expected to cover operating and capital costs. In addition, Armenia has been taken off negative watch, as the envisaged privatisation of the country’s operating lease is designed to partly offset the drawbacks of the recentralisation seen in the sector last year. However, it remains to be seen whether consolidating water assets under a single operator will achieve its stated objectives of imposing greater spending discipline and curbing corruption.

Despite progress with the transposition of EU directives, little progress has been made with the implementation of a new supporting framework for renewable energy in Poland. That framework would have facilitated a move away from a green certificate system towards an auction-based system, which would have been in line with EU recommendations on support for renewable energy. Its absence could mean a decline in new investment in 2016 and beyond. In parallel, an environmental law focusing on social and grid stability concerns has significantly restricted the growth of onshore wind technology by imposing minimum distance requirements that rule out the majority of potential locations for future windfarm projects. As a result, growth in the production of renewable electricity is expected to slow substantially, making it more difficult to achieve the country’s renewable energy target for 2020.

In Kazakhstan, significant amendments to the country’s Green Economy Law have failed to lead to increases in renewable energy and energy-efficiency projects owing to the persistence of other barriers (including low energy prices, which discourage investment in energy efficiency). Furthermore, this year the government has decided to suspend until 2018 the trading and penalties put in place under the Kazakhstan Emission Trading Scheme.

In FYR Macedonia, meanwhile, last year’s positive developments relating to the government’s new renewable energy strategy have not resulted in any significant structural changes. Despite the previous commitment shown by the country, its failure to adopt renewable action plans agreed with the Energy Community has resulted in it being taken off positive watch.

Albania, on the other hand, is no longer on negative watch, as some progress has been made with the approval and implementation of key legislation on renewable energy and energy efficiency.

The only country on the negative watch list in this area is Romania, where authorities have embarked on successive retrospective modifications to the support mechanisms for operational renewable energy installations, increasing uncertainty for many owners of renewable energy assets and potential investors.

Given the extent of the 2014 banking scandal in Moldova – which saw US$ 1 billion in assets (around 13 per cent of the country’s GDP) disappear from the banking system, reflecting low levels of corporate governance and transparency – and the fact that there have been limited signs of improvement, the country’s banking sector, which was put on negative watch last year, has been downgraded from 2+ to 2. Given that these negative developments reach beyond the banking sector, the score for insurance and other financial services has also been downgraded from 2+ to 2.

Azerbaijan, meanwhile, is being put on negative watch in light of an increase in financial sector vulnerabilities. Two-step devaluations in 2015 led to balance sheet pressure in the banking sector and to increased dollarisation. Azerbaijan’s Financial Markets Supervisory Authority, which was established in February 2016 to replace the central bank as the sector’s regulator, has taken an active stance on restructuring in the banking sector. By mid-September 2016, 10 out of 43 banks had been closed and a number of remaining banks had been required to present recapitalisation or restructuring plans.

In Croatia, new legislation forcing banks to convert Swiss franc-denominated loans, which has resulted in large losses for banks and dented their willingness to lend, has led to the country being placed on negative watch.

Negative developments have also been seen in Poland, where regulatory and legal changes (including the introduction of a levy of 0.44 per cent, annualised, on banks’ assets that coincided with a major programme of social spending) are threatening to reduce investors’ desire to acquire senior and subordinated bonds, which could result in funding pressures. Nevertheless, the introduction of a new law on covered bonds is a positive step, as it should improve access to long-term funding for mortgage banks.

In Greece, the fact that the country’s four main banks completed a market-led recapitalisation process in December 2015 was a positive development. However, levels of NPLs remain significant (accounting for around 35 per cent of all loans at end-2015), which continues to represent a major challenge. All banks are making efforts to address this issue, with the aid of internal and external initiatives, and supported by a new legal framework for non-performing loans.

The resolution of NPLs is also a challenge in Cyprus. However, the country’s banking sector has shown positive momentum in other restructuring efforts, including the repayment of significant parts of the Emergency Liquidity Assistance (ELA) funding extended to the largest bank in Cyprus. This has led to an upgrade in the banking sector score from 3- to 3.

Georgia, meanwhile, has been taken off negative watch, as the implementation of its law on banking supervision was suspended in October 2015 by the country’s constitutional court. The Georgian government has now decided not to proceed with these legislative changes, so the National Bank of Georgia will retain its supervisory function.

Developments in the private equity and capital markets sectors have been mostly positive in the last year. In Belarus, the country’s first institutional-quality private equity fund, Zubr Capital I, was launched in June 2016, with a fund size of US$ 50 million. Increased access to equity funding and management expertise is particularly welcome in Belarus, given its relatively small private sector. In Serbia, meanwhile, government bonds are now listed on the stock exchange, providing institutional investors with an observable pricing benchmark. A master repurchase agreement for government bonds has been implemented, and the first interbank transactions have been carried out. In addition, the Belgrade Stock Exchange and the Zagreb Stock Exchange have both joined the SEE Link platform, allowing improved access to Serbian and Croatian equity markets. This should broaden the countries’ investor bases and improve the availability of funding. In Poland, on the other hand, the capital markets sector has been placed on negative watch. Covered bond issuance has increased, but senior bond issuance has declined for banks and other corporations. In particular, medium-sized and large bond issues still remain difficult to place. Furthermore, there is continued uncertainty surrounding the future of the Polish pension system, and this is affecting Poland’s capital markets.

