Report No. 18467-KZ Kazakhstan Joint Private Sector Assessment September 30, 1998 Country UnitVIII Europe and Central Asia Document of the World Bank CURRENCY EQUIVALENTS Currency Unit = Tenge EXCHANGE RATE (May 31, 1998) USD 1 = Tenge 76.10 ACRONYMS AND ABBREVIATIONS CEE - Central and Eastern Europe CIS - Commonwealth of Independent States EBRD - European Bank for Reconstruction and Development ECA - Europe and Central Asia FDI - Foreign Direct Investment GDP - Gross Domestic Product IMF - International Monetary Fund KEGOC - Kazkhstan Electricity Grid Operating Company MoF - Ministry of Finance NBK - National Bank of Kazakhstan RB - Rehabilitation Bank SME - Small and Medium Enterprise SPC - State Property Committee UNDP - United Nations Development Program USAID - United State Agency for International Development WB - World Bank Vice President Mr. Johannes Linn Country Director Mr. Kiyoshi Kodera Sector Manager Mr. Lajos Bokros Task Managers Mr. Albert Martinez and Mr. Robert E. Anderson PREFACE The objectives of this assessment are twofold: (a) to identify priority issues in the development of the private sector in Kazakhstan; and (b) to map out actions and next steps to be undertaken by the Government in addressing these issues. In some cases, the actions recommended by the assessment are specific. In other cases, the next steps recommended require more analysis and detailed specification of strategies. In all cases, the Bank is ready to assist and support the Government in its initiatives to improve the environment for private business in Kazakhstan, and this report will enable and provide the basis for the Bank to respond rapidly to government requests for such assistance. This assessment was developed by a joint team from the World Bank Group, including staff from the International Finance Corporation and Foreign Investment Advisory Services. The assessment also builds on past and current work on several related Bank projects: Finance and Enterprise Development Loan, Financial Sector Adjustment Loan, Public Sector Resource Management Adjustment Loan, Pension Reform Project, and Legal Reform Project. The mission visited Kazakhstan in February 1998 and consisted of Albert F. Martinez and Robert E. Anderson (ECSPF, co-task managers), Irina Astrakhan (PSDMF), Andrew Baldwin (CMECM), Rafael Benvenisti (FIAS), Lazzat Buranbayeva (ECCKZ), Marinela Dado (ECSPF), Simeon Djankov (PRMEP). Mr. Gennady Pilch (LEGEC) contributed to the report. This report was discussed with the various government officials in June 1998. The Government gave its approval for the publication and distribution of the report in August 1998. As an outcome of the discussions, the Government provided the Bank with a tentative list of areas where expert advice and assistance would be requested. In September 1998, the Bank sent a mission to Kazakhstan in response to a Government request for assistance in the reform of the insurance sector. The Joint Assessment mission wishes to thank its counterparts in the Ministry of Finance, Agency for Strategic Planning, and National Bank of Kazakhstan. The mission also acknowledges the support of the Bank resident office in Almaty. TABLE OF CONTENTS EXECUTIVE SUMMARY Introduction ................................................... i Business Environment ....................................................i Privatization, Governance, and Restructuring .................................................... v Infrastructure Development ................................................... vii Financial Sector Development ................................................... xi MAIN REPORT INTRODUCTION ....................................................1 CHAPTER ONE: IMPROVING THE BUSINESS ENVIRONMENT ................... 2 Structure ....................................................2 Laws, Regulations, and Their Administration .................................................... 2 Promotion of Foreign Investment ....................................................5 Small and Medium Enterprises ...................................................8 CHAPTER TWO: ENTERPRISE PRIVATIZATION, GOVERNANCE, AND RESTRUCTURING ................................................... 13 Privatization ................................................... 13 Restructuring and Governance ................................................... 16 CHAPTER THREE: INFRASTRUCTURE DEVELOPMENT ................ .............. 24 Natural Monopolies ................................................... 24 Power Sector ................................................... 24 Telecommunications Sector ................................................... 29 Regulation of Natural Monopolies ................................................... 31 Partial Risk Guarantees for Infrastructure Projects .................................................. 33 CHAPTER FOUR: FINANCIAL SECTOR DEVELOPMENT .............................. 35 Framework ................................................... 35 Banking System ................................................... 35 Development of Securities Markets ................................................... 42 ANNEX 1 ................................................... 46 EXECUTIVE SUMMARY Introduction 1. Kazakhstan has made major strides in stabilization since independence and has started along a growth path after a cumulative GDP decline of 35% from 1992-95. Kazakhstan's growth prospects are dependent on the availability of foreign savings and the recovery of public and private savings -- recent trends in national savings show a worrisome decline to 10 percent of GDP in 1997 from 16% in 1995. The recovery of domestic savings, accompanied by further increases in foreign investment in the non-extractive sectors, is predicated on continued progress of structural reforms and on productivity growth in the economy. 2. This Joint Private Sector Assessment focuses on four major determinants of private sector growth: (a) an enabling environment for private business; (b) the privatization and restructuring of SOEs; (c) the efficiency of the infrastructure sector; and (d) the deepening of the financial system. The section on business environment focuses on simplifying the regulatory framework and reforming public administration, with special attention to the promotion of Foreign Direct Investment and Small and Medium Enterprises. The section on privatization discusses the unfinished privatization agenda and the constraints to post-privatization restructuring. The section on infrastructure focuses on private participation in the power and telecommunications sectors, and the regulation of natural monopolies. The section on the financial system covers banking and capital markets, with special attention to the blue chip program and linkages to pension reform. Business Environment 3. Legal and Administrative Framework. During the period 1994-97, the government created a basic legal framework for private business activities including a new Constitution, a Civil Code, a Decree on Licensing, a Law on the Freedom of Entrepreneurial Activities, and State Registration of Legal Entities. The new Income Tax Code also seems to follow the best international models -- it is comprehensive, tax rates are moderate, and exemptions are limited. Currently, there are only a few gaps in the legal framework. A revised Company Law is needed to protect minority shareholders, and a revised Collateral Law and a new Leasing Law are needed to facilitate lending by banks and other financial institutions. 4. The major weakness with the laws, regulations, and tax code is their administration and implementation. It is relatively easy to draft laws and regulations following international models with the advice of foreign experts, but it is difficult to train thousands of government officials and establish procedures for the effective administration and implementation of these laws and regulations. The most common complaint by both Kazakhstani and foreign businessmen is the difficulty in dealing with officials at all levels of government. Based on published surveys of foreign investors and mission interviews with both foreign and domestic investors, the major problems in dealing with the government include: * Corruption. This is a serious problem at all levels ranging from governors (Akims) to local safety and health inspectors. i * Licensing and regulation. About 26 different state bodies supervise business activities. The procedures for obtaining licenses are complicated, multiple government agencies are involved, delays are long, and fees are substantial. Several attempts have been made to reduce this regulatory burden (for example, Presidential Decree of June 14, 1996, on Small and Medium Enterprise Regulation), but the problem of complexity still remains. * Tax administration. Though the overall level of taxes is not considered high and the number of taxes has been reduced, businessmen must still pay 11 different taxes plus payments to three social funds and several other funds. Taxes are levied at different stages of production and based on different indexes. Tax officials are often unfamiliar with the new tax code, harass taxpayers, and confiscate bank accounts apparently without due process. In spite of a bilateral agreement with Russia, Kazakhstani businessmen must still pay the value-added tax twice on exports to Russia. * Customs procedures. These are still cumbersome, and businessmen complain about long delays. Customs officials are not familiar with regulations that permit VAT payments to be deferred on imported machinery and equipment. * Land ownership. Though the Land Law allows both foreign and domestic investors to buy or lease land, a local land committee allocates land to investors and the procedure is slow and cumbersome. 5. Though the Government places a high priority on developing the private sector, it seems that no government agency has a clear mandate to develop policies and programs to assist the private sector. At this time, the agency best placed to carry out this function is the Goskominvest (Investment Comrnmittee). Goskominvest should shift its focus from fiscal incentives to investment promotion by becoming the major advocate or spokesman for the private sector, working towards the reduction of transaction costs faced by private business, and the development of market-friendly government policies that would improve the business environment in Kazakhstan. 6. There are four main areas where the government could improve the environment for private business. First, the regulatory regime should be simplified significantly to reduce transaction costs that deter business entry and reduce productivity. Eliminating unnecessary licensing and regulatory requirements and implementing a more transparent processing of necessary regulations would also reduce the scope for corruption. 7. Second, the government should accelerate the administrative reform that is currently being implemented, including improvements in the tax administration. Administrative reform includes the streamlining of the republican government and reforming the civil service to ensure professionalism in government service. These reforms should also extend to the local governments, which interface with local businesses. 8. Third, the legal framework and administration should be completed and strengthened. In addition to passing a revised Company Law, a revised Collateral Law, and a new Leasing Law, the existing body of legislation and regulatory enactments should be reviewed to identify inconsistencies and major conceptual and implementation problems. Training of the legal profession and better access to legal information for both the courts and businessmen would upgrade the quality and efficiency of the judicial system. ii 9. Fourth, a special agency could be created to hear complaints from the private sector about their treatment by government officials. This agency could be called the Commission for Complaints or Office of the Ombudsman. It would investigate complaints from the public against any national or local government authority including state-owned enterprises. The only exceptions would be the President, the Parliament, and the judicial system. If the Commission felt that the complaint was justified, it would ask for a response including steps that the official or agency proposes to take to remedy the situation. The Commission could also turn over complaints to the legal authorities if a crime may have been committed. Such a Commission would help to make government authorities more response to private businessmen, improve the quality of government services, and reduce corruption. 10. Foreign Direct Investment. The level of foreign direct investment in Kazakhstan on a per capita basis is substantially higher than that of its immediate neighbors such as Russia, Uzbekistan, Azerbaijan, or Tajikistan. Foreign investment in Kazakhstan is almost entirely due to the strong foreign interest in the extractive sectors such as petroleum and metals -- approximately 80 percent of foreign investment has been in these sectors. Sale of enterprises to foreign investors during case by case privatization has been the second most important source of foreign investment. The level of foreign investment on a per capita basis, however, is still only a small fraction of that in some of the countries in Central Europe such as Poland and Hungary, where investment in manufacturing has proven to be a major component of foreign investor interest. 11. Like some other countries, Kazakhstan has attempted to attract foreign investment by providing incentives for projects in selected priority sectors. However, many investors are attracted to particular countries primarily because of fundamental economic factors such as political and economic stability, business environment, market size, geography, or labor costs. In this context, incentives are clearly of secondary importance, at best. In addition, such incentives (especially grants, subsidies, and tax holidays, such as those currently employed in Kazakhstan) can be costly to the government and ineffective in attracting foreign investment. They usually create biases between old businesses that do not receive these incentives and new businesses that receive the incentives, and invite corruption in the granting of the incentives. The effectiveness of current incentives in attracting foreign investment to Kazakhstan is questionable. 12. The program of subsidizing foreign investment should be eliminated as soon as possible. But if the government nevertheless insists on such programs, at a minimum, incentives should be standardized and granted automatically to qualified investors rather than allocated on a case by case basis, as is now the case. The government would specify objective criteria that an investment project should meet and the associated incentives that would be provided. Any investment project that meets these criteria would automatically receive the specified incentives. There would be no need for a lengthy review of the qualifications of each project. 13. Most of the effort of the Investment Committee (Goskominvest) is now devoted to processing applications for investment incentives. By streamlining project evaluation, scarce resources could be devoted to more productive ends. The Committee could strengthen its ability to facilitate and assist foreign investors in ways other than providing financial incentives. The Investment Committee could also become a spokesman and advocate for government policies and practices that help all investors, domestic as well as foreign. iii 14. Another concern to foreign investors is the difficulty in obtaining visas and other procedures that make it difficult for them to bring in expatriate employees even though these employees often have special skills not available in Kazakhstan. Examples include the long waiting periods to obtain visas, the requirement for a letter of invitation, the requirement to obtain a license to employ foreign workers, the requirement to register passports and visas with local authorities, the harassment including arrest of foreigners who do not have the necessary papers with them, controls on movement within the country, and the need to apply for permission to exit the country (viewed as particularly onerous and intimidating). The Investment Committee can push for the elimination of most of these administrative barriers and assist investors in obtaining licenses, registration, or work permits and help with customs procedures. 15. Small and Medium Enterprises. The official data suggests that SMEs are much less important in Kazakhstan (accounting for about eight percent of GDP) than in many developed countries or even in other transition economies. According to one study, SMEs account for 53 percent of employment in the United States, 64 percent in Gerrnany, and 80 percent in Italy. Among transition economies, SMEs account for 58% of employment in Georgia, 37% in the Czech Republic, 24% in Hungary, and 23% in Poland. Even if the data were adjusted for the size of the informal sector, Kazakhstan would probably also lag the other countries. To increase SME share in economic activity, the Government has had a policy of providing support for SMEs. A number of international and bilateral agencies have also provided support for this sector. 16. The licensing and business supervision practices in Kazakhstan impose tremendous transaction costs on SMEs and provide opportunities for corruption. A wide range of activities have to be licensed before an entrepreneur can commence a business. These procedures are complicated and involve numerous government offices, resulting in costs to the entrepreneur not only in terms of fees paid but time spent following up paperwork. Unlike large enterprises, SMEs typically do not have staff to perform the follow-up of the paperwork, and the entrepreneur himself or herself would have to devote time to dealing with the government rather than focusing on the business itself. There is therefore a disproportionate impact of a poor legal and regulatory environment on SMEs. 17. The main complaints from small and medium scale entrepreneurs relate to tax administration. Tax rules are applied inconsistently and incorrectly. This may be attributable to the frequent changes in tax rules -- over a two year period between 1995-97, nearly 20 amendments were enacted. SMEs are also required to use accrual accounting and to use relatively expensive cash registers -- some SMEs may be too small to merit the costs of such systems. There is no threshold for compulsory VAT registration unlike in many East European countries, thereby imposing an additional administrative burden on small businesses. 18. The Government has tried to increase lending from the financial system to SMEs because small businesses often complain about a lack of funds for working capital or investment. This complaint, however, is made by small businesses the world over. Often the main source of funds for a small business is the owner's own capital or funds from relatives and friends. In the EU where SMEs account for 65% of employment and 40% of export sales, SME growth is financed by reinvested profits (65%), bank loans (20%), personal/family funds (10%), and additional equity (5%). In every country, banks have found that lending to small businesses is risky, and such loans have a high rate of default. Consequently, government programs to provide or guarantee loans to SMEs often have a high rate of default and end up costing the government a iv great deal of money. This may be even more likely in Kazakhstan because banking skills are still being developed and there is a lack of good collateral and bankruptcy systems. 19. There are three areas where the Government could encourage the development of SMEs. First, the Government could eliminate or at least reduce many of the transaction costs that SMEs incur in dealing with the regulatory regime. As an immediate action, the Government should consider reducing the number of entrepreneurial activities that require licensing. The Government should review the fees charged for licensing and other services. The Government should also review its procurement procedures to ensure that these are not biased against SMEs. 20. Second, the Government could improve SME access to financing by passing a stronger Collateral Law that would provide greater protection to lenders and a Leasing Law to encourage the development of new vehicles of SME financing. In addition, the Government could eliminate restrictions on lending margins that discourage banks from lending to relatively more risky SMEs. 21. Third, tax administration should be improved in many ways. A turnover threshold for VAT registration could be established -- this ranges from USD50,000 to USD100,000 in many East European countries. Small enterprises should be allowed to use cash instead of accrual accounting, and should not be subject to expensive compulsory audits or required to use expensive cash registers. Tax rules should be stable, disseminated widely, and applied consistently. Finally, the reporting requirements could be simplified and the frequency reduced. Privatization, Governance, and Restructuring 22. Privatization. Though Kazakhstan has privatized thousands of enterprises, many large important enterprises remain in majority state ownership. Though few in number, these large and very large enterprises dominate the economy. The State is still the only owner of 333 of these enterprises, and they account for about a third of GDP. Many of these large and very large enterprises have been transferred by the State Property Committee to "trust management" in which existing managers or the regional administrators have control over the enterprises. Regardless, these enterprises are still in state ownership, and trust management should not be a permanent solution. Substantial additional privatization is needed in Kazakhstan to create a truly private economy. 23. In choosing a privatization method for these large and very large enterprises, the Government should consider simply selling most or all of the shares in the enterprise to a strategic investor (either domestic or foreign) that offers the highest cash bid in a competitive auction. The process should avoid complicated requirements on how the new owner should manage the company (for example, investment requirements). In this way, the Government will avoid becoming involved in the management of these companies after privatization and avoid disputes over whether the new owners have satisfied the requirements of the sale contracts. Furthermore, this method of privatization is more likely to result in the largest revenue to the government and help to achieve fiscal targets for privatization. 