Report No. 30852-KZ Republic of Kazakhstan Country Economic Memorandum Getting Competitive, Staying Competitive: The Challenge of Managing Kazakhstans Oil Boom June 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank Produced under the Joint Economic Research Program of the World Bank and the Ministry of Economy and Budget Planning Republic of Kazakhstan: Getting Competitive. Staying Competitive: The Challenge of Managing Kazakhstan's Oil Boom EXECUTIVE SUMMARY ........................................................................................................... 1) Economic Policy ......................................................................................................... ...i 111 2) Human Capital ............................................................................................................ iv 3) Infrastructure................................................................................................................. v 4) Public Sector Institutions............................................................................................ vi 5) vu1 ... Innovation and R&D................................................................................................... Sectoral Policies........................................................................................................ 6) i x 1 I CONTEXT:ATASTEOFtHEFUTURE . Summary o f Diagnostics and Recommendations ................................................................. .......................................................................... 1 A. Transforming Kazakhstanwithin aDecade...................................................................... 1 n 11 .B . 2004: The Two Faces o fKaza~sta................................................................................ 2 CATCHING UP WITHHIGH-MIDDLE INCOME ECONOMIES ............................ 5 A. The Challenge's Perspective............................................................................................. 5 B. The Key Ingredientso f Competitiveness inKazakhstan.................................................. 7 1. The Framework............................................................................................................. 7 2. A SimpleBenchmarking Exercise................................................................................ 9 a. Economic Management ............................................................................................ 9 b. Labor Productivity .................................................................................................. 13 c. Infrastructure ........................................................................................................... 13 d. Institutions............................................................................................................... 15 . . e. Summary ................................................................................................................. 17 11I. THESTRATEGICPOLICYAGENDA ........................................................................ 19 A. Policy Context................................................................................................................. 19 1. Current Policy Stance ................................................................................................. 19 2. Additional Considerations .......................................................................................... 22 B. The Economic Management Agenda for Competitiveness ............................................ 28 1. The Oil Windfall: Benefits and Risks......................................................................... 28 2. Policy Choices ............................................................................................................ 31 a. Fiscal Policy............................................................................................................ 31 b. Exchange Rate Policy ............................................................................................. 37 c. Supervision and Regulatory Policy and Policies towards Capital Inflows.............38 C. The Structural Reform Agenda for Competitiveness...................................................... 40 1. Infrastructure: the Case o f Telecommunication Reform ............................................ 40 a. Market Liberalization.............................................................................................. 41 b. Tariff Rebalancing.................................................................................................. 42 c. Interconnection ....................................................................................................... 42 d. Roles and Responsibilities o fDifferent Players ..................................................... 44 2.e Sector Policies: The Case o f Local Content for the Oil and Gas Sector..................... . PromotingUniversal Access inRuralAreas .......................................................... 45 48 Background: Partnering with Multinationals.......................................................... 48 b. a. Obstacles to Domestic Supply into the Oil and Gas Sector.................................... 49 c. A Three-Pronged Strategy to Foster Competitivenesso f Suppliers ....................... 51 Annex Table 1:Kazakhstank Key Economic Indicators. 1999-2004 .................................... 59 Annex Table 2: Kazakhstan: GDP Growth. 1999-2005 ......................................................... 60 Annex Table 3: Kazakhstan: Structure o f GDP. 2003 ............................................................ 60 Annex Table 4: Kazakhstan: Value Added inRegions, 1996-2003 ....................................... 61 Annex Table 5: Kazakhstan: Real Exchange Rate, 2000-2004 .............................................. 61 Annex Table 6: Kazakhstan: Savings and InvestmentRates, 1999-2004 .............................. 