Bank financing is the most important source of external finance for SMEs. It used to be covered by the old SME finance indicator and remains an important element of the new assessment. Similarly, the methodology used to assess the legal framework for bank lending has remained largely the same. Non-bank financing instruments, on the other hand, feature more prominently in the new assessment. Non-bank financing can be an important source of funding for SMEs. Leasing and factoring, in particular, can help SMEs to overcome constraints in terms of capital expenditure and working capital. In more advanced markets, bonds or equity investments can provide additional financing or development opportunities.

Finally, two new components have been added: business skills and standards, and the business environment. Skills are very important on both the demand side and the supply side, in order to enable SMEs to access financing. While banks’ skills in providing finance to SMEs were captured well under the old assessment, SMEs’ skills were not taken into account, despite financial literacy and business planning being crucial in order to present bankable projects or grow a business. Furthermore, improvements in standards can help SMEs to access new markets, attract outside investors and become more efficient. SMEs also suffer disproportionately from red tape and excessive regulation, as well as low levels of competition and transparency. The new assessment tries to capture this by using selected key measures which exemplify the barriers that SMEs face. A more detailed list of components and indicators can be found in the methodological notes in the online version of this Transition Report (tr-ebrd.com).

The results of this new assessment are presented in Table S.2. The picture is similar to those observed in other sectors, with central Europe and the Baltic states showing the highest levels of progress (with gaps generally small, and occasionally medium-sized). In contrast, many countries in eastern Europe, the Caucasus, Central Asia and the southern and eastern Mediterranean have large gaps.

It is noticeable that non-bank financing options are hugely underdeveloped across the EBRD region, with the exception of EU countries, Morocco, Russia, Tunisia and Turkey. This is partly due to the limited development of private equity and capital markets, which are difficult to access even for larger companies. Leasing and factoring are better developed, but uptake remains limited nevertheless. This is often due to legal frameworks failing to contain specific rules reducing uncertainty surrounding leasing or factoring transactions.

There are also a great many countries with large gaps when it comes to business skills and standards. These reflect relatively low levels of financial literacy, which we use as a proxy for the financial management skills of small firms, but also a lack of certification and limited desire to innovate, particularly in eastern Europe, the Caucasus, Central Asia and some parts of the Western Balkans.

In comparison, gaps are mostly small or medium-sized when it comes to the business environment, which may be surprising given the continued prevalence of informality and corruption, as well as the mixed track record in terms of the enforcement of competition policy. That relatively good performance may be a result of governments focusing more on streamlining administrative processes, for example with the help of one-stop shops or e-government measures, as well as efforts to improve headline indicators in the World Bank’s Doing Business report.

Regional inclusion gaps are clearly a major issue, given that, as discussed in the Transition Report 2013 and Chapter 3 of this report, an individual’s place of birth is a major driver of inequality of economic opportunity. The EBRD’s analysis of regional inclusion gaps, which is based primarily on LiTS III data, aims to capture the extent to which institutions shape differences in economic opportunities across different regions within a country. The methodology compares mean performance levels across regions in four categories: the quality of local institutions; access to services (such as utilities or health care); labour markets; and education.

The assessment of regional inclusion gaps has been expanded this year to integrate new information, and its geographical coverage has been increased to include Greece. Indicators have been added in order to look in greater detail at regional disparities in labour markets, education and access to services.

The resulting regional inclusion gaps are shown in Table S.3. The most pronounced gaps can be observed in south-eastern Europe and Central Asia. Regional gaps in terms of the quality of local institutions remain large across most of south-eastern Europe, particularly in Albania, Bosnia and Herzegovina, Bulgaria, Kosovo and Romania. Belarus, Moldova and Turkey also display large regional gaps in this area.

Significant regional gaps in terms of access to services can be observed across all Central Asian countries, highlighting the challenges that these countries face – particularly as regards access to water and IT infrastructure. Medium-sized gaps can be seen in most of eastern and south-eastern Europe and the Caucasus, driven primarily by access to heating and gas. Gaps are small across most of central Europe and the Baltic states (with the exception of Croatia and the Slovak Republic, where they are medium-sized).

A similar picture emerges for labour markets, with Azerbaijan, the Kyrgyz Republic, Russia, the Slovak Republic, Tajikistan and Turkey displaying the largest regional disparities in terms of employment opportunities. This measure also takes account of informality and the extent of underemployment. For most of these countries, school-to-work transition is weak and vocational education and training do not provide adequate skills, which is one of the main barriers to regional development. Turkey has the highest regional variation in unemployment rates of all countries covered by Eurostat.

The most pronounced regional gaps in terms of education can be observed in the southern and eastern Mediterranean and in eastern and south-eastern Europe. These gaps measure differences in the number of years of education, the availability of training and the perceived quality of education (at both household and firm level).