24. Governance. To examine the change in governance structures after privatization, 62 former state owned enterprises in the manufacturing sector were surveyed and compared with similar enterprises in five other CIS countries -- Russia, Ukraine, Georgia, Kyrgyz Republic, and Moldova. Insiders -- managers and employees -- in the Kazakhstani firms surveyed own about v 37 percent of the shares (29 percent by managers and 8 percent by employees), compared to 73 percent in the Kyrgyz Republic, 64 percent in Georgia, 62 percent in Ukraine, and 60 percent in Russia. However, the State still has significant ownership share in Kazakhstani firms in the survey, although the state share has significantly decreased from 35 percent in 1995 to 16 percent in 1997. Many Kazakhstani firms complain that while the State has minority shareholdings, the state representative to the Board can block certain decisions. Non-insider local investors account for 30 percent of ownership of Kazakhstani firms in 1997 -- up from 24 percent in 1995 -- and foreign investors account for another seven percent. Kazakhstani firms in the survey sample had the highest ownership share of non-insider local and foreign investors compared to the firms in the other countries. Unlike many other countries in the FSU, enterprise owners in Kazakhstan are open to the possibility of attracting foreign investors even if those acquired majority stakes in their respective companies. 25. Privatization resulted in changes in top management in 32 percent of the Kazakhstani firms surveyed, the highest among the sample countries. However, management turnover was not as high as would be expected in a change in ownership, as is the case in many developed economies. One possible explanation is that many managers of the former state owned firms were able to purchase significant ownership rights during the privatization process. Nonetheless, it is not clear a priori whether new management per se would result in better governance. It may be that the change in ownership structure would bring about better oversight and incentives that would result in better performance by management, whether new or existing. 25. Restructuring. Restructuring is the adjustment process that enables enterprises to reach commercial viability. Restructuring can lead to different outcomes -- firms could increase their productivity and market share, or they could shrink by getting rid of nonviable or noncore portions of their operations. Thus, the decline in business activity of an enterprise need not be associated with lack of restructuring. Using the same sample of 62 firms, the mission measured the extent of restructuring using nine complementary indicators: labor shedding, increases in sales per worker, closure or sale of unprofitable units, creation of a retail network and marketing, development of new products, seeking contracts with new partners, renovations at the factory to improve working conditions, initiation of a quality control process, and a reduction in barter transactions. The results were compared with firms in other CIS countries. 26. Labor shedding during the period 1995-97 occurred in about 25 percent of the Kazakhstani firms, and sales per worker grew by about 11 percent. Sale of assets occurred in 24 percent of the firms and minor renovations in 39 percent. New products were developed in 33 percent of the firms, and in 16 percent of firms a new retail network was developed with the collapse of the centralized monopoly state owned distributors. These indicate evidence of restructuring occurring in privatized Kazakhstani firms, but not as extensively as one would hope given initial conditions. 27. To determine what are the important constraints to restructuring, the survey included questions on this issue. Lack of marketing capability was identified by 25 percent of the Kazakhstani firms as a major constraint. Lack of skills, changes in regulation, lack of financing, and tax problems were identified by 11 to 14 percent of the firms. 28. Ownership structure in mass-privatized firms has evolved to the point where effective corporate governance is in place in the majority of enterprises. Enterprise restructuring has been passive, mostly through labor shedding, sale of assets, and exit from unprofitable markets. Active vi restructuring (through new investment) has only just begun in a handful of enterprises. To enable enterprises to accelerate the restructuring process, the main constraints identified by the enterprises themselves should be addressed, and would require training in sales and marketing, accounting, and exporting. Infrastructure Development 29. Kazakhstan has made substantial progress in the reform of the power and telecommunications sectors and is ahead of most other countries in the region in privatizing a large portion of these sectors. There is a risk, however, that the pace of reform is slowing down. In earlier years, because of the economic crisis facing the country, the Government may have been more willing to adopt bold reform plans. Now that the economy is stabilized, the urgency for reform has been reduced. 30. Power Sector. Beginning in 1996, the Government privatized or placed under management contract about 37 plants accounting for 82 percent of the generation capacity in the country. In 1997, the government also tried to privatize both the national transmission company and the 18 regional distribution companies but with little success. According to the State Property Committee only two of the regional distribution companies were sold to private investors. This failure to privatize the distribution companies resulted in power shortages even though the generation companies were willing to supply power if they were paid for the power. This is because the poorly managed distribution companies did not collect from their own customers and thus could not pay for power purchased from the private generation companies. 31. There are two lessons to be learned from the experience with privatizing the power sector in Kazakhstan. The first lesson is that privatizing the distribution systems should be done first. The mismanagement of the distribution systems (most importantly, the failure to collect for power sold) is causing most of the other problems of the system. Without a reliable source of revenue, the distribution companies cannot pay the generation companies, and the generation companies cannot pay for fuel and essential maintenance. As a result, the country experiences shortages of electricity. This does not mean that the Government should privatize both generation and distribution to the same investor as was done in Almaty. Privatizing a vertically integrated monopoly in which a single company owns both generation and distribution limits competition. 32. The second lesson is that it is desirable to sell the local district heating company and the local power distribution company to the same investor. Only a combined company is likely to enforce payment for heating. Such a combined company can bill customers for power and heating jointly and better assure that customers pay for both or else suffer termination of electricity service. 33. An important issue that the power companies and the regulatory agencies will have to confront is the elimination of cross subsidies in pricing for power. In Kazakhstan and elsewhere in the region, the practice has been to charge prices to industrial customers above the cost of supply and to charge prices to household customers below the cost of supply. With the introduction of competition, these cross subsidies are no longer tenable. Competing power companies will offer to sell power to the industrial customers now paying high prices and thus force down these prices. Local distribution companies will then have no choice but to raise prices to household customers to a level that covers the cost of supplying them. vii 34. To see the magnitude of the required changes in prices, power prices in Kazakhstan were compared with those in other countries. In Western countries, prices charged to household customers are typically twice as high as those charged to industrial customers. This is because the cost of supplying household customers is much higher than the cost of supplying industrial customers. In Kazakhstan and other countries of the region, however, prices are much more equal, or industrial prices are even higher than household prices. 35. Telecommunications Sector. In 1997, the Government sold a 40 percent stake in the national telephone company, Kazakhtelecom, to Daewoo Corporation. Daewoo guaranteed that Kazakhtelecom would invest US$1 billion in modernization and expansion of the telephone network by the year 2000. In exchange, the Government granted certain monopoly rights to Kazakhtelecom. 36. Critics have raised questions about this privatization transaction. Daewoo is a telecommunications equipment manufacturer rather than an operator of telephone companies. Critics argue that the company should have been sold to a buyer with more operating experience. Daewoo's response is that that they will employ the best experts and consultants to help manage the company. Others suggest that there may be a conflict of interest between Daewoo's role as a major owner of Kazakhtelecom and its role as a potential supplier of telephone equipment. Daewoo's response is that Kazakhtelecom will conduct fair and open competitive tenders for the procurement of any equipment and all qualified suppliers will be treated equally. 37. Following the Asian crisis, Daewoo has decided to pull out of the telecom deal. Since this occurred after the Joint Assessment mission, this report does not have specific information about this latest transaction. It appears that Daewoo has sold their shares to Kazkommertz, a Kazakstani company, although what happens to Daewoo's obligations is unclear. Nonetheless, this presents an opportunity for the Government to review its earlier decision to grant a very long term license and possibly to invite another strategic investor which would not have the conflict of interest situation posed by Daewoo and which would have the capability to finance large additional investments. 38. The prices for telecommunications services charged by Kazakhtelecom are distorted and will have to be rebalanced in the face of competition. In particular, prices for services used by households are below the cost of supply while prices for services used by businesses are above the cost of supply. 39. Businesses in Kazakhstan are more likely to use long distance and international services compared to households. Prices for these services are high compared to British Telecom. For example, the price charged by Kazakhtelecom for a call from Kazakhstan to the UK is almost twice as high as the price charged by British Telecom for a call from the UK to Kazakhstan. Furthermore as telecommunications markets become more competitive, the prices for international service are likely to be reduced further. The market between the UK and the US is perhaps the most competitive since the telecommunications industry in both countries is largely deregulated and privatized. The distance between the UK and the US is roughly the same as between the UK and Kazakhstan. Yet the prices for international calls between the UK and the US are less than 20 percent of the prices now charged by Kazakhtelecom for calls between the UK and Kazakhstan. Naturally, Kazakhtelecom is concerned about competition because viii competition might force down the price of international phone calls to a fraction of what it is now charging. 40. In addition to the granting of a legal monopoly to Kazakhtelecom, some of the existing competitors complain that the government does not provide a level playing field even in those areas where competition is permitted. Competitors said that the Ministry of Telecommunications tends to favor Kazakhtelecom in its regulation of the sector. One example of this perceived bias by the Ministry is in the granting of licenses for cellular telephone service. Currently, the only cellular service in Kazakhstan is provided by a joint venture between Kazakhtelecom and a foreign company. The Ministry is proposing to grant licenses for two new cellular telephone services using the GSM technology. Competitors are concerned that Kazakhtelecom can use its right of first refusal for the spectrum to obtain both of these licenses and thus continue its monopoly on cellular service as well as conventional telephone service. 41. The Ministry of Telecommunications should do the most it can to encourage competition in the sector. If Kazakhtelecom continues to have a monopoly on various telephone services for the next 15 years, there is a substantial risk that the development of the telecommunications sector will lag behind most other countries. With the pulling out of Daewoo, the Government should review the terms of the license. 42.. Regulation of Natural Monopolies. Natural monopolies is regulated by the Anti- monopoly Committee located within the Ministry for Strategic Planning. It also deals with merger, monopoly, and competition issues. Members of the Committee admit that the prices set for natural monopolies are often influenced by political forces and by senior officials in the government. The Committee is responsible for the regulation of the power sector, telecommunications, gas pipelines, oil pipelines, railroads, air-navigation, water supply, and sewer systems. There are nine committee members supported by a staff of only 55 people to carry out its many responsibilities. For comparison, the three regulatory agencies in Great Britain responsible for regulating the power sector, telecommunications, and natural gas have a total staff of about 400. 43. Privatization of these natural monopoly sectors requires that a professional and independent regulatory commission be in place. If not, investors will be concerned that the regulatory authorities will not allow them to recover the money they invest in the company or to earn a reasonable rate of profit on that investment. This lowers the value of the state's assets in these sectors and thus the proceeds from privatization. 44. Given the complex technical issues involved in the different natural monopoly industries, the Government should review and consider the establishment of independent regulatory agencies for each industry. The experience of countries that have adopted single or multiple regulatory agency models should be examined to determine under what conditions one type is more successful than the other. 45. Partial Risk Guarantees. Partial Risk Guarantees enable transition countries to attract private financing for high priority infrastructure investments rather than rely on financing from public resources. This is achieved by providing lenders to a particular infrastructure project with a guarantee against non-payment of debt service as a consequence of government actions or certain events of political force majeure ("political risk"). Partial Risk Guarantees are especially relevant for large-scale infrastructure projects that require long-term financing. They are also ix relevant in the context of transition countries that have not yet built a track record of successful private sector projects. The lack of track record and the perception of high political risks often prevent lenders from risking their funds without some type of guarantee. 46. The World Bank provides such guarantees to enable transition countries with high infrastructure investment requirements to attract private financing for infrastructure projects. The diagram below illustrates how partial risk guarantees are structured. GOVERNMENT S | ~~~~INVESTORS l WORLD BANK _ 47. The risks that are covered by these guarantees include inconvertibility and inability to transfer currency, war and civil disturbance, and government performance risks. Government performance risks are generally based on contractual commitments made by the government to a private consortium in the context of an infrastructure project. For example, the government awards a concession to a consortium to build and maintain an oil pipeline, and enters into a contractual agreement with the concessionaire defining the length of the concession, say 25 years, and the tax and tariff structure for usage of the pipeline, based, for example, on the quantity of oil transported. A Partial Risk Guarantee would cover the lenders in case the government imposed higher tariffs or taxes once the pipeline was operating, or arbitrarily ended the concession before the end of the 25 years, thereby preventing the concessionaire to recover its costs and pay back the lenders. 48. Partial Risk Guarantees unbundle political risks from commercial risks. They allow the private sector to focus on the commercial risks of an infrastructure project, as the government takes responsibility for political risks, which it can control and mitigate. Indeed, a World Bank guarantee is always counter-guaranteed by the government through an Indemnity Agreement (see the illustration above). If a covered risk occurs and affects the consortium's debt repayment capacity, either the government pays damages to the investor or the lenders for his/their loss, or the guarantee kicks in. If the guarantee is called, and World Bank funds are used to compensate the lenders, the government has the obligation to indemnify the World Bank upon demand or as the Bank may otherwise direct. x Financial Sector Development 49. The financial system of Kazakhstan is at an early stage of development. Kazakhstan has over the past few years made significant strides in establishing financial policies, building the legal framework for finance, and developing important segments of the financial infrastructure such as accounting systems and banking supervision capacity. Financial sector reform over the past few years has focused on the banking system, whose restructuring began in 1994 with the assistance of the Bank and the Fund. Current reform efforts are focused on the securities market with the blue chip program and the development of the stock exchange and related institutions. With pension reform, pension funds are expected to play a major role in financial markets. Other nonbank financial institutions such as insurance and leasing are still undeveloped, and should be in the agenda of the next generation of financial reforms. 50. Banking System. The banking system is characterized by concentrated ownership and concentrated lending. With regard to concentrated ownership, as of end-January 1998, two banks (one state owned and the other private) accounted for more than 50 percent of assets and deposits. State owned banks accounted for about 40 percent of total banking assets. With the privatization of state owned banks to the major private banks, the concentration of ownership of the banking system will be exacerbated, at least in the short term. 51. With regard to concentration of lending, the share of the largest 20 borrowers in the loan portfolios of five major banks ranged from 43 percent to 74 percent. These five banks account for about 70 percent of total loans in the banking system. While the mission was not able to get information on the exposure of the whole banking system to these largest borrowers, it may be the case that the whole banking system may be suffering from concentration of lending to same group of borrowers. 52. Two indicators suggest that the health of the banking system is improving. First, there has been an improvement in the performance of banks in meeting prudential standards. At end- 1995, only half the banks met all the prudential standards. This improved to 66 percent at end- 1996 and 71 percent at end-1997. By end-1998, 30 banks are expected to meet the minimum capital requirement of Tenge one billion (about USD 13 million) as well as all the international prudential standards. Another 30 banks are expected to meet the minimum capital requirement of Tenge one billion capital by end-1999. Second, there has been progress in reducing nonperforming loans. From 55 percent at end-1994, the share of nonperforming loans has gone down to less than 30 percent at end-1997. Loans classified as unsatisfactory, doubtful, or loss accounted for 13 percent of total loans at end-1997. 53. The attainment of international standards by all banks, expected by end-1999, would complete the banking reform begun in 1995. However, the following additional reforms would improve efficiency and improve financial intermediation. First, entry restrictions on foreign banks should be relaxed. Specifically, the National Bank should eliminate the requirement that the combined capital of all foreign banks should not exceed 25 percent of total banking capital. Removing this restriction would encourage more competition in the banking system. 54. Second, the state owned commercial banks should be sold to reputable strategic investors. In the short run, this strategy may aggravate the structural problem in the banking system if state owned banks are bought by existing private domestic banks. However, removing restrictions on foreign bank entry as recommended above would introduce greater competition xi thereby mitigating the concentration problem. With respect to the method of privatization of the Savings Bank, the focus should be on attracting a strategic investor which can exert governance. Due to the dominant share of Savings Bank in the household deposit market, potential strategic investors should be limited to reputable and well capitalized banks. An investment banker should be hired to develop and implement a privatization strategy for the Savings Bank. 55. Third, the National Bank should review the concentration of lending to a few enterprises or sectors. The risks posed by certain enterprises or sectors should be examined and adequate steps undertaken to reduce the exposure of the banking system. In East Asia, for example, some regulators put limits on or discouraged additional exposure to the real estate or construction sector when the banking system was becoming heavily exposed to this sector. 56. Fourth, the Government could establish partial risk guarantee schemes to unbundle political and credit risks. This would allow the financial system to focus on evaluation of commercial risk. 57. Securities Development. There are several major reforms still needed to develop a securities and capital market. First, a new company law should be passed as quickly as possible to provide minority protection to minority investors and provide a basis for the issuance of corporate bonds. Second, accounting reform should continue towards international standards, and use of IAS audits for widely held companies should be required. Third, the blue chip program should proceed as planned to provide an adequate supply of companies in the stock exchange. Fourth, the insurance sector should be developed by putting in place an appropriate legal and regulatory framework as well as improving supervision capacity. Fifth, investment funds in general and the pension funds in particular should be subject to proper regulation and supervision. xii MAIN REPORT INTRODUCTION i. Kazakhstan embarked on a comprehensive program of macroeconomic stabilization and structural reforms in 1993. Since then, the authorities have followed a determined policy of economic reform. Although policy implementation has been at times uneven, significant progress has been made in transforming the economy into a market-based system and toward achieving macroeconomic stabilization. During 1993-94, price liberalization was virtually completed, most of the restrictions on foreign trade were eliminated, and a new currency with a unified rate was introduced. At the same time, state orders were phased out and privatization initiated. Since early 1996, the authorities have accelerated privatization, extending it to many large enterprises in strategic sectors. In recent years, the National Bank of Kazakhstan (NBK) has gained an increasing degree of independence, and major progress has been made in the development of monetary policy instruments, debt management, and budgetary procedures. ii. The country has made major strides in financial stabilization since independence. While an initial effort to bring down inflation failed due to monetization of the interenterprise arrears in early 1994, inflation has continuously fallen since then. From a peak of 3,000 percent sometime in 1992, inflation in 1997 was about 17 percent. Fiscal reform in 1995 included the removal of government guaranteed credit and the introduction of a new and modern tax code, resulting in a reduction in the fiscal deficit of the general government from seven percent of GDP in 1994 to two percent in 1995 and 3.6 percent in 1997. After a cumulative decline of 35 percent in 1992-95, real GDP grew by 1.1 percent in 1996 and by two percent in 1997. iii. Kazakhstan's growth prospects are dependent on the availability of foreign savings and the recovery of public and private savings. Recent trends in national savings show a worrisome decline to 10 percent of GDP in 1997 from 16 percent in 1995 due to the, sluggishness of private savings and lower than expected public savings. The recovery of domestic savings, accompanied by further increases in foreign investment in the non-extractive sectors, is predicated on continued progress of structural reforms, especially in the enterprise sector, and on productivity growth in the economy. iv. This Joint Private Sector Assessment focuses on four major determinants of private sector growth: (a) an enabling environment for private business; (b) the privatization and restructuring of SOEs; (c) the efficiency of the infrastructure sector; and (d) the deepening of the financial system. The section on business environment focuses on simplifying the regulatory framework and reforming public administration, with special attention to the promotion of Foreign Direct Investment and Small and Medium Enterprises. The section on privatization discusses the unfinished privatization agenda and the constraints to post-privatization restructuring. The section on infrastructure focuses on the private participation in the power and telecommunications sectors, and regulation of natural monopolies. The section on the financial system covers banking and capital markets, with special attention to the blue chip program and linkages to pension reform. CHAPTER 1 IMPROVING THE BUSINESS ENVIRONMENT Structure 1. In terms of share of the private sector in GDP, Kazakhstan is ahead of many ECA countries (see Figure 1). However, about 57 percent of the largest firms are still in state ownership (see Table 1), and these account for about a third of GDP. Moreover, industrial production is dominated by large enterprises in the oil-related and metals industries. The challenges for private sector development are twofold: (a) completing the privatization process; and (b) increasing private investment in small and medium scale enterprises and nonextractive industries. Encouraging private investment -- domestic and foreign -- requires the establishment of an environment that minimizes transaction costs and uncertainty over government policy. For this reason, the establishment of property rights, clear and credible rules of commerce, and effective administration of laws and regulations (e.g., enforcement of contracts) are basic preconditions for private investment. This chapter focuses on gaps in the legal and regulatory framework and the effectiveness of administrative capacity in implementing laws and regulations. Table 1: Functioning enterprises according to size and ownership, January 1998. Total State % Private* % Mixed** % All firms 232,317 2,606 1% 221,946 96% 7,765 3% Self-employed 195,643 - 0% 193,354 99% 2,289 1% Small 28,736 1,452 5% 22,910 80% 4,374 15% Medium 7,354 821 11% 5,510 75% 1,023 14% Large (> 1,500 workers) 341 187 55% 108 32% 46 13% Very large (> 5,000 workers) 243 146 60% 64 26%/c 33 14% Source: State Statistical Office * more than 50 percent private ownership ** 50 percent or less private ownership Laws, Regulations, and Their Administration 2. Legal Framework. During the period 1994-97, the government created a basic legal framework for private business activities including a new Constitution, a Civil Code, a Decree on Licensing, a Law on the Freedom of Entrepreneurial Activities, and State Registration of Legal Entities. The new Income Tax Code also seems to follow the best international models -- it is comprehensive, tax rates are moderate, and exemptions are limited. 2 Figure 1: Private Sector Share of GDP (end-1997) C ze ch R ep u b Ic 75 H ungary 75 S lavak Re public 75 E sto n ia 7 0 L ith u a n ia 7 0 A l b a fl i a 6 65 K yrg yz 6 5 P o la n d 6 5 Kazakhsan t60 L a t v ia 6 0 R ussia 60 A rm e n ia 5 5 C raatia 5 5 G e o r g iaS 5 5 FYR M acedonia 50 R om ania s50 S loven ia 5 0 U k ra in e _ 50 M oldova 445 U zbekistan _45 Azerbaijan 40 B ulgaria 30 Turkm enistan _25 B e la ru s 20 Ta jikistan 20 0 20 40 60 80 P e r c e n t 3. Currently, there are only a few gaps in the legal framework. A revised Company Law is needed to protect minority shareholders, and a revised Collateral Law and a new Leasing Law are needed to facilitate lending by banks and other financial institutions. A revised Company Law will support current efforts to establish an active equity market and improve corporate governance. A Collateral Law will provide security to lenders, without which financial institutions are reluctant to lend, in particular to small and medium enterprises. A Leasing Law will provide the foundation for the establishment of leasing companies whose main clients tend to be small and medium enterprises. 4. Administration of Laws, Regulations, and Tax System. The major weakness with the laws, regulations, and the tax code is in their administration and implementation. It is relatively easy to draft laws and regulations following international models with the advice of foreign experts, but it is difficult to train thousands of government officials and establish procedures for the effective administration and implementation of these laws and regulations. The most common complaint by both Kazakhstani and foreign businessmen is the difficulty in dealing with officials at all levels of government. Based on published surveys of foreign investors and mission interviews with both foreign and domestic investors, the major problems in dealing with the government include: 3 * Corruption. This is a serious problem at all levels ranging from governors (Akims) to local safety and health inspectors. * Licensing and regulation. About 26 different state bodies supervise business activities. The procedures for obtaining licenses are complicated, multiple government agencies are involved, delays are long, and fees are substantial. Several attempts have been made to reduce this regulatory burden (for example, Presidential Decree of June 14, 1996, on Small and Medium Enterprise Regulation), but the problem of complexity still remains. * Tax administration. Though the overall level of taxes is not considered high and the number of taxes has been reduced, businessmen must still pay 11 different taxes plus payments to three social funds and several other funds. Taxes are levied at different stages of production and based on different indexes. Tax officials are often unfamiliar with the new tax code, harass taxpayers, and confiscate bank accounts apparently without due process. In spite of a bilateral agreement with Russia, Kazakhstani businessmen must still pay the value-added tax twice on exports to Russia. * Customs procedures. These are still cumbersome, and businessmen complain about long delays. Customs officials are not familiar with regulations that permit VAT payments to be deferred on imported machinery and equipment. * Land ownership. Though the Land Law allows both foreign and domestic investor to buy or lease land, a local land committee allocates land to investors and the procedure is slow and cumbersome. 5. With respect to the administration of the legal system, the problems identified include the following: * judges and court personnel are not well trained and lack resources to perform their duties in a timely and effective manner; * the executive branch and law enforcement agencies dominate the judicial and parliamentary branches resulting in an ineffective system of checks and balance; * law enforcement and other agencies staff lack sufficient training and resources to fight economic crimes; * ministry and agency staff are poorly trained and lack legal/regulatory drafting skills; * judicial associations and independent legal associations are only beginning to emerge and are not effective; and * in general, while the government has made an effort to reduce the number of civil servants, not enough attention and resources are being devoted to ensuring that the streamlined government bureaucracy is professional, capable of fulfilling its duties, and properly paid. 6. Advocate for the Private Sector. Though the Government places a high priority on developing the private sector, it seems that no government agency has a clear mandate to develop policies and programs to assist the private sector. At this time, the agency best placed to carry out this function is the Goskominvest. The Agency should shift its focus from fiscal incentives to investment promotion by becoming the major advocate or spokesman for the private sector, working towards the reduction of transaction costs for private business, and the development of market-oriented government policies that would improve the business environment in Kazakhstan. 7. Recommendations. There are four main areas where the government could improve the environment for private business. First, the regulatory regime should be simplified significantly to reduce transaction costs that deter business entry and reduce productivity. Eliminating unnecessary licensing 4 and regulatory requirements and implementing a more transparent processing of necessary regulations would also reduce the scope for corruption. 8. Second, the government should accelerate the administrative reform that is currently being implemented, including improvements in the tax administration. Administrative reform includes the streamlining of the republican government and reforming the civil service to ensure professionalism in government service. These reforms should also extend to the local governments, which interface with local businesses. The Bank's Public Sector Resource Management Adjustment Loan supports government initiatives in administrative reform. 9. Third, the legal framework and administration should be completed and strengthened. In addition to passing a revised Company Law, a revised Collateral Law, and a new Leasing Law, the existing body of legislation and regulatory enactments should be reviewed to identify inconsistencies and major conceptual and implementation problems. Training of the legal profession and better access to legal information for both the courts and businessmen would upgrade the quality and efficiency of the judicial system. The Bank's Legal Reform Project would support initiatives in these areas. 10. Fourth, a special agency could be created to hear complaints from the private sector about their treatment by government officials. This agency could be called the Commission for Complaints or Office of the Ombudsman. It would investigate complaints from the public against any national or local government authority including state-owned enterprises. The only exceptions would be the President, the Parliament, and the judicial system. If the Commission felt that the complaint was justified, it would ask for a response including steps that the official or agency propose to take to remedy the situation. The Commission could also turn over complaints to the legal authorities if a crime may have been committed. Such a Commission would help to make government authorities more response to private businessmen, improve the quality of government services, and reduce corruption. Promotion of Foreign Investment 11. Background. The level of foreign direct investment in Kazakhstan on a per capita basis is substantially higher than that of its immediate neighbors such as Russia, Uzbekistan, Azerbaijan, or Tajikistan (see Table 2). These are figures provided by the International Monetary Fund, are consistent from country to country, and thus appropriate for making cross country comparisons. It should be noted that the Kazakhstani government estimates of foreign direct investment are substantially higher than these estimates -- the major difference is that the government figures may include commitments made by foreign investors rather than actual flows. The estimates in Table 2 do not include these commitments. 5 Table 2: Cumulative Foreign Direct Investment in ECA Countries, 1994-97 Total US$ Per Capita Total US$ Per Capita Million US$ Million US$ Hungary 9,645 946 Romania 1,673 74 Czech Republic 6,081 590 Azerbaijan 530 70 Estonia 696 464 Kyrgyz Republic 281 61 Latvia 1,072 429 Russia 7,833 53 Slovenia 790 395 Moldova 120 28 Poland 14,532 376 Ukraine 1,186 23 Slovak Republic 847 160 Armenia 60 16 Lithuania 416 113 Georgia 74 14 Bulgaria 710 85 Uzbekistan 305 13 Kazakhstan 1,375 84 Belarus 93 9 Albania 253 79 Tajikistan 51 9 Source: International Monetary Fund 12. Foreign investment in Kazakhstan is almost entirely due to the strong foreign interest in the extractive sectors such as petroleum and metals. Approximately 80 percent of foreign investment has been in these sectors (see Figure 2). Sale of enterprises to foreign investors during case by case privatization has been the second most important source of foreign investment. The level of foreign investment on a per capita basis, however, is still only a small fraction of that in some of the countries in Central Europe such as Poland and Hungary, where investment in manufacturing has proven to be a major component of foreign investor interest. 6 Figure 2: Breakdown of Foreign Direct Investment by Industry, 1993-1997 (in per cent of total) Food Other 4% 15% Non-ferrous metals 28% Ferrous metals 4% Oil and gas Source: National Bank of Kazakhstan 13. Some of the reasons for the low investor interest in Kazakhstan compared to such countries as Poland and Hungary are beyond the control of the government, for example, geographical location. There are a number of steps, however, that the government can take to encourage foreign investment. The most important of these have already been discussed above, namely, to improve the general business environment. A poor business environment hampers all investors whether they be domestic or foreign, big or small. 14. Incentives. Like some other countries, Kazakhstan has attempted to attract foreign investment by providing incentives for projects in selected priority sectors. These incentives are granted by the State Committee on Investments and include in-kind assets such as land or facilities, as well as tax and import duty concessions. As of the end of 1997, ten projects have been approved for these incentives. 15. There is considerable debate over the merit of providing special incentives for foreign investment. On the one hand, officials in some countries believe that providing such incentives are necessary to compete for foreign investment since firms can choose to locate in many different countries in today's global market place. On the other hand, most investors say that they are attracted to particular countries primarily because of fundamental economic factors such as political and economic stability, business environment, market size, geography, or labor costs. In this context, incentives are clearly of secondary importance, at best. In addition, such incentives (especially grants, subsidies, and tax holidays, such as those currently employed in Kazakhstan) can be costly to the government and ineffective in attracting foreign investment. They usually create biases between old businesses that do not receive these incentives and new businesses that receive the incentives, and invite corruption in the granting of the 7 incentives. The effectiveness of current incentives in attracting foreign investment to Kazakhstan is questionable. 16. However, if the Govermnent decides to continue to provide incentives for foreign investment, the issue is how this can best be done. Some kinds of investment incentives offered by other countries operate automatically through the tax code, involve minimal economic distortions, and do not require government screening (such as generous accelerated depreciation, loss carry-forwards, or investment tax allowances). Better yet are uniformly low tax rates, and the ability to deduct expenses such as marketing, training, inventory losses, and bad debts. 17. Under the current system in Kazakhstan, experts from the Investment Committee evaluate each proposed project on a case by case basis, determine whether the project is in one of the priority sectors and will benefit the country, and decide on a package of incentives that will make the project profitable. In order to work as expected, this process would require government officials with a high degree of skill and experience in evaluating private investment projects. Even under the best of circumstances, this subjective and highly judgmental approach invites allegations of corruption. Furthermore, the Committee must monitor and supervise the implementation of the project to assure that the foreign investors fulfill their commitments, which is costly, difficult, and usually ignored by most governments. 18. Recommendations. The program of subsidizing foreign investment should be eliminated as soon as possible. But if the government nevertheless insists on such programs, then at a minimum, incentives should be standardized and granted automatically to qualified investors rather than allocated on a case by case basis. The government would specify objective criteria that an investment project should meet and the associated incentives that would be provided. Any investment project that meets these criteria would automatically receive the specified incentives. There would be no need for a lengthy review of the qualifications of each project. 19. Most of the effort of the Committee is now devoted to processing applications for investment incentives. By streamlining project evaluation, scarce resources could be devoted to more productive ends. The Conmmittee could strengthen its ability to facilitate and assist foreign investors in ways other than providing financial incentives. The Investment Committee could also become a spokesman and advocate for government policies and practices that help all investors, domestic as well as foreign. 20. Another concern to foreign investors is the difficulty in obtaining visas and other procedures that make it difficult for them to bring in expatriate employees even though these employees often have special skills not available in Kazakhstan. Examples include the long waiting periods to obtain visas, the requirement for a letter of invitation, the requirement to obtain a license to employ foreign workers, the requirement to register passports and visas with local authorities, the harassment including arrest of foreigners who do not have the necessary papers with them, controls on movement within the country, and the need to apply for permission to exit the country (viewed as particularly onerous and intimidating). The Investment Committee can push for the elimination of most of these administrative barriers and assist investors in obtaining licenses, registration, or work permits and help with customs procedures. Small and Medium Enterprises 21. Background. In many developed as well as transition economies, small and medium sized enterprises (SME) have been a major engine of growth and increased employment. Counting the number of small and medium sized businesses and measuring their importance in the economy are particularly difficult because many such businesses operate informally and are not officially registered. The official 8 data estimate that these enterprises produce about eight percent of GDP in Kazakhstan and account for about six percent of employment. More than half are engaged in trading activities and services. A small or medium sized business in Kazakhstan is defined to be an enterprise with 100 or fewer employees. According to government statistics, there were approximately 150,000 SMEs registered in Kazakhstan in 1997, of which 52,000 were functioning. 22. In most countries, there is a sizable informal sector where many SMEs operate. The informal sector is estimated to account for 30-50% of GDP in Indonesia, Philippines, and Thailand, and 20-30% in South Korea, Malaysia, and Taiwan. One reason why many of these enterprises operate informally is to escape a burdensome regulatory and tax regime. A small entrepreneur's reaction to excessive taxes and harassment from regulatory and tax authorities may be to operate his or her business illegally and not register the business or pay taxes. Thus the employment or production in such a business is probably not recorded in the official data. 23. The official data suggests that SMEs are much less important in Kazakhstan than in many developed countries or even in other transition economies (see Figure 3). According to one study, SMEs account for 53 percent of employment in the United States, 64 percent in Germany, and 80 percent in Italy. Among transition economies, SMEs account for 58% of employment in Georgia, 37% in the Czech Republic, 24% in Hungary, and 23% in Poland. Even if the data were adjusted for the size of the informal sector, Kazakhstan would probably also lag the other countries. Thus the government has had a policy of providing support for SMEs. A number of international and bilateral agencies have also provided support for this sector. 24. SME Programs. Because of the importance of SMEs in the economy, most governments have a variety of programs to assist these businesses. It is difficult to measure the success of these programs, however, because a small business may have been successful even without support from one of these programs. Also these programs can be expensive if they provide credits or loans to small businesses and then the credits or loans are not repaid. The World Bank has surveyed the experience in various countries to determine which programs are likely to be successful (see Box 1). Box 1: Effective Approaches to Assisting Small and Medium Enterprises * Policy reforms that achieve macro-economic stability, a complete legal framework, and low transaction costs (market as well as licensing, registration, reporting, taxation); * Lower transaction costs of financing (while subsidized credit programs have been a failure); * "Light touch" technical and marketing assistance (to overcome information asymmetries both at company and market level), in which the public sector supports private sources; * Policies that enhance demand-driven access to training and technology (payroll levies combined with policies offering choice of private providers; tax incentives less effective); * Measures that enhance inter-firm networking and clustering to meet the challenge of globalization (achieving critical mass to improve credit, training, technology and export access). Source: Leila Webster, et. al., World Bank Lending for Small enterprises, 1989-93, World Bank Discussion paper 311, 1996 25. The most important support that the government can give to SMEs is to improve the overall business environment as discussed above. Paradoxically, reducing the tax and regulatory burden may actually increase the taxes paid by SMEs for two reasons. First, this would increase the number and 9 importance of SMEs. Second, this would encourage a larger proportion of SMEs to register, operate legally, and pay taxes. 26. In addition to improving the business environment, the government has tried to assist the sector in a variety of ways. Two Presidential Decrees, four laws, ten government decrees, and seven regulatory acts over the past five years have dealt with SME support. Despite these programs and initiatives, the impact on SME development to date has been minimal based on feedback from entrepreneurs and official statistics. In a recent survey conducted by USAID covering 500 SMEs in Almaty, the main constraints identified were: (a) lack of access to credit; (b) bureaucracy and corruption; and (c) high and unpredictable taxes. These constraints are consistent with surveys covering CEE and other CIS countries. Box 2 summarizes the USAID SME survey results. 27. Legal and Regulatory Environment. The licensing and business supervision practices in Kazakhstan impose tremendous transaction costs on SMEs and provide opportunities for corruption. A wide range of activities have to be licensed before an entrepreneur can commence a business. These procedures are complicated and involve numerous government offices, resulting in costs to the entrepreneur not only in terms of fees paid but also time spent following up paperwork. Unlike large enterprises, SMEs typically do not have staff to perform the follow-up of the paperwork, and the entrepreneur himself or herself would have to devote time to dealing with the government rather than focusing on the business itself. There is therefore a disproportionate impact of a poor legal and regulatory environment on SMEs. 28. While there have been several attempts to improve the regulatory regime (e.g., Decree of the President of June 14, 1996 and March 25, 1997 on the regulation of SMEs), entrepreneurs complain that the situation has not improved. Part of the problem is that the administration and implementation of relevant legislation and many regulations depend on the attitude of the Akims to entrepreneurs. Akims have tremendous power in the region, but they are not accountable to the people since they are appointed, not elected. Compounding the problem is the poor dissemination of information to the entrepreneurs about laws, regulations, and support programs. 10 Box 2: Kazakhstan SME Survey Results * most important constraints: (a) lack of access to credit; (b) bureaucracy and corruption; and (c) high/unpredictable taxes. * least important constraints: (a) raw materials/machinery; (b) access to market information; and (c) cooperation with other SMEs (only 8% belonged to an Industry association/union). * Ownership: average age of owner was 30-40 years, 80% male, 90% with university education, 75% previously employed in a state firm or Government. * Sectoral focus: 70% of all SMEs were in the trade or services sector. * labor force: two thirds of SMEs employed less than ten (83% less than twenty); 90% of employees full time. * activity levels: 30% of the 850 SMEs registered with the tax authorities were found to have closed operations or never been active; 20% operated for less than 8 months per year, the main reason being shortage of capital. * age: virtually all SMEs were less than 4 years of age (45% less than 2 years); very few surviving SMEs had been established prior to 1994. * origins: 80% of enterprises started as new businesses, rather than state enterprise purchases; none had been purchased from another private business owner. * sources of finance: nearly 75% founded from savings of owner or relatives/friends (20% used bank loans). Collateral requirements cited as the main reason (60%) for inability to obtain bank credits. * Premises and capital stock: two thirds of SMEs rented their premises (75% rented from state entities); 50% of the SMEs had purchased their equipment second hand. * income levels: only 10% of employers had experienced a decease in incomes since their SME foundation; 70% had registered sharp or moderate increases. Source: USAID 29. Tax Administration. Since independence, the tax system has undergone considerable changes - - a new Tax Code effective July 1, 1995 and a Presidential Decree on Taxes and Other Obligatory Budgetary Payments effective June 1, 1997 (with status of law) simplified and modernized the tax system. The number of taxes were reduced from 40 to 11 (five of which are obligatory local taxes). In addition, there are obligatory payments to social security (which has three types of funds), the Employment Fund, the Road Fund, the Environrnent Protection Fund, and the Republican Fund for Natural Resources Protection and Rehabilitation. 30. The main complaints from entrepreneurs relate to tax administration. Tax rules are applied inconsistently and incorrectly. This may be attributable to the frequent changes in tax rules -- over a two year period between 1995-97, nearly 20 amendments were enacted. SMEs are also required to use accrual accounting and to use relatively expensive cash registers -- some SMEs may be too small to merit the costs of such systems. There is no threshold for compulsory VAT registration unlike in many East European countries, thereby imposing an additional administrative burden on small businesses. 31. Financing SMEs. The government has tried to increase lending from the financial system to SMEs because small businesses often complain about lack of funds for working capital or investment. This complaint, however, is made by small businesses the world over. Often the main source of funds for a small business is the owner's own capital or close family and friends. In the EU where SMEs account for 65% of employment and 40% of export sales, SME growth is financed by reinvested profits (65%), 11 bank loans (20%), personal/family funds (10%), and additional equity (5%). In every country, banks have found that lending to small businesses is risky, and such loans have a high rate of default. Consequently, government programs to provide or guarantee loans to SMEs often have a high rate of default and end up costing the government a great deal of money. This may be even more likely in Kazakhstan because banking skills are still being developed and there is a lack of good collateral and bankruptcy system. 32. As noted above, the most important step that the government can take to increase lending to SMEs is to enact good collateral and leasing laws. Another is to remove any restrictions on lending margins charged by banks. Margins for loans to SMEs have to be higher than for other loans because of greater risk and higher transaction costs incurred by the lender. The government has a requirement that loans to SMEs should be at least 10 percent of a bank's total loans, although this is not binding for many banks since their SME lending is above the minimum requirement. 33. Bilateral donors have established financial institutions to lend to Kazakhstani businesses, for example, the Central Asian-American Enterprise Fund and Post-Privatization Fund. These funds, however, only make loans and investment of over US$ I million which is beyond the needs of most SMEs. The European Bank for Reconstruction and Development will begin a lending program for small and medium enterprises in mid-1998. 34. Training and Support Services. Another area of possible government assistance to SMEs is to provide training or consulting services to owners and managers in such subjects as management, marketing, and accounting. The government and bilateral donors are providing such assistance through the Kazakhstani Center for SME Support, the Kazakhstani Training Center, and the SME Development Agency in Aktube, UNDP Center and affiliated organizations. There are some 40 Small Business Support Centers in Kazakhstan providing training programs to entrepreneurs. 35. To develop policy and coordinate assistance to SMEs, the has established the Agency for Small Business Support. Similar units have been established in many of the oblasts by regional government authorities. To be effective, these units need more training and assistance in developing SME programs. 36. Recommendations. There are three areas where the government could encourage the development of SMEs. First, the government could eliminate or at least reduce many of the transaction costs that SMEs incur in dealing with the regulatory regime. As an immediate action, the government should consider reducing the number of entrepreneurial activities that require licensing. The government should also review the fees charged for licensing and other services. The government should also review its procurement procedures to ensure that these are not biased against SMEs. 37. Second, the government could improve SME access to financing by passing a stronger Collateral Law that would provide greater protection to lenders and a Leasing Law to encourage the development of new vehicles of SME financing. In addition, the government could eliminate restrictions on lending margins that discourage banks from lending to relatively more risky SMEs. 38. Third, tax administration should be improved in many ways. A turnover threshold for VAT registration could be established -- this ranges from USD50,000 to 100,000 in many East European countries. Small enterprises should be allowed to use cash instead of accrual accounting, and should not be subject to expensive compulsory audits or required to use expensive cash registers. Tax rules should be stable, disseminated widely, and applied consistently. Finally, the reporting requirements could be simplified and the frequency reduced. 12 CHAPTER TWO ENTERPRISE PRIVATIZATION, GOVERNANCE AND RESTRUCTURING Privatization 39. Kazakhstan has adopted a pragmatic approach to privatization and has used almost every method. One can argue that one method is better than another, but every method has weaknesses and disadvantages. The key conclusion, however, is that by adopting many methods, Kazakhstan was able to privatize a large proportion of its enterprises. In the privatization of the large enterprises that still remain in state ownership, the Government should consider using one method of privatization that has not been widely used before -- the sale of majority stakes in enterprises to strategic investors offering the highest price. 40. Small and Medium Scale and Agricultural Privatization. Because so many different methods of privatization were used, the history of privatization is somewhat complicated. The first method begun in 1991 was spontaneous privatization in which managers and employees were able to take over ownership of small and medium enterprises. Regional administrations allowed these "insiders" to buy shares for free or under generous conditions (for example, interest free loans of long duration). About 7,000 small and medium enterprises and housing units were privatized in this way. 41. After this early experience with privatization, the government decided to adopt more open and equitable methods of privatization in which investors other than managers and employees could participate. In mid-1993, the government adopted a program of small-scale privatization that is still going on today to a limited extent. This program privatized approximately 13,000 small establishments in agriculture, retail trade, catering, services, health, and some school facilities. These were sold through cash auctions though housing vouchers could also be used as payment. 42. The government's program of agriculturalprivatization has transferred more than 90 percent of all farms and 80 percent of farmland to private owners primarily in the form of agricultural cooperatives. Each worker in a forrner state-farm received a long-term transferable right to use a portion of the farm's land and could opt out of the cooperative to establish an independent farm. Agro-processing enterprises were also transferred to cooperatives or to agricultural suppliers. The sector still suffers, however, from unclear property rights to different types of agricultural land. 43. Mass or Coupon Privatization. Based on the experience in the Czech and Slovak Republics, the government began a mass or coupon privatization program in early 1993. Some critics regard this program as a failure because it did not provide good owners who could restructure enterprises. In retrospect, this program had a number of weaknesses. The mass privatization program had two main objectives. The first was to provide free to all citizens an equal ownership share in the enterprises included in the program. The second was to create privatization investment funds (privatization funds) that could act as the owners of these enterprises and encourage them to restructure. 44. The first objective was to be achieved by giving each citizen free of charge coupons that could be used to bid for shares of enterprises in special coupon auctions. The second objective was to be achieved by requiring each citizen to turn over their coupons to a privatization fund that he or she could freely select. This privatization fund would actually bid for the enterprise shares using the coupons and would 13 hold the enterprise shares in its portfolio on behalf of all the citizens who entrusted their coupons to the fund. Privatization funds would then be major shareholders in the enterprises included in the program and could oversee and supervise the activities of managers to assure that they restructured the enterprises. Eventually, as the enterprises became profitable and paid dividends to the funds, they in turn would pay dividends to the citizens who entrusted them with their coupons. These citizens would become shareholders in the funds, and the funds would be shareholders in the enterprises. 45. Distribution of coupons took place at the end of 1993, the privatization funds began bidding for enterprise shares in mid-1994, and the last auction was held in January 1996. Approximately 1,700 enterprises were included in the program - substantially less than the initial target of 3,000. Though 170 privatization funds were formed, the 30 largest accumulated two thirds of the coupons collected from citizens. 46. Critics argue that the mass privatization program failed to achieve either of its two main objectives. Almost all privatization funds have ceased to exist or became dormant, and thus most citizens who participated received nothing of value. By most accounts, the privatization funds have done little to supervise the activities of the enterprises and contribute to their restructuring. Various reasons have been given for the failure of the mass privatization program to achieve its objectives including: * Many poorly performing enterprises were included. They had little chance of survival regardless of the efforts of the new owners, and thus the value of the citizens' ownership interest in the privatization funds was greatly reduced. More than 40 percent of the enterprises included in mass privatization have ceased operation. * Each privatization fund initially could not own more that 20 percent of the shares in a particular company. Thus three or more funds had to cooperate in order to have a majority shareholding and thus exercise control over management (the 20 percent limit was later increased to 31 percent). * Moreover, a majority of shares in about 40 percent of the enterprises was sold to a cash investor or retained by the government. The funds were relegated to being minority shareholders and had little voice in the management of the company. If these enterprises failed to restructure, this should be blamed on the majority shareholder and not on the powerless funds. * The majority shareholders of the profitable companies were reluctant to pay dividends to the funds. Thus the funds were deprived of any revenue to cover their expenses or pay dividends to their own shareholders. * Until recently, privatization funds have not been allowed to transform themselves into other organizational forms which might be able to exercise more control over the enterprises. In the Czech and Slovak Republics, most funds have converted themselves into holding companies and have themselves come under the control of major investors. Many if not most of the original coupon holders have sold their shares in the Czech and Slovak funds to these large investors. These investors wanted to gain control of the Czech and Slovak funds because it was a way of gaining control over the enterprises included in mass privatization. Ownership of enterprises in the Czech and Slovak Republics have become much more concentrated and this will probably improve the ability of the owners to restructure the enterprises. Until August of 1997, this was not possible for funds in Kazakhstan, and by then most funds had ceased to exist. 14 47. Case by Case Privatization. Beginning in 1996, the government turned more towards case by case privatization in which enterprises are sold in cash auctions or negotiated direct sales. The government sold shares in about 1,600 companies using this method. These privatization contracts are confidential, but apparently they tended to be complex with the investors making various commitments to the government as to how they would manage the companies. 48. In the privatization contracts, the government wished to ensure that the new private owners would follow an agreed plan of restructuring the enterprise. For example, the private investor often agreed to pay off existing debts including wage arrears and make new investments. These complex privatization contracts, however, have two disadvantages. First, the government says that it wants to turn control of enterprises over to private owners because private owners are better than the state in managing these companies. Yet the government uses these contracts to control how the private owners manage the companies, for example, dictating the investment strategy of the new owners. Such contracts create the impression that the government is not committed to private ownership and control and intends to intervene in the management of private companies. Second, these complex contracts are likely to involve the government in disputes with investors. Regardless of who is at fault in such disputes, they tend to create the impression that the government does not abide by its contractual obligations, is not reliable, and does not treat investors fairly. Thus foreign investors will tend to view investing in Kazakhstan as risky. 49. Public Offering. The last method of privatization is selling shares on the stock market in a public offering. In Kazakhstan, this is referred to as the Blue Chip Program. As discussed in Chapter 4 of this report, the government proposes to sell blocks of shares in the best known companies in Kazakhstan to many small investors and passive institutional portfolio investors. Though this may encourage trading on the stock market, such ownership does not promote restructuring of these enterprises. Small investors have little ability to control or monitor the performance of the managers of these companies. They are passive portfolio investors rather than active strategic investors. 50. For the companies in the Blue Chip Program, a majority of shares should be sold to an active strategic investor and only a minority of shares sold on the stock market. Sometimes managers of state- owned companies argue that all of the shares of the company should be sold on the stock market to small investors. This is a self-serving argument by management. The many owners would have little control over the managers who would have free rein to manage the company as they see fit. In such cases, they may manage the company for their own benefit rather than the benefit of the owners. The government is unable to supervise these managers since the government has sold its shares, and yet the small shareholders are also unable to supervise the managers. 51. Completing the Privatization Process. Though Kazakhstan has privatized thousands of enterprises, many large important enterprises remain in majority state ownership. The government says that privatization is almost complete, but this does not seem to be supported by the data on the ownership of enterprises. One explanation for this difference is that the government may consider that enterprises are privatized when private investors own a significant minority shareholding in the company but not a majority shareholding. This paper has a stricter definition and does not consider an enterprise privatized until private investors own more than 50 percent of the shares. According to the Statistical Office, less than half of the large and very large enterprises are fully privatized in that private investors own more than 50 percent of the shares. Another group of these enterprises have mixed ownership in which both the state and private investors own shares. 15 52. Though few in number, these large and very large enterprises dominate the economy. The state is still the only owner of 333 of these enterprises, and they account for about a third of GDP. Many of these large and very large enterprises have been transferred by the State Property Committee to "trust management" in which existing managers or the regional administrators have control over the enterprises. Regardless, these enterprises are still in state ownership, and trust management should not be a permanent solution. Substantial additional privatization is needed in Kazakhstan to create a truly private economy. 53. In choosing a privatization method for these large enterprises, the government should consider simply selling most or all of the shares in the enterprise to a strategic investor (either domestic or foreign) that offers the highest cash bid in a competitive auction. The process should avoid complicated requirements on how the new owner should manage the company (for example, investment requirements). In this way, the government will avoid becoming involved in the management of these companies after privatization and avoid disputes over whether the new owners have satisfied the requirements of the sale contracts. Furthermore, this method of privatization is more likely to result in the largest revenue to the government and help to achieve fiscal targets for privatization. Restructuring and Governance 54. Management Contracts for Large Enterprises. While Kazakhstan made strides in privatizing small, medium and large enterprises, the Government early on was concerned about the social consequences of the quick sale of some 100 very large enterprises.. Many of these firms faced serious problems related to mismanagement, absence of market-based accounting practices, enormous social obligations, and large inter-enterprise, payroll and tax arrears that investors would be generally unwilling to assume. In essence, the Government aimed to restructure such enterprises prior to privatization. 55. The Government resorted to management contracts in which it assigned enterprises for a specified period of time to a management firm. The management company would benefit from an agreed upon remuneration. The enterprises would benefit from know-how and market access with possible links to international investors. The Government would benefit from passing on the obligations of the enterprises to the management firm and the possibility of extracting bonus payments out of the management contracts. 1 56. The Government signed 41 management contracts covering 94 enterprises in December 1994. The enterprises were either in processing, services or mining and mineral processing. The length of the contracts varied from 18 months to 15 years but the majority was five years. The majority of the contracts were signed with management companies registered in Kazakhstan and some with lesser known firms with the exception of Samsung (for copper mining and manufacturing) and Lufthansa (for the management of the Almaty airport that was subsequently canceled). 57. These contracts stipulated the payment of specified arrears to the Government, utility companies, transport and input suppliers. Many contracts included initial bonus payments to the Government within 120 days of signing by the State Property Committee (SPC). Some contracts required the management firms to assume operating expenses for the facilities and to undertake some investments in a couple of cases. A few contracts even tried to ensure the sale of output at world prices. Authority over the I These bonuses were not typical of management contracts used in many developing countries where the governments attracted managernent skills in exchange for remuneration. 16 contracts varied -- the State Property Committee or Council of Ministers Resolution or the Republic of Kazakhstan Resolution. Monitoring also involved several government offices. At the outset, the SPC was responsible for monitoring the bonus payments to the Government and the repayment of arrears and for on-site monitoring visits, while the Ministry of Industry and Trade was authorized to oversee environmental obligations. 58. Another initiative was taken in 1996 involving mass-privatized companies in which existing managers were given "trust management" of the state's remaining shares. Twenty-one trust management contracts were signed by the SPC or the oblast administrations to relieve the state of its governance role and to preclude the new owners from asset stripping. 59. Performance in meeting obligations under the contracts and in turning around the enterprises varied. Seventeen contracts were canceled either because the management firms failed to meet the financial obligations under the contracts or companies themselves withdrew from the contracts due to higher-than-expected arrears of the enterprises. On a positive note, twelve contracts were revised in 1996 in favor of selling some of the equity to the management firms. Under these contracts, the decline of production in those enterprises stopped, their financial positions stabilized, and tax and wage arrears declined. A recent State Property Committee report states that only 33 contracts remained in effect as of end 1997. 60. While management contracts in theory can lead to improved governance, market access and transfer of know-how, their success in practice depends on a competitive tender process, careful delineation and negotiations of the contract terms, and the capacity of governments to enforce the terms and closely monitor the management companies. The Government's concern to quickly stem the decline of production in the large enterprises and accumulation of arrears led to a majority of the contracts being signed without a tender process. Some contracts covering capital intensive enterprises had vague clauses to preclude exploitation of these firns without full depreciation costs. 61. Enforcement capacity within the Government was limited and monitoring responsibilities were vaguely delineated. Although there were quantitative targets and time schedules put in place for the settlement of the enterprises' obligations, penalties other than contract cancellation were not always clear. While the SPC was technically responsible for the management of all state assets pending privatization and restructuring, the responsibility for monitoring management contracts, especially those under trust management, was later shifted to the Ministry of Industry and Trade. While the SPC had representation in the Ministry's offices at the oblast level, these offices were still located at some distance from the firms. In fact, those enterprises still came under the supervision and power of the oblast akims. Notwithstanding the role of the latter, the SPC and the Ministry in the oblasts did not interact very much and therefore did not coordinate supervision of the contracts. 62. Restructuring, which was central to such contracts, was made difficult in some cases when contracts prohibited layoffs and divestiture of social assets, or controlled output levels and supply relations. The trust management contracts signed in 1996 for mass-privatized firms reportedly even provided existing managers veto power over most initiatives of shareholders and supervisory boards, thereby rendering the managers immune from shareholder control. 63. The Government had intended for the contracts to divest state control and attract foreign capital, i.e., the management companies could obtain the right to purchase controlling equity in the enterprises outside of the cash auction or the open tender used in the case-by-case process. The Government eventually sold equity stakes of 49 to 65 percent of shares of some enterprises to management companies. 17 Nevertheless, such priority rights when they were exercised undermined the Government's case-by-case strategy of promoting competition for the highest price. 64. Rehabilitation Bank. The Rehabilitation Bank (RB) was established through a presidential decree in April 1995 to deal with the most highly indebted large enterprises in financial distress. The objective was to control the financial flows into the distressed enterprises by limiting access of these enterprises to RB for credit, including the financing of operating deficits. For an enterprise to have access to RB resources, it had to present and implement a restructuring program approved by a center established by the Government. The center would serve as an independent body to review the enterprise's proposed plans and work with the enterprise to come up with a program to be presented to RB. In theory, the Rehabilitation Bank would analyze the feasibility of an enterprise's restructuring program that could include privatization or liquidation within four years for those with no prospects of viability. If RB found the program feasible within 18-24 months, it would become the lead creditor of the enterprise and provide credits at negotiated terms to satisfy the other creditors. The Rehabilitation Bank would also be responsible for monitoring the financial performance of the enterprise. 65. In practice, the center was not established until 1996 such that the enterprises developed restructuring plans on their own based on methodology developed by advisors to RB. The decree did not set precise guidelines for RB's operations and so the Government adopted some operating rules. Credit from RB to an enterprise must be reduced by at least 25 percent in real terms over the previous 6 months' credit. The funds received from RB would be used strictly for downsizing (severance payments or disposal of social assets). Any restructuring plan must include employment reduction of at least 30 percent and reduction of negative operating cash flow by at least 50 percent within the first 12 months. The enterprises could be privatized at any time. 66. The Government transferred 46 enterprises to RB's control between 1995-97. Funding by RB was used for severance payments and payments of arrears to the payroll, suppliers, social funds and the government. RB did not undertake any new investments in fixed assets. RB negotiated with other key creditors of the enterprises for a joint moratorium. Credit agreements signed with enterprises included installment repayment schedules. The restructuring programs did include time-bound actions, including employment reduction of at least 30 percent within a year. However, it has been difficult to monitor compliance with the requirement to reduce the enterprises' negative cash flows. As of end 1997, only 20 remained in RB's portfolio of which liquidation proceedings were initiated against four insolvent enterprises, including Karaganda Liquidshakht.2 One chemical enterprise was declared bankrupt and the rest were returned to the State Property Committee's control for privatization, or for management contracts. 67. The Rehabilitation Bank did exercise a fair degree of financial and other monitoring (both onsite and offsite) in a number of enterprises. It was also successful in replacing the management of some enterprises. But RB suffered from internal weaknesses and external constraints. In its early days, RB had to grapple with the urgency of setting up procedures and internal systems and of upgrading the skills of its staff. But the bank's effectiveness was hindered by the shortage of funding from the Govermment's 2 Karaganda Liquidshakht (KL) was established as a state-owned enterprise to undertake the closure of 8 coal mines owned by two enterprises in Karaganda. It either laid off or transferred about 2,000 workers originally employed in the mines. Two-thirds of the employees received two months lay-off notice and severance payments equivalent to three months' salary. Th.e other third, mainly those suffering from work-related accidents or illness, were transferred to other mines. The final steps before KL could close its operations would be to sell off some equipment installations and to complete the clean-up and safety measures of the mines. KL anticipates to wind down its operations at the end of this year. 18 budget, especially for severance payments, the weaknesses of the courts in handling bankruptcy applications and its financial inability to retain good staff. RB was initially envisaged to be a vehicle for restructuring enterprises but it lacked the support that was to be provided by the advisory center in developing restructuring programs. As mentioned previously, the center was unable to provide technical assistance for the preparation of restructuring programs, as it did not even have the expertise to review initial plans submitted by the enterprises; it was only much later that the center acquired foreign expert support. Moreover, in some instances, enterprises were transferred out of the Rehabilitation Bank prematurely -- months before their privatization plans were completed. 68. Corporate Governance After Privatization. As mentioned earlier, investment funds were only allowed to take minority positions in all mass-privatized companies. The original plan to have a second round of privatization where investment funds would be able to invest in additional shares did not materialize. Instead, the residual shares, frequently representing the majority stake, were sold for cash to local investors in less than transparent deals. The sale of majority shares was administered at the regional level. Of the 1,700 enterprises that participated in the first wave of mass-privatization, 1,100 were later sold to strategic investors. Another 400 were reportedly closed down; and the rest still remain without a majority owner. In such circumstances, the investment funds have effectively remained without any control over corporate governance issues. 69. To examine the change in governance structures after privatization, 62 former state owned enterprises in the manufacturing sector3 were surveyed and compared with similar enterprises in five other CIS countries -- Russia, Ukraine, Georgia, Kyrgyz Republic, and Moldova. Insiders -- managers and employees -- in the Kazakhstani firms surveyed own about 37 percent of the shares (29 percent by managers and 8 percent by employees), compared to 73 percent in the Kyrgyz Republic, 64 percent in Georgia, 62 percent in Ukraine, and 60 percent in Russia. The state still has significant ownership share in Kazakhstani firms, although the share has significantly decreased from 35 percent in 1995 to 16 percent in 1997. Many Kazakhstani firms complain that while the state has minority shareholdings, the state representative to the Board can block certain decisions. Non-insider local investors account for 30 percent of ownership of Kazakhstani firms in 1997 -- up from 24 percent in 1995 -- and foreign investors account for another seven percent. Kazakhstani firms in the survey sample had the highest ownership share of non-insider local and foreign investors compared to the firms in the other countries. Unlike many other countries in the FSU, enterprise owners in Kazakhstan are open to the possibility of attracting foreign investors even if those acquired majority stakes in their respective companies. Table 3 below gives the survey results on changes in ownership structure. 3The sectors covered were metals (6), chemicals (5), machinery (11), wood and furniture (4), construction materials (8), textile and apparel (12), food and beverage (14), and pharmaceuticals (2). The 62 firns were located in Almaty (51) and Karagandi (11). 19 Table 3: Changes in the ownership structure (Percent Share of Total Equity) Country Managers Employees The State Outside Local Outside Foreign Others Investors Investors Georgia X X X_ _ _X 1995 41.5 9.4 41.0 4.9 1.0 2.2 1997 53.6 10.4 23.3 8.0 2.2 2.5 Kazakhstan 1995 23.1 10.7 34.8 23.6 4.4 3.4 1997 29.4 8.2 16.1 30.2 6.8 9.3 Kyrgyz Republic 1995 28.1 38.3 12.4 16.8 2.2 2.2 1997 34.4 36.4 5.6 18.9 2.3 2.4 Moldova 1995 7.2 21.6 38.6 24.7 0.3 7.6 1997 18.3 19.7 23.8 22.6 2.1 13.5 Russia 1995 25.4 26.0 23.5 23.4 1.6 0.1 1997 36.3 23.3 14.7 21.5 3.8 0.4 Ukraine 1995 14.6 23.6 42.6 18.9 0.3 0 1997 46.2 15.3 15.4 17.7 0.9 4.5 Note: The shares are unweighted averages. State ownership includes property under local and municipal administrations. Outside Local Investors include investment funds. 70. Privatization resulted in changes in top management in 32 percent of the Kazakhstani firms surveyed, the highest among the sample countries. Management turnover was not as high as would be expected in a change in ownership, as is in the case in many developed economies. One possible explanation is that many managers of the former state owned firms were able to purchase significant ownership rights during the privatization process. Nonetheless, it is not clear a priori whether new management per se would result in better governance. It may be that the change in ownership structure would bring about better oversight and incentives that would result in better performance by management. Table 4 gives management turnover survey results. 20 Table 4. Management Turnover (percent) | Georgia Kazakhstan Kyrgyz Rep. Moldova Russia Ukraine New manager since 1994 (% of fms) 16.1 32.4 28.3 26.4 23.2 18.6 How did the change occur? X _________ a. new owner/manager 76.5 59.2 66.3 35.6 24.9 23.4 b. internal succession 4.2 8.8 6.0 13.6 5.6 10.6 c. new manager brought by new 15.6 22.6 10.8 8.5 48.9 39.8 owner d. new outside manager brought 3.7 9.4 16.9 42.3 20.6 26.2 by existing Board of Directors 71. Restructuring After Privatization. Restructuring is the adjustment process that enables enterprises to reach commercial viability. Restructuring can lead to different outcomes -- firms could increase their productivity and market share, or they could shrink by getting rid of nonviable or noncore portions of their operations. Thus, the decline in business activity of an enterprise need not be associated with lack of restructuring. 72. Using the same sample of 62 firms, the mission measured the extent of restructuring using nine complementary indicators: labor shedding, increases in sales per worker, closure or sale of unprofitable units, creation of a retail network and marketing, development of new products, seeking contracts with new partners, renovations at the factory to improve working conditions, initiation of a quality control process, and a reduction in barter transactions. The results were compared with firms in other CIS countries. 73. Labor shedding during the period 1995-97 occurred in about 25 percent of the Kazakhstani firms, and sales per worker grew by about 11 percent. Sale of assets occurred in 24 percent of the firms and minor renovations in 39 percent. New products were developed in 33 percent of the firms, and in 16 percent of firms a new retail network was developed with the collapse of the centralized monopoly state owned distributors. These indicate evidence of restructuring occurring in privatized firms, but not as extensively as one would hope given initial conditions. Table 5 gives the results of the survey on restructuring. 21 Table 5: Measures of Restructuring (percent of firms surveyed, unless otherwise indicated) Country Labor shedding, Sales per Worker Sale of Assets Own Retail Network 1995-97 Growth, p.a. 1995-97 Georgia 31.2 19.2 18.2 24.6 Kazakhstan 24.8 11.4 24.3 16.5 Kyrgyz Rep. 27.3 14.6 33.6 29.7 Moldova 24.1 9.4 23.7 15.2 Russia 15.2 12.1 24.6 22.3 Ukraine 10.3 10.8 21.1 27.1 Country New Products New Partners Minor Renovations Quality Control Percent Share of Barter Trade Georgia 23.6 40.5 24.2 12.2 24.2 Kazakhstan 32.6 11.2 39.2 15.2 28.3 Kyrgyz Rep. 25.8 14.8 44.2 19.6 19.3 Moldova 27.4 26.3 29.6 16.3 33.2 Russia 33.7 29.7 30.2 21.6 44.1 Ukraine 41.9 18.8 52.6 38.4 48.6 74. To determine what are the important constraints to restructuring, the survey included questions on this issue. Lack of marketing capability was identified by 25 percent of the Kazakhstani firms as a major constraint. Lack of skills, changes in regulation, lack of financing, and tax problems were identified by 11 to 14 percent of the firms. Table 6 gives the results. Table 6: What is the major constraint to further restructuring (percent of total responses) Constraint Georgia Kazakhstan Kyrgyz Rep. Moldova Russia Ukraine Lack of skills 16.7 14.3 4.1 21.6 5.7 16.4 Lack of financing 16.2 13.8 4.7 12.2 9.2 12.3 Lack of marketing capability 30.1 24.8 5.2 21.8 7.4 7.2 Changes in regulations 8.3 13.9 12.1 14.9 20.3 11.1 Corruption 10.7 5.3 2.5 2.2 11.2 13.3 Taxation 6.9 11.7 69.1 15.3 24.1 30.4 Inability to sell off assets 8.8 13.4 1.4 10.2 11.7 7.2 Organized crime 2.3 2.8 0.9 1.8 10.4 2.1 Note: The shares are unweighted averages. 22 75. The survey also asked what types of training were needed to enable firms to improve productivity and growth. Marketing and sales, accounting, and export strategy were identified as the most important areas for skills development. This result is consistent among firms across the six CIS countries where the survey was conducted as shown in Table 7. Table 7: What kind of training is necessary (percent of total responses) Skill Area Georgia Kazakhstan Kyrgyz Rep. Moldova Russia Ukraine Marketing and Sales 37.4 41.3 48.0 34.8 26.4 29.7 Accounting 21.5 18.1 17.2 17.4 18.5 14.2 Quality Control 1.6 2.4 3.0 5.6 9.3 5.1 Export Strategy 18.4 11.6 n.a. 7.5 8.1 11.7 Secondment of 7.4 14.3 5.2 17.8 11.4 17.9 managers abroad Foreign languages 4.9 6.3 1.2 14.7 3.2 8.2 Not necessary 8.8 6.0 4.9 2.2 23.1 13.2 Note: The shares are unweighted averages. 76. Conclusion. Ownership structure in formerly mass-privatized firms has evolved to the point where effective corporate governance is in place in the majority of enterprises. Enterprise restructuring has been passive, mostly through labor shedding, sale of assets, and exit from unprofitable markets. Active restructuring (through new investment) has only just begun in a handful of enterprises. To enable enterprises to accelerate the restructuring process, the main constraints identified by the enterprises themselves should be addressed, and would require training in sales and marketing, accounting, and exporting. 23 CHAPTER THREE INRASTRUCTURE DEVELOPMENT 77. Providing efficient infrastructure services to business sector is crucial to establishing an environment that is conducive to investment and greatly affects the international competitive position of businesses in a country. Studies show that investment in infrastructure has significantly reduced the cost of manufacturing in a number of high-income countries. This section focuses on government policy in the power and telecommunications sectors to ensure that these provide efficient services to the business sector. Natural Monopolies 78. The restructuring and development of the natural monopoly sectors create special challenges for the government. The electric power and telecommunications sectors share a number of serious problems. Until recently, they were dominated by state-owned monopolies. There was little incentive for these monopolies to reduce costs, improve operating efficiency, or set prices at appropriate levels. 79. Though prices were often below the cost of supply, many customers simply did not pay even these low prices or paid by means other than cash. One consequence of low prices and non-payment is that these sectors have had a chronic shortage of funds and were unable to make necessary investments in maintenance, new capacity, and modernization. 80. The approach to reform in many countries has been to privatize these sectors and introduce competition where technically feasible. This approach, however, is likely to be controversial in Kazakhstan as it has been in other countries. Workers in these sectors are afraid of losing their jobs if private owners attempt to lower costs. Some consumers will have to pay substantially higher prices for services that they previously received for free or at nominal prices. The sale of companies in these sectors to foreign investors raises fears of foreign domination and control. 81. In spite of this controversy, Kazakhstan has made substantial progress in the reform of these sectors and is ahead of most other countries in the region in privatizing a large portion of the power sector and telecommunications. There is a risk, however, that the pace of reform is slowing down. In earlier years, because of the economic crisis facing the country, the government may have been more willing to adopt bold reform plans. Now that the economy is stabilized, the urgency for reform has been reduced. Power Sector 82. Background. Reform of the power sector in Kazakhstan is ahead of most other countries in the region. The government gave first priority to the privatization of generation and was largely successful. The government is now attempting to privatize transmission and distribution. With the benefit of hindsight, however, the government should have given first priority to the privatization of distribution rather than generation. The major problems of the sector arise in the poorly managed distribution companies -- not in the generation companies. 83. Like other infrastructure sectors, the power sector was structured as part of a larger system serving the entire Former Soviet Union rather than as an integrated system serving Kazakhstan. The total installed generating capacity is about 17,800 MW, but because of poor maintenance, the actual functioning capacity is reported to be only 13,000 MW and possibly much less. The primary fuel for 24 generation is coal, accounting for about three-fourths of capacity. The balance is mostly hydroelectric with a small amount of gas and oil fired capacity. About 30 percent of capacity is found in plants that produce both power and heat for district heating. 84. Privatization of Generation Plants. Beginning in 1996, the government privatized or placed under management contract about 37 plants accounting for 82 percent of the generation capacity in the country. Many of the investors were Western companies including AES, Samsung, Japan Chrome, Ispat, and Independent Power Company. Some of these were established electric power companies that wanted to expand into Kazakhstan. Others were manufacturing or mining companies already located in the country that wanted to assure themselves a reliable source of power. 85. To outsiders, it is somewhat of a mystery as to how the government was able to privatize such a large part of its generation assets in 1996. Kazakhstan would seem to be high risk from an investor's point of view. In particular, there was not an independent regulatory system that could assure investors that they would be able to charge prices adequate to give them a reasonable return on their investment. Instead the politicians and regulatory authorities kept prices low, and a large percentage of customers including government ministries simply did not pay even these low prices (non payment was as high as 70 percent in some regions). 86. Because the details of the actual privatization transactions are confidential, it is difficult to ascertain why investors were willing to accept these risks, but there are a number of possible explanations. Some investors bought generation assets primarily to supply their own industrial or mining activities. Thus the regulatory regime was of little importance to their decision. Other investors paid low prices for existing generation assets thus reducing their risk, but did commit to make large future investments. The investors have some time to evaluate the legal, political, and regulatory environment before making these investments. If the environment turned out to be worse than expected and risks higher, they could delay making investments or not make them at all arguing that circumstances had changed. 87. Some investors had contracts with the government in which the government either agreed to purchase their power or guaranteed them the right to charge certain prices for the sale of the power. In effect, these contracts became a substitute for regulation. These contracts, however, may not have provided investors with as much protection as they had expected. In at least one case, the purchaser of a generation company negotiated an agreement with the government in which the former state-owned transmission company agreed to buy the power produced by the generation company. The transmission company, however, was unable to fulfill the terms of the agreement because it was not collecting adequate revenue from the distribution companies. In another case, the owner of the Almaty distribution company has argued that the government has not met its contractual commitment to allow the company to charge prices high enough to cover the full cost of supplying power. 88. Privatization of Transmission and Distribution. In 1997, the government also tried to privatize both the national transmission company and the 18 regional distribution companies but with little success. The government negotiated with two international companies, National Grid (UK) and ABB (Swedish/Swiss) to buy the national transmission grid, but the negotiations were not successful. According to the State Property Committee, only two of the regional distribution companies were sold to private investors. 89. The mission was unable to determine exactly why the government was unable to sell more of the transmission and distribution companies. Some observers suggest that this was due to the burdensome 25 terms and conditions that the government attempted to impose on investors. Investors may have been required to pay all existing debts (for example, large wage arrears and accounts payable), make substantial investments, and make an up front cash payment. Furthermore, investors must have been concerned about the lack of an established regulatory system. 90. This failure to privatize the distribution companies resulted in power shortages even though the generation companies were willing to supply power if they were paid for the power. This is because the poorly managed distribution companies did not collect from their own customers and thus could not pay for power purchased from the private generation companies. 91. The Almaty Power Company. The privatization of the Almaty regional company is a special case but still illustrates the importance of privatizing distribution. In this case, a subsidiary of the Belgian Tractebel group owns generation plants, the local power distribution system, and the local district heating system. This company is different from the other distribution companies because it is largely self sufficient in terms of power generation and does not need to buy power from the generation companies. 92. Tractebel has been largely successful in solving the non-payment problem in the Almaty region for both power and district heating. It is now collecting 95 percent of revenue due for the sale of power and 85 percent for heat. Previously, collections were less than 30 percent of revenue owed to the company. Tractebel solved the non-payment problem for power by terminating service to customers that do not pay. This included some of the largest and most important institutions in the country such as government ministries and military establishments. Solving the non-payment problem for district heating, however, is more difficult because it is often impossible to physically terminate service to individual residences, for example, apartments in large buildings. Also, because of the extreme winter temperatures, not supplying space heating would threaten safety and health. Tractebel has solved this problem by linking the payment for heat to the payment for electricity. Since Tractebel owns both the electricity and the heat distribution systems, it can send a single bill for both services and terminate electricity service if the bill for both is not paid. 93. Lessons Learned. There are two lessons to be learned from the experience with privatizing the power sector in Kazakhstan. The first lesson is that privatizing the distribution systems should be done first. The mismanagement of the distribution systems (most importantly, failure to collect for power sold) is causing most of the other problems of the system. Without a reliable source of revenue, the distribution companies cannot pay the generation companies, and the generation companies cannot pay for fuel and essential maintenance. As a result, the country experiences shortages of electricity. This does not mean that the government should privatize both generation and distribution to the same investor as was done in Almaty. Privatizing a vertically integrated monopoly in which a single company owns both generation and distribution limits competition. 94. The second lesson is that it is desirable to sell the local district heating company and the local power distribution company to the same investor. Only a combined company is likely to enforce payment for heat. Such a combined company can bill customers for power and heat jointly and better assure that customers pay for both or else suffer termination of electricity service. 95. Future Reform. After the failure to privatize the distribution companies and the transmission company, the government created a new state-owned company in July 1997, called the Kazakhstan Electricity Grid Operating Company (KEGOC). This new company was given ownership of the transmission grid and dispatch management. Furthermore, the government in September 1997 gave the new company the right to manage 11 of the 18 regional distribution companies. It also manages one of 26 the newest and largest power stations in the country. The government appointed a respected businessman to be president of the company and introduce commercial business practices. The company claims to have improved the management of the transmission grid and the distribution companies under its control, for example, reducing the level of non-payment. 96. KEGOC is attempting to raise $100 million on the international debt markets to finance needed maintenance and upgrading of the transmission and distribution networks. Unfortunately, the financial turmoil in Asia may make it difficult to raise funds. This would increase the need to privatize the distribution companies as soon as possible. 97. In addition, the government gave KEGOC responsibility for the overall restructuring of the power sector (Resolution No. 1193, 31 July 1997). KEGOC has an ambitious plan for the creation of a competitive power sector that includes the following elements: * local distribution companies would only distribute power to final consumers and would not generate or buy and sell power; * consumers would buy their power from competing wholesale suppliers; * the wholesale suppliers would buy their power from the various independent generation companies; * the wholesale market would be organized by an independent market operator (initially KEGOC); and D the wholesale market would utilize sophisticated options and forward contracts. 98. The mission is concerned about KEGOC's plan to introduce a sophisticated wholesale market for power. Experience in other countries of the region (for example, Russia and the Ukraine) demonstrates that the major obstacle to such markets is the high level of non-payment. These kinds of markets simply cannot operate unless the participants pay for the power purchased. 99. The experience of the Almaty power company suggests that the non-payment problem will not be solved until the distribution companies are privatized. A sophisticated wholesale market for power may be possible only when its participants are privately owned companies that honor their obligations to pay for power. KEGOC should examine carefully why the privatization of the distribution companies was not successful in 1997 and recommend different terms and conditions that are likely to attract private investors. 100. It may be desirable to start with a simpler form of the wholesale market that can be implemented now and will provide incentives to reduce non-payment. The privatized generation companies have already created a simple wholesale market based on bilateral contracts with purchasers. The advantage of bilateral contracts is that they help to enforce payment discipline. If a purchaser such as a distribution company does not honor the contract (for example, failing to pay for the power), the seller has no obligation to continue to supply that purchaser. 101. The one drawback of a system based on bilateral contracts is that generation plants may not be dispatched in the most efficient way. In other words, the system may fail to achieve "economic" or "merit order" dispatch in which the plants with the lowest variable cost are operated first. Economic dispatch can be achieved, however, if the generation companies organize a trading system or "pool" among themselves. They will have an incentive to do this since it will lower their cost of producing power. Such a power pool can be organized entirely by the generating companies and does not require the detailed involvement of the regulatory authorities. When the power sector has been restructured and privatized and the non-payment problem solved, then it would be desirable to consider more sophisticated forms of a wholesale market. 27 102. Finally, the government has taken a risk in giving responsibility for the restructuring and privatization of the power sector to the largest organization in the sector, namely, KEGOC. Experience in other countries shows that it is difficult for a state-owned monopoly to effectively restructure the industry. Restructunng involves breaking up the monopoly, privatizing it, and reducing its size, power, and influence. Managers of such organizations often oppose any reduction in their power and responsibility. It is hoped that KEGOC is the exception to this pattern of behavior seen in other countries and will be an effective leader for the continued restructuring and privatization of the sector. 103. Cross Subsidies. An important issue that the power companies and the regulatory agencies will have to confront is the elimination of cross subsidies in pricing for power. In Kazakhstan and elsewhere in the region, the practice has been to charge prices to industrial customers above the cost of supply and to charge prices to household customers below the cost of supply. With the introduction of competition, these cross subsidies are no longer tenable. Competing power companies will offer to sell power to the industrial customers now paying high prices and thus force down these prices. Local distribution companies will then have no choice but to raise prices to household customers to a level that covers the cost of supplying them. Figure 3: Prices for power in various countries (1997). Czech Republic Finland France* G erm any* Hungary =| Household K azakhstan-* rJ I n d u s try Kore a PoIand R ussia- ** United Kingdom United States l I llI 0 .0 0 0.05 0.1 0.1 0.20 0.25 US Dollars1kWh Source: Kazakhstan, Price Waterhouse Russia, RAO UES Other countries, International Energy Agency, 1st qtr. *1995 prices *"average of 14 104. To see the magnitude of the required changes in prices, compare power prices in Kazakhstan with other countries (Figure 3). In Western countries, prices charged to household customers are typically twice as high as charged to industrial customers. This is because the cost of supplying household customers is much higher than the cost of supplying industrial customers. In Kazakhstan and other countries of the region, however, prices are much more equal, or industrial prices are even higher than household prices. 28 Telecommunications Sector 105. In the telecommunications sector, the government has made substantial progress with privatization. The trend around the world is to privatize state-owned telephone companies and open up the sector to competition. Kazakhstan has taken the first step but not the second. 106. Privatization. Last year, the government sold a 40 percent stake in the national telephone company, Kazakhtelecom, to Daewoo Corporation. Daewoo guaranteed that Kazakhtelecom would invest US$1 billion in modernization and expansion of the telephone network by the year 2000. In exchange, the government granted certain monopoly rights to Kazakhtelecom that will be discussed in more detail below. 107. Critics have raised questions about this privatization transaction. Daewoo is a telecommunications equipment manufacturer rather than an operator of telephone companies. Critics argue that the company should have been sold to a buyer with more operating experience. Daewoo's response is that that they will employ the best experts and consultants to help manage the company. Others suggest that there may be a conflict of interest between Daewoo's role as a major owner of Kazakhtelecom and role as a potential supplier of telephone equipment. Daewoo's response is that Kazakhtelecom will conduct fair and open competitive tenders for the procurement of any equipment and all qualified suppliers will be treated equally. 108. Following the Asian crisis, Daewoo has decided to pull out of the telecom deal. Since this occurred after the Joint Assessment mission, this report does not have specific information about this latest transaction. It appears that Daewoo has sold their sales to Kazkommertz, although what happens to Daewoo's obligations is unclear. Nonetheless, this presents an opportunity for the government to review its earlier decision to grant a very long term license and possibly to invite another strategic investor which would not have the conflict of interest situation posed by Daewoo and which would have the capability to finance additional investments. 109. Cross Subsidies. The prices for telecommunications services charged by Kazakhtelecom are distorted and will have to be rebalanced in the face of competition. In particular, prices for services used by households are below the cost of supply while prices for services used by businesses are above the cost of supply. 110. To illustrate this distortion in pricing, the price of telephone services charged by Kazakhtelecom is compared with those charged by British Telecom in the United Kingdom (see Table 8). The United Kingdom is a good comparison because the sector there is competitive. Because of competition, British Telecom has been forced to rebalance its prices so that all prices cover costs and that no service is overpriced or underpriced. If a service is overpriced, competitors (such as Mercury Telecommunications) will offer a lower price in an attempt to attract new customers. 111. Pricing in Kazakhstan favors residential customers. Kazakhtelecom charges a much lower installation fee for residential service compared to business while British Telecom charges the same fee. Similarly the monthly subscriber fee for residential customers is very low in Kazakhstan compared to business customers. 29 Table 8: Telephone prices excluding VAT as of January 1, 1998. (tenge). .___ Kazakhtelecom British Telecom Residential Business Residential Business Installation 8,333 40,000 12,375 12,375 Subscriber fee per month 150 739 944 1,493 Local per minute 0.25 0.25 4.20 4.20 Long distance per minute up to 100 kms (daytime) 3.00 10.00 8.41 8.41 International per minute (daytime) Kazakhstan to UK 158 158 UK to Kazakhstan 85 85 UK to US I _ 25 25 Source: Mission calculations based on data from Kazakhtelecom and British Telecom 112. Businesses in Kazakhstan are more likely to use long distance and international services compared to households. Prices for these services are high compared to British Telecom. For example, the price charged by Kazakhtelecom for a call from Kazakhstan to the UK is almost twice as high as the price charged by British Telecom for a call from the UK to Kazakhstan. Furthermore, as telecommunications markets become more competitive, the prices for international service are likely to be reduced further. The market between the UK and the US is perhaps the most competitive since the telecommunications industry in both countries is largely deregulated and privatized. The distance between the UK and the US is roughly the same as between the UK and Kazakhstan. Yet the prices for international calls between these the UK and the US are less than 20 percent of the prices now charged by Kazakhtelecom for calls between the UK and Kazakhstan. Naturally, Kazakhtelecom is concerned about competition because it might force down the price of international phone calls to a fraction of what it is now charging. 113. Lack of Competition. Pursuant to an agreement between the government and the Daewoo Corporation, Kazakhtelecom has been granted a license that gives it certain exclusive rights to provide long distance and international telecommunications services over the next 15 years. The license also seems to enhance the Kazakhtelecom monopoly in two other ways. First, the license gives Kazakhtelecom the right to refuse to interconnect other networks that offer long distance or international service and attempt to "bypass" the public telephone network. Second, Kazakhtelecom has the right of first refusal to obtain any rights to use the electromagnetic spectrum that the government may decide to make available. Thus Kazakhtelecom has potential control over competing telecommunications technologies that use the spectrum. 114. Though the language of the license is not entirely clear, it would seem that competing telecommunications companies could offer long distance and international service only to customers that were directly connected to their networks. Such companies, however, could not originate or terminate long distance and international calls on the Kazakhtelecom network. Thus a customer connected only to the Kazakhtelecom network would have no choice but to use Kazakhtelecom for long distance and international service. 30 115. It is not surprising that Kazakhtelecom does not want to share the profitable long distance and international service with competitors. The government may have agreed to grant a monopoly for these services because it increased the sales value of the company and reduces pressure on the government to increase prices for services used by residential customers. Granting such a monopoly for long distance and international service, however, has a number of disadvantages from the point of view of the entire country. First, it reduces the competitiveness of Kazakhstani businesses that rely on long distance and international service. Second, it reduces pressure on Kazakhtelecom to improve the quality of its long distance and international services because it has a captive market. Third, it keeps prices for services used by residential customers artificially low and encourages them to use too much of these services. For example, the low per minute charges for local service do not encourage customers to reduce the length of their phone calls. 116. Other countries have recognized the need to rebalance prices before the sector is opened fully for competition. Sometimes the existing telephone company is granted a limited monopoly for a few years (for example, five or six) before it faces full competition. However, this paper is unaware of a situation where a 15-year monopoly has been granted. 117. In addition to the granting of a legal monopoly to Kazakhtelecom, some of the existing competitors complain that the government does not provide a level playing field even in those areas where competition is permitted. Competitors said that the Ministry of Telecommunications tends to favor Kazakhtelecom in its regulation of the sector. One example of this perceived bias by the Ministry is in the granting of licenses for cellular telephone service. Currently, the only cellular service in Kazakhstan is provided by a joint venture of Kazakhtelecom and a foreign company. The Ministry is proposing to grant licenses for two new cellular telephone services using the GSM technology. Competitors are concerned that Kazakhtelecom can use its right of first refusal for the spectrum to obtain both of these licenses and thus continue its monopoly on cellular service as well as conventional telephone service. 118. Conclusion. The Ministry of Telecommunications should do the most it can to encourage competition in the sector. If Kazakhtelecom continues to have a monopoly on various telephone services for the next 15 years, there is a substantial risk that the development of the telecommunications sector will lag behind most other countries. With the pulling out of Daewoo, the government should review the terms of the license. Regulation of Natural Monopolies 119. Current Regulatory Arrangements. Natural monopolies have been regulated by the Anti- monopoly Committee which also deals with mergers, monopoly, and competition issues. The Committee is now located within the Ministry for Strategic Planning. Members of the Committee admit that the prices they set for natural monopolies are often influenced by political forces and by senior officials in the government. The Committee is responsible for the regulation of the power sector, telecommunications, gas pipelines, oil pipelines, railroads, air-navigation, water supply, and sewer systems. There are nine committee members supported by a staff of only 55 people to carry out its many responsibilities. By comparison, the three regulatory agencies in Great Britain responsible for regulating the power sector, telecommunications, and natural gas have a total staff of about 400. 120. Privatization of these natural monopoly sectors requires that a professional and independent regulatory commission be in place. If not, investors will be concerned that the regulatory authorities will not allow them to recover the money they invest in the company or to earn a reasonable rate of profit on 31 that investment. This lowers the value of the state's assets in these sectors and thus the proceeds from privatization. 121. Characteristics of An Effective Regulatory Commission. A regulatory commission should have four major characteristics: * Independence The commissioners should be appointed in such a way that they are as independent as possible from political influence and control. For example, they should be able to make decisions about prices based on objective criteria rather than what is political popular. To assure independence, the President should appoint commissioners for a fixed term, and they can not be removed from their positions except in the case of illegal behavior or incompetence. The budget of the commission should be derived from fees charged to the companies being regulated. * Transparency. The decision making process used by the commission should be open to public scrutiny. All evidence and data used by the commission to make a decision should be available to the public, the public should have a right to present evidence and arguments to the commission, and all decisions of the commission should be in writing explaining the reasons for the decision. * Objective Standards. The agency should set prices based on objective standards and follow accepted international regulatory methodologies. The prices should allow the regulated company to recover its costs of providing service including a reasonable after-tax profit on the capital invested in the company. The prices should also encourage the company to reduce costs and increase operating efficiency and give appropriate price signals to consumers about the cost of supplying the service. * High Quality Staff To assure that the staff of the agency is of high quality, the trend in other countries is to exempt the staff of the agency from the normal government rules on salaries, promotions, and recruitment. The regulatory agency must often compete for its staff with the private companies that it is regulating. Unless the agency can offer competitive salaries, it will be at a disadvantage in the regulatory process. 122. A widely accepted way for a regulatory commission to exercise its control over regulated companies is through a system of licenses. In the case of the power sector, for example, the commission would issue separate licenses for generation, transmission, dispatch, distribution, and supply. Each license spells out the allowed activities, duties, and responsibilities of the license holder. One company may hold more than one license if it engages in more than one of these activities. 123. In designing a regulatory system, one issue is whether to have a single commission regulate all natural monopoly industries or to have multiple commissions each regulating one industry. Arguments can be made for either approach, and there does not seem to be a widespread consensus among international experts that one approach is significantly better than another. 124. Single Regulatory Commission. Arguments for a single regulatory commission regulating all natural monopoly industries include: * Saving resources and lowering the costs of regulation. Skilled professionals (economists, financial experts, lawyers, etc.) can be shared between sectors and can be shifted from one sector to another as needed. 32 * Facilitate learning between sectors. Many regulatory issues are substantially the same across natural monopoly industries, and experience and learning from one industry can be transferred to another. * Reduce the risk of "capture" and political interference. A risk with any regulatory agency is that it might be unduly influenced by one of the industries it is supposed to regulate. This is known as regulatory "capture." Another risk is that the agency may come under the influence of politicians and government officials from other ministries and thus lose its independence. Both risks may be reduced if the commission is large and important. It is probably less likely that a single industry might be able to capture a commission that is responsible for many industries. * Phased development of regulation. Since the pace of reform is likely to vary from one natural monopoly industry to another, a regulatory commission responsible for all such industries can develop its capacity to deal with each industry in phases as the that industry is reformed and regulation is required. 125. Multiple Regulatory Commissions. There are, however, a number of arguments in favor of multiple regulatory commissions including: * Greater industry expertise. The commission members and its staff can focus on a single industry and better understand the unique features of that industry. Because the final decisions are made by the commission members, it is unrealistic to expect that each member can be an expert in many different industries. * Faster reform. It may be necessary to develop a regulatory strategy for all natural monopoly industries prior to the establishment of a single commission responsible for their regulation. This could mean that the pace of reform of each industry will be slowed to the pace of the slowest industry. In other words, it may not be possible to proceed with reform in one sector ahead of the others. The govemment officials responsible for the power sector, for example, may not want to have the development of a regulatory agency for that sector tied to the creation of a regulatory agency for the water sector. 126. Conclusion. Given the complex technical issues involved in the different natural monopoly industries, the govemment should review and consider the establishment of independent regulatory agencies for each industry. The experience of countries that have adopted the single or multiple regulatory agency should be examined to determine under what conditions one type is more successful than the other. Partial Risk Guarantees for Infrastructure Projects 127. Partial Risk Guarantees enable transition countries to attract private financing for high priority infrastructure investments rather than rely on financing from public resources. This is achieved by providing lenders to a particular infrastructure project with a guarantee against non-payment of debt service as a consequence of Govermment actions or certain events of political force majeure ("political risk"). Partial Risk Guarantees are especially relevant for large-scale infrastructure projects that require long-term financing. They are also relevant in the context of transition countries that have not yet built a track record of successful private sector projects. The lack of track record and the perception of high political risks often prevent lenders from risking their funds without some type of guarantee. 33 128. The World Bank provides such guarantees to enable transition countries with high infrastructure investment requirements to attract private financing for infrastructure projects. Figure 4 illustrates how partial risk guarantees are structured: Figure 4: Structure of World Bank G(uarantees |GOVERNMENT| I sEN I | ~~~~~~INVESTORS l |WORLD BANK _ l ,I LENDERS 129. The risks that are covered by these guarantees include inconvertibility and inability to transfer currency, war and civil disturbance, and government performance risks. Government performance risks are generally based on contractual commitments made by the Government to a private consortium in the context of an infrastructure project. For example, the Government awards a concession to a consortium to build and maintain an oil pipeline, and enters into a contractual agreement with the concessionaire defining the length of the concession, say 25 years, and the tax and tariff structure for usage of the pipeline, based, for example, on the quantity of oil transported. A Partial Risk Guarantee would cover the lenders in case the Government imposed higher tariffs or taxes once the pipeline was operating, or arbitrarily ended the concession before the end of the 25 years, thereby preventing the concessionaire to recover its costs and pay back the lenders. 130. Partial Risk Guarantees unbundle political risks from commercial risks. The Government takes responsibility for political risks, which it can control and mitigate. Indeed, a World Bank guarantee is always counter-guaranteed by the Government through an Indemnity Agreement (see Figure 4 above). If a covered risk occurs and affects the consortium's debt repayment capacity, either the Government pays damages to the investor or the lenders for his/their loss, or the guarantee kicks in. If the guarantee is called, and World Bank funds are used to compensate the lenders, the Government has the obligation to indemnify the World Bank upon demand or as the Bank may otherwise direct. (See Box 3 in Chapter 4 for a more detailed description of the Political Risk Guarantee Facility of the World Bank). 34 CHAPTER FOUR FINANCIAL SECTOR DEVELOPMENT Framework 131. The financial system of Kazakhstan is at an early stage of development. Based on the framework for financial sector development shown in Figure 5, Kazakhstan has over the past few years made significant strides in establishing financial policies, building the legal framework for finance, and developing important segments of the financial infrastructure such as accounting systems and banking supervision capacity. Financial sector reform over the past few years has focused on the banking system, whose restructuring began in 1994 with the assistance of the Bank and the Fund. Current reform efforts are focused on the securities market with the blue chip program and the development of the stock exchange and related institutions. With pension reform, pension funds are expected to play a major role in financial markets. However, other nonbank financial institutions such as insurance and leasing are still undeveloped, and should be in the agenda of the next generation of financial reforms. Banking System 132. During the last years of the Soviet Union, the financial system was composed of Gosbank and five specialized state banks.4. In 1988, Gosbank began licensing new commercial banks. At the time of independence, Kazakhstan had a financial system composed of the National Bank of Kazakhstan (formerly a branch of the Gosbank), five specialized banks, and 72 commercial banks. Except for the Savings Bank, the specialized banks were converted into joint stock companies and allowed to operate in all sectors of the economy. A rapid expansion of the banking system followed as enterprises began establishing their own banks to finance their operations. By end-1994, there were 184 banks of which 176 were private, including two privatized specialized banks.5 The Government continued to control the other three specialized banks and established five additional state banks: the Housing Construction Bank, the Rehabilitation Bank, the Budget Bank, the Exim Bank, and the Development Bank. At end-1995, these state banks accounted for 35 percent of total commercial banking assets. 4The Savings Bank (Sberbank), the Bank for Foreign Trade (Vneshekonombank), the Agricultural Bank (Agroprombank), the Industry and Construction Bank (Promstroibank), and the Social Investment Bank (Zhilsotsbank). 5 The Industry Bank become Turan Bank and the Industry and Construction Bank became Kredsoz Bank. 35 A Framework for Financial Sector Development Build other Establish Build Legal %financial Develop market Upgrde olicies franmework sector / Develop segments and Uklla poice _ _ sect_or_ _ Infrastructure lnfrastrucue Itttin exhgs / hemes.- Figure 5 133. At end-1995, total assets of the banking system before loan loss provisioning were reported at about US$ 4.0 billion and total capital was about US$ 400 million. In 1994, international auditors estimated that about 50-55 percent of all commercial loans were either doubtful or loss. Using this assumption for loan provisioning, adjusted capital of the banking system at end-1995 would have been negative US$850 million. The Government's banking reform had to resolve these problem loans and recapitalize or liquidate bankrupt banks. 134. Reform Strategy. Given the state of the banking system in 1994, the authorities adopted a reform strategy that had two major components: (a) creating an environment that would reduce the operating risk faced by the banks; and (b) dealing with the problem loans and insolvent banks. The authorities implemented a number of legal and regulatory reforms to establish the appropriate framework for prudent banking and to bring banking practices to international standards. In addition, the authorities dealt directly with the stock of nonperforming loans and the problem banks. Major portions of nonperforming loans were carved out to special institutions -- the Rehabilitation Bank, EximBank, and the Agricultural Support Fund. Nonviable banks were closed, a number of state owned banks were privatized, and state owned banks that were considered too big to fail were restructured with the intent of privatizing them at a later date. 135. Beginning in 1995, the National Bank began a systematic process of liquidating nonviable banks. Although the accounting and disclosure standards were deficient, the National Bank went ahead and identified nonviable banks and began liquidation proceedings. Initially, the National Bank had difficulties due to the lack of a clear legal framework and uncertain property rights, but responded to these uncertainties by securing a Presidential Decree in 1995 which gave the National Bank effective tools to deal with problem banks. The National Bank created special liquidation units in the banking supervision department to oversee the liquidation of nonviable banks. However, a recent court ruling placed the liquidation process with the judicial system. 36 136. In 1995, the National Bank withdrew the licenses of 42 banks and a total of 56 banks exited (see Table 9). In 1996 and 1997, 55 more banks exited, reducing the number to 82 at end-1997 (and 76 at end-January 1998). The largest bank closure was that of Kramds Bank, which in 1996 was the fourth largest bank. In early 1996, Kramds Bank faced a liquidity crisis. The National Bank provided lender- of-last-resort financing and required the bank to undertake restructuring measures. However, in October 1996, the National Bank refused to provide further liquidity support, and the bank's license was withdrawn, effectively closing the bank. Table 9: Bank entry and exit, 1995-97 1995 1996 1997 Number of Banks at the Beginning of the Year 184 130 101 New Banks Licensed During the Year 2 1 6 Bank Exits During the Year Due To: Withdrawal of License by National Bank 42 27 1 7 Merger 1 3 2 Other 13 0 6 Total Exits 56 30 25 Number of Banks at the End of the Year 130 101 82 Source: National Bank of Kazakhstan 137. Legal and Institutional Reform. To support banking reform, the authorities strengthened the legal foundation for lending. In 1995, Parliament passed Part One of the Civil Code that clarified property rights. Part II is still being drafted. The President also issued in 1995 decrees on bankruptcy and mortgages. The Decree on Bankruptcy introduced norms for enterprise reorganization, out-of-court settlement procedures, and creditor rights. 138. The poor quality of accounting and financial disclosure limited the ability of the National Bank to monitor the conditions of the banking system. Furthermore, the lack of a standardized reporting format limited its ability to monitor banking system developments. To address these problems, the Ministry of Finance and the National Bank developed in 1995 a new chart of accounts for enterprises and for commercial banks. New accounting instructions and manuals were drafted to assist in the training of accountants in modern practices. In 1997, all commercial banks ran both the new and the old chart of accounts in parallel and will shift to the new accounts by 1998. A Presidential Decree established the Accounting Commission in 1996, charged with the development and implementation of accounting standards in line with Internationally Accepted Accounting Practices (IAAP). To date, some 20 new accounting standards have been approved and implemented, making the Kazakhstani system closer to international standards. 139. The authorities have also begun to set up registries on borrowers, their real property, their pledges of property, and their borrowings. The government improved company registration, the World Bank supported a Land Registration Project, and in the interim existing registry bureaus began to handle registration of non-movable collateral. Fees on registration and notarization were also lowered. 37 140. Prudential Regulations and Banking Supervision. The National Bank began putting in place in 1995 an internationally consistent system of prudential norms and regulations. Supported by Presidential Decrees on the National Bank and on Banking, it established prudential regulations on capital, liquidity, lending limits, insider transactions, and reserve Tequirements. In 1996, it modified some of the prudential regulations (such as the differentiation between tier 1 and tier 2 capital) to bring them fully in line with international practices. 141. Because banks could not comply with the new prudential regulations immediately, the National Bank announced a timetable for phasing in the enforcement of the regulations over a period of five years (except for loan loss provisioning which was immediately put into effect). Moreover, the National Bank required restructuring plans from banks in exchange for a period of regulatory forbearance. Banks that could not submit a restructuring plan acceptable to the National Bank were liquidated. In mid-1996, the National Bank announced a program of incentives aimed at shortening the transition period to international standards by banks from five to three years. Banks on the fast track are permitted to participate in the following activities: (a) own stock in investment companies; (b) participate in National Bank credit auctions; (c) conduct international operations; (d) issue bonds, certificates of deposit, and checks; and (e) act as custodian in the corporate securities market. 142. To improve enforcement of regulations, the National Bank increased the number of staff in its Banking Supervision Department and mobilized technical assistance to the extent of some six man-years per year. The Supervision Department was reorganized into teams in charge of clusters of banks, and oblast-level staff were moved to headquarters. Off-site inspections were enhanced with the introduction of a standardized reporting form. On-site inspections were intensified. 143. As the reliability of information improves with better accounting systems and the practice of external audits becomes commonplace, onsite supervision should go beyond determination of financial condition and performance and evolve towards assessing the ability of banks to identify, measure, and manage risk. This involves the analysis of banks' policies, internal controls, management information, and risk management systems. If the systems are adequate, supervisors would then determine the efficacy of these systems in practice by conducting tests. Recommendations could then be made to address systemic weaknesses. This proactive approach tackles at an early stage the root causes of problems that eventually manifest themselves in the prudential ratios. 144. Privatization. Major privatizations in the banking system either have taken place or are scheduled to take place in 1998. Both TuranAlem Bank and Zhilstroi Bank have been sold to local investors this year. The Savings Bank has begun a program of privatization that it plans to complete in three years. The Exim Bank is also currently offered for privatization, with discussions started with Bank Bumiputra of Malaysia and the IFC. However, due to the current financial crisis in Asia and its impact on Malaysian banks, this transaction has fallen through. 145. The privatization program for the Savings Bank has three stages. In the first stage, about 18 percent of the shares were sold to the bank's depositors, with a limit equal to the investor's deposits. The second stage will involve selling 51 percent of bank ownership, possibly through the stock exchange. In the third stage, in about 2001, the state will sell the remaining shares, although consideration is given to having the state own some residual shares. The privatization of the Savings Bank will most likely result in dispersed ownership, with ambiguous effect on governance due to the lack of a strategic investor. 146. The privatization of TuranAlem, Savings Bank, and Zhiltroi was designed to keep majority ownership of these banks in the hands of Kazakhstani investors. The strategy is to create two or three 38 large local banks that can compete with the foreign banks. Currently, the aggregate capital of foreign banks cannot exceed 25 percent of total banking capital. The intention is to remove this limit after the creation of large Kazkhstani owned banks through the mergers of several locally owned banks. Citibank, Societe General, and ING either have applied or intend to apply for banking licenses. 147. Concentration. The banking system is characterized by both concentrated ownership and concentrated lending. With regard to concentrated ownership, as of end-January 1998, only two banks (one state owned and the other private) accounted for more than 50 percent of assets and deposits. State owned banks accounted for about 40 percent of total banking assets (see Table 10). With the privatization of state owned banks to the major private banks, the concentration of ownership of the banking system will be exacerbated, at least in the short term. Table 10: Share of major banks in assets, loans, deposits, and net worth, January 31, 1998 (percent). Net Name of Bank Assets Loans Deposits Worth Halyk Bank 25.6 22.5 38.6 12.2 Kazkommertz Bank 24.5 21.4 14.2 28.9 TuranAlem Bank 8.1 8.3 12.3 4.9 ABNAmro 5.0 2.1 7.5 5.3 Exim Bank 3.5 5.6 2.7 10.0 Merchant Bank 3.3 2.5 4.9 1.6 Zhilstroi Bank 2.9 2.9 4.6 2.2 CentreCredit Bank 2.6 3.5 3.0 2.4 Agroprom Bank 2.2 2.8 2.9 4.0 Other Banks 22.3 28.4 9.3 28.5 Source: Mission calculations based on National Bank of Kazakhstan data 148. With regard to concentration of lending, the share of the largest 20 borrowers in the loan portfolios of five major banks ranged from 43 percent to 74 percent (see Table 11). These five banks account for about 70 percent of total loans in the banking system. While the mission was not able to get information on the exposure of the whole banking system to these largest borrowers, it may be the case that the whole banking system may be suffering from concentration of lending to same group of borrowers. Table 11: Percent share of largest borrowers in loan portfolios of five banks as of December 31, 1997. Halyk Kazkommertz TuranAlem CentreCredit Exim -Top 10 Borrowers 49.6 35.0 31.6 35.7 53.1 Top 20 Borrowers 62.6 49.0 43.4 50.5 74.4 Source: National Bank of Kazakhstan 149. Financial Condition of Banks. Two indicators suggest that the health of the banking system is improving. First, there has been an improvement in the performance of banks in meeting prudential standards (see Table 12). At end-1995, only half the banks met all the prudential standards. This improved to 66 percent at end-1996 and 71 percent at end-1997. By end-1998, 30 banks are expected to 39 meet the minimum capital requirement of Tenge one billion as well as all the international prudential standards. Another 30 banks are expected to meet these standards (including the Tenge one billion capital) by end-1999 Table 12: Percent of banks meeting prudential standards. Prudential Standard Dec 1995 Dec 1996 June 1997 All Standards 50.0 65.3 70.8 Tier 1 Capital Adequacy na 81.2 83.3 Capital Adequacy (Tier 1 and 2) 95.4 96.0 84.3 Single Borrower Limit 82.3 89.1 84.4 Lending to Related Parties 91.5 95.0 96.8 Liquidity 91.5 94.0 88.5 Source: National Bank of Kazakhstan 150. Second, there has been progress in reducing nonperforming loans and in loan loss provisioning (see Table 13). From 55 percent at end-1994, the share of nonperforming loans has gone down to less than 30 percent at end-1997. Loans classified as unsatisfactory, doubtful, or loss accounted for 13 percent of total loans at end-1997. Table 14 gives the consolidated balance sheet of the banking system during the period 1995-97. Table 13: Loan classification as of December 31, 1997 (percent) Provisions As % of _______________Principal Interest Principalplus Interest Standard 72.4 51.9 v Substandard 15.3 18.0 6.7 Unsatisfactory 4.3 15.5 20.4 High Risk 1.8 2.6 43.6 Loss 6.2 12.0 95.9 Total Loans 100.0 100.0 8.9 Source: National Bank of Kazakhstan 40 Table 14: Consolidated balance sheet at year end 1995 1996 1997 Tenge Tenge Tenge million % million % million % ASSETS Reserve Assets 14,772 7.7 27,522 14.4 32,087 19.0 Foreign Assets 28,197 14.7 20,067 10.5 20,889 12.4 Claims on Government 5,104 2.7 8,664 4.5 25,615 15.1 Claims on Households 11,361 5.9 13,008 6.8 4,401 2.6 Claims on Enterprises 60,627 31.7 51,034 26.7 72,861 43.1 Other 71,282 37.3 70,979 37.1 13,238 7.8 TOTAL 191,343 100.0 191,274 100.0 169,092 100.0 LIABILITIES Foreign Short Term Loan 10,939 5.7 3,135 1.6 11,540 6.8 Foreign Medium/Long Term Loan 15,546 8.1 1,273 0.7 3,929 2.3 Government and National Bank 11,299 5.9 26,234 13.7 28,066 16.6 Deposits Bank Deposits 5,265 2.8 6,006 3.1 3,551 2.1 Enterprise Deposits 48,739 25.5 50,605 26.5 57,291 33.9 Household Deposits 13,234 6.9 19,364 10.1 27,165 16.1 Other Deposits 1,958 1.0 1,123 0.6 0 0 Bonds 1,902 1.0 94 0.1 29 0 Other Liabilities 53,202 27.8 45,682 23.9 6,436 3.8 Net Worth 29,259 15.3 37,759 19.7 31,086 18.4 TOTAL 191,343 100.0 191,274 100.0 169,092 100.0 Source: Mission calculations from National Bank of Kazakhstan data. 151. Completing the Reform Program. The attainment of international standards by banks, expected by end-1999, would complete the banking reform begun in 1995. However, the following additional reforms would improve efficiency and improve financial intermediation. 152. First, entry restrictions on foreign banks should be relaxed. Specifically, the National Bank should eliminate the requirement that the combined capital of all foreign banks should not exceed 25 percent of total banking capital. Removing this restriction would encourage more competition in the banking system. 153. Second, the state owned commercial banks should be sold to reputable strategic investors. In the short run, this strategy may aggravate the structural problem in the banking system if state owned banks are bought by private domestic banks. However, removing restrictions on foreign bank entry as recommended above would introduce greater competition thereby addressing the concentration problem. With respect to the method of privatization of the Savings Bank, the focus should be on attracting a strategic investor which can exert governance. Due to the dominant share of Savings Bank in the household deposit market, potential strategic investors should be limited to reputable and well capitalized banks. An investment banker should be hired to develop and implement a privatization strategy for the Savings Bank. 41 154. Third, the National Bank should review the concentration of lending to a few enterprises or sectors. The risks posed by certain enterprises or sectors should be examined and adequate steps undertaken to reduce the exposure of the banking system. In East Asia, for example, some regulators put limits on or discouraged additional exposure to the real estate or construction sector when the banking system was becoming heavily exposed to this sector. 155. Fourth, the government could establish partial risk guarantee schemes to unbundle political and credit risks. This would allow the financial system to focus on evaluation of commercial risk. Box 3 gives a description of political risk guarantee facilities provided by the World Bank. Development of Securities Markets 156. The development of an equity market in Kazakhstan has two main target markets: (a) foreign portfolio investors; and (b) pension funds. To attract these investors, the equity market would need the highest levels of transparency and investor protection. The current strategy does not allow for direct access to the stock market by individuals. With the target markets in mind, the authorities have developed a "blue chip" program where a limited number of top rated companies would list their shares on the Kazakhstani Stock Exchange. Concurrently, a pension reform program is underway. 157. Market Infrastructure. In 1997, the Government took major steps to create the infrastructure required to bring the issuers and investors together. With the exception of a new company law, the overall framework is now in place. Laws "On Securities Market", "On Registration of Transactions with Securities of the Republic of Kazakhstan", and "On Investment Funds in the Republic of Kazakhstan" were passed in March 1997. These provide a satisfactory legal framework for securities transactions, stock markets, investment banks, registries, custodian services, and investment companies. One concern, however, is the absence of an effective system for the protection of the rights and interests of investors, specifically portfolio and small non-professional investors. Such safeguards are expected to be incorporated in a new company law, which would address corporate governance and the rights and responsibilities of shareholders and issuers. 158. The physical infrastructure for securities trading is close to meeting international (G-30) requirements. The Kazakhstani Stock Exchange recently merged with the National Bank's Almaty Financial Instrument Exchange (used for Treasury Bills) and is expected to be the dominant exchange. The members of the exchange, composed of banks and private companies, are in the process of adopting a charter based on the "one member, one vote" principle. The USAID-sponsored Central Asian Stock Exchange still exists, but its future is uncertain. 159. The clearance and settlements system became fully operational in June 1997 and is compatible with Group of 30 recommendations, including T+3 settlement, same day funds, and delivery versus payment. Established in May 1997, the depository is a members-owned organization with self-regulatory status. The central depository settles securities transactions, provides custody services for nominee holders, and administers securities held in its care. Securities are dematerialized, and ownership is recorded with the registrar. Settlement information is electronically transmitted from the stock exchange and is controlled by the central depository. The National Bank accepts cash payments through the central depository accounts. 42 Box 3: Political Risk Guarantee Facilities The World Bank has developed a new product, the Political Risk Guarantee Facility (PGF), whose purpose is to re- activate existing production facilities in transition economies. PGFs provide access to foreign capital, in particular for projects involving existing local enterprises. PGFs make available guarantees against political risks to private enterprises doing business in countries where real and/or perceived political risks are high, and therefore limit foreign capital flows and access to credit. Indeed, foreign input suppliers and their banks may be willing to do business with local enterprises if certain political risks could be eliminated. The PGF allows the host country to benefit from increased economic activity without having to provide full government guarantees to attract foreign capital. In addition, PGFs can play a key role during a country's transition period while domestic markets are still developing. In the early stages of implementation, the projects supported by PGFs provide essential support to local banks by allowing them to finance cross-border transactions. Furthermore, a PGF can help the host country build its reputation with private sector risk-takers by establishing a track record of sound commercial business transactions without government interference. Finally, the results achieved by a PGF are sustainable as the commercial links between foreign and commercial companies enabled by a guarantee facility can last far beyond the life of the project itself. The following figure illustrates how a PGF is structured: __~~~~~~~~~~~~~~~~i Authority to Authority to withdraw ~ ~ ~~~Aremet issue guarantees credit funds ' l e r t and operate escrow account Letter o;\/ Credit \/ Guarantee facilities unbundle commercial risks from political risks. The Government is responsible for political risks, which it can control and mitigate, while the private sector can focus on the commercial aspects of the transaction without worrying about government interference or other political risks. Typically, a PGF would cover the following risks: (a) inconvertibility and inability to transfer currency; (b) expropriation; (c) war and civil disturbance; and (d) government interference/performance risks (such as a retroactive increase in importlexport tariffs or arbitrary withdrawal of a license) The PGF is a flexible mechanism that can support a wide array of transactions (see below). PGFs can be cross- sectoral, or sector-specific (i.e. transactions in agriculture and agro-processing, the mining sector, etc.). Most importantly, PGFs can be tailored to a country's specific environment and needs, in terms of the risks that are covered, and the types of transactions that are eligible for cover. Examples of eligible transactions include: (a) sale of goods, usually on credit terms; (b) financial lease; (c) operational lease; (d) import of capital equipment for use by the guarantee holder in carrying on its business; (d) import of goods to stock for sale; (e) import of goods for processing and export; (f) loans and prepayments by foreign lenders to local enterprises; and (f) obligations of confrming banks in respect of documentary credits issued by local private banks. 43 160. As of end-1997, there were 60 custodian banks and 34 registrars that kept 3,289 rolls of shareholders. Under the law, joint stock companies with 500 or more shareholders are to move their register to an independent registrar, while companies with less than 500 shareholders can use an internal registry if they employ a licensed registry manager, of which some 400 have been licensed. In March 1997, the government adopted a new regulation for licensing custodians. 161. As of end- 1997, the Securities Commission had granted broker-dealer licenses to 60 companies, including 31 banks. Minimum equity requirements have been US$ 200,000 since June 1997. There are over 2,000 persons who have passed a qualification test and are licensed by the Securities Commission to work as broker-dealers. The Securities Commission is now also demanding that broker-dealers cannot enter into other types of business activities. There are several applications from foreign brokers to establish subsidiaries in Kazakhstan and buy seats at the stock exchange. 162. The Securities Commission is an executive regulatory body that reports directly to the President. The Securities Commission consists of a chairman, three commissioners, and three representatives from the National Bank, Ministry of Finance, and Ministry of Justice. The Securities Commission shares the registration of emissions with the Ministry of Justice, which is in charge of the registration of small and medium size companies. 163. The Blue Chip Program. In the "Blue Chip" Program, the Government plans to list and then sell on the Kazakhstani Stock Exchange minority equity stakes in the leading Kazakh companies. A controlling stake of each of these companies will first be sold by open tender to a strategic investor that will also be responsible for the management of that company. All "blue chip" companies will undertake an audit of their financial statements, and investment banks will be chosen by tender to manage the listing process. The long list of 56 "blue chip" companies are mainly in the oil and gas, metal and mining, infrastructure, and financial sectors. In November 1997, the exchange named five companies for listing: (a) 5-20 percent of Zhezkazgantsvetmet copper plant of which Samsung already owns 40 percent; (b) 5-7 percent of Mangistaumunaigas of which Medco, an Indonesian company, owns 40 percent; (c) 5-15 percent in Aktobemunaigas, of which the Chinese National Petroleum Company owns 60 percent; (d) 2- 4.5 percent of Kazakhtelekon, of which Kazkommertz owns 40 percent; and (e) 16.5 percent of Ust- Kamenogorsk titanium and magnesium plant. 164. Foreign Portfolio Investors. Foreign portfolio investors have begun purchasing much of the "blue chip" equity available in the market. In the second of half of 1997, four investment funds have been established, targeting Central Asia in general and Kazakhstan in particular. These funds have raised close to US$ 500 million and are managed by AIG, Global, Peregrine, and Regent Pacific. 165. Pension Reform. On January 1, 1998, Kazakhstan launched an ambitious Chilean-style reform of the pension system. Under the 1997 legislation, pension funds will collect mandatory and voluntary contributions that will be invested by professional asset managers. The public has a choice of three types of pension funds -- the state pension fund, corporate funds (for employees of a corporation), and open funds (catering to several companies). As of end-January 1998, the Securities Commission had licensed six non-state pension funds. Investments are limited to government securities, bank deposits, and financial institutions' bonds. Currently, funds are required to keep at least 50 percent of assets in government securities, but in due course, funds will be allowed to invest in the equity and bonds of domestic "blue chip" companies. 44 166. Privatization Funds. During the mass privatization process, 67 percent of the population invested their coupons in 170 privatization investment funds, acquiring shares in more than 1,700 enterprises. Until recently, the absence of legally defined proxy voting rights meant that privatization funds were unable to convene a general shareholders meeting, preventing registration as joint stock companies. In August 1997, the law was changed to allow proxy voting rights, but only three funds have held general shareholders meetings. Furthermore, companies privatized through the mass privatization process were generally unattractive and few, if any, paid dividends. There is widespread distrust of privatization funds. Even if they convert into investment companies as envisioned under the Law "On Investment Funds", it is expected that the majority of shareholders would cash out at the earliest opportunity by selling their shares in the funds. 167. Insurance Sector. As of end-1997, there were 64 insurance companies with a total of US$ 55 million in capital. The estimated total of insurance premiums in 1997 was about US$ 50 million, of which some 70 percent was accounted for by casualty insurance and carrier liability. Given the small size of the sector and the short-term nature of their activities, it is unlikely that insurance companies will be substantial players in the near term. 168. Recommendations. There are several major reforms still needed to develop a securities capital market. First, a new company law should be passed as quickly as possible to provide minority protection to minority investors and provide a basis for the issuance of corporate bonds. Second, accounting reform should continue towards international standards and use of IAS audits for widely held companies should be required. Third, the blue chip program should proceed as planned to provide an adequate supply of companies in the stock exchange. Fourth, the insurance sector should be developed by putting in place a regulatory framework and supervision capacity. Fifth, investment funds in general and the pension funds in particular should be subject to proper regulation and supervision. 45 Annex 1 Area of Reform Action/Next Steps Business Environment Complete some gaps in the legal framework for commerce and lending * pass a revised Company Law * pass a stronger Collateral Law * pass a new Leasing Law * review laws and their implementing rules to identify inconsistencies and major conceptual and implementation problems Simplify regulatory regime to reduce transaction costs * review licensing and other regulatory requirements to eliminate unnecessary procedures and to reduce processing time and frequency of reporting Improve public administration in general and tax administration in * implement recommendations in the Bank's Public Resource particular Management Adjustment Loan covering streamlining and upgrading of civil service and tax administration * extend the public administration reforms to the local governments Upgrade legal profession * implement recommendations in the Bank's Legal Reform Project including training of judges and improved legal information Establish special agency to hear complaints from private sector * establish an Office of Ombudsman regarding treatment by government officials Promote Foreign Direct Investment * standardize system of incentives to minimize subjectivity and reduce processing time * eliminate the subsidies over time * refocus activities of Investment Committee towards assisting foreign investors who have complaints about red tape and harassment * streamline visa processing for foreign investors and skilled workers Encourage development of Small and Medium Enterprises * simplify regulations and tax administration * pass Leasing Law and stronger Collateral Law * eliminate restrictions on lending margins on bank loans 46 Annex 1 Area of Reform Action/Next Steps Privatization, Restructuring, and Governance Privatize large state enterprises * sell these to strategic investors using price as main criterion in a competitive bidding process * review one company town issues Develop post-privatization support mechanisms to enable privatized * Improve skills in marketing, exports, and finance enterprises to restructure successfully * Improve business environment especially in the areas of regulation and taxation 47 Annex I Area of Reform Action/Next Steps Infrastructure Restructure and privatize the power sector * privatize the distribution companies * develop a simple wholesale market for power * rebalance the rate structure to minimize cross subsidies * develop an regulatory framework with an independent regulator Introduce competition in the telecommunications sector * ensure entry of more participants in the sector, such as in the cellular services segment * rebalance the rate structure to minimize cross subsidies Strengthen regulator of natural monopolies * ensure that the regulator is professional and independent, with a transparent decision making process and supported by high quality staff * consider the establishment of multiple regulatory agencies for natural monopolies 48 Annex 1 Area of Reform Action/Next Steps Financial Sector Development Complete reforms of the banking system * privatize remaining state owned banks to reputable financial institutions utilizing investment bankers to develop and implement privatization strategies * analyze the exposure of the banking system to certain companies and sectors and develop a plan for dealing with lending concentration issues * relax the restrictions on foreign bank entry by eliminating the 25% maximum share of foreign bank capital to total capital * upgrade banking supervision capacity to assess risk using techniques and software available in the Bank Develop equity markets * pass the revised Company Law * upgrade the Securities Commission through an institutional development program * implement the blue chip program by accelerating the IAS audits of the blue chip companies and the appointment of reputable investment banks to manage the listing process * review regulations and supervision of investment funds and pension funds Develop the insurance sector * make an assessment of the insurance sector with particular attention to supervision and regulation, covering among others licensing, financial strength monitoring, and investment rules 49