62 (% OfGDP) ............................................................................................................................. 62 Annex Table 7: Kazakhstan: Exports o f Key Commodities, 1999-2004............................... Annex Table 8: Kazakhstan: Consolidated Govemment Fiscal Accounts, 1999-2007..........63 64 Annex Table 9: Kazakhstan: Commercial bank loans by sector, 1998-2004 ......................... 65 Annex Table 10: Selected indicators for Kazakhstan and Comparator Countries, 1990-2003 ..................................................................................................... 66 Annex 2: List o f Background Papers and Activities............................................................... 68 Annex 3: References ............................................................................................................... 70 List of Text Tables, Figures, Boxes, and Diagrams Table 1: Performance inVenezuela and Kazakhstan during Selected Oil Boom Periods Table 2: Kazakhstan: Composition o f Investment inFixedAssets, 1999-2004 Table 3: Volatility o f Exchange Rates and Prices, January 1997 to September 2004 Table 4: Kazakhstan:Use of Oil Inflows and Overall Spending Priorities, 2000-2007 Table 5: Kazakhstan: end-2002 Net Wealth under Alternative Assumptions Table 6: Kazakhstan: Key Economic Indicators, 2000-2007 Figure 1: Kazakhstan: Two transitions, 1990-2004 Figure2: Kazakhstan: Gross ForeignDirect Investments, 1993 - 2003 Figure 3: Kazakhstan: Real GDP Growth, 1997-2005 Figure4: Kazakhstan: Oil Revenue Saved and Spent, and Total Spending Levels, 1999-2005 Figure 5: Kazakhstan: Real Exchange Rate Index, 2000-2004 Figure6:Kazakhstan: Saving and Investment Ratios, 1997-2003 Figure 7: Kazakhstan: Structure o f GDP, 2003 Figure 8: Kazakhstan: Exports o f Selected Goods, 1997-2004 Figure 9: GNIper capita innew EUand Common Economic Space Countries, 2003 Figure 10: Kazakhstan: Convergence with EU8, 1990-2024 Figure 11: Fuel Exports in Selected Oil Countries, 1970-2002 Figure 12: Kazakhstan: Total Savings Ratio, 1995-2003 Figure 13: Kazakhstan: Total InvestmentRatio, 1992-2003 Figure 14: Kazakhstan: Non-oil Investment Ratio, 1999-2003 Figure 15: Kazakhstan: Government Spending, 1993-2003 Figure 16: Kazakhstan: ManufacturingLabor Productivity per Worker, 1992-2003 Figure 17: Kazakhstan: Agriculture Labor Productivityper Worker, 1992-2005 Figure 18: Kazakhstan: Infant Mortality Rate, 1990-2002 Figure 19: Kazakhstan: Public Spending inHealth and Education, 1995-2001 Figure 20: Kazakhstan: Selected Benchmarks o f Transport and Telecommunications Infrastructure Figure21: Kazakhstan: Selected Benchmarks for the Institutional Framework, 2002 Figure22: Growth Experience in Selected Oil Rich Countries Figure23: Kazakhstan: State Budget Spending inMajor Categories, 1999 - 2007 Figure 24: Kazakhstan: Potential Oil Production, 1999 - 2035 Figure 25: A Simulation o f the New Saving Rule Box 1: What Kindo f State Support for Agriculture? Box 2: Strengthening the Contribution of Education to Kazakhstan's Economic Transformation Box 3: Approaches to Industrial Policy Box 4: Strategic Directions for Telecommunication Reform Diagram 1: A Framework to Study Competitiveness inKazakhstan Diagram 2: Key Players inthe Oil & Gas Value Chain inKazakhstan Diagram 3: Pyramid o f Supporting Industries Diagram 4: The UpstreamValue Chain-Where Local Companies Can Most Effectively Integrate? Diagram 5: Strategic Direction to Transform Local Content System ACKNOWLEDGEMENTS The World Bank and the Government o fKazakhstan have had extensive discussions on the issue of competitiveness over the past two years. Inthe process, ten independentPolicy Notes were produced focusing on issues that the government and other stakeholders consider most relevant (Annex 2). This report synthesizes those discussions and the Policy Notes. Inaddition, the Bank provided written comments on various official programs, and organized workshops and training sessions on topics o f strategic importance and o f special interest to government counterparts. The discussions included a brainstorming session with highlevel government officials and a panel o f international experts on rules for the management o f oil revenues. These activities are part o f the ongoing Joint Economic Research Program being conducted by the World Bank and the Ministry o f Economy and BudgetPlanning. It i s the result o f substantial collaboration among numerous govemment officials. Inparticular, we would like to thank Messrs./Mmes.: Erbol Orynbayev of the Administration o fthe President; Kairat Kelimbetov, Kairat Aitekenov, Bakhyt Sultanov, Shamil Dauranov, Zhasser Jarkinbayev, and MaulenUtegulov o f the Ministryo fEconomy and BudgetPlanning; Arman Dunaev, Gani Uzbekov, RuslanDalenov, andArystan Kabikenov o f the Ministry o fFinance; Nurlan Kusainov, Kuanysh Bishimbayev, and Madina Abylkasymova o f the Center for Marketing and Analytical Research under the MEBP;Aset Issekeshev and Zhanar Aitjanova o f the Ministry o f Industryand Trade; Evgeny Dominov o f the National Innovation Fund; Anvar Saidenov, Gulbanu Aimanbetova, Askar Elemesov, Aigul Buranbaeyva, and Daniyar Akishev o f the National Bank o f Kazakhstan; Bolat Zhamishev and Yelena Bakhmutova o f the Financial Supervision Agency; and Yuri Shokomanov, DametkenKairova, and Emma Tlepbergenova o f the National Statistical Agency o f Kazakhstan. This report was prepared by a team consisting o f Bank staff and consultants. The team was ledby Pedro L.Rodriguez and composed o f Sweder Van Wijnbergen, Madi Umbetaliev, Ilyas Sarsenov, and 'Laura Lucas. Backgroundnotes were producedby Nina Budina (PRMEP); Gregory Jedrzejczak, and Alfred Jay Watkins (ECSPF); Thomas Glaessner and Joaquin Gutierrez (OPD); GarethLocksley and Howard P. Williams (CITPO); Thilakaratna Ranaweera (DECDG); Sweder Van Wijnbergen (University o f Amsterdam); Ricardo Hausmann (Harvard University);Roberto Rigobon (Massachusetts Institute o f Technology); Gary Gereffi (Duke University); and Artur Radzwill and Paul Domjan (Consultants). This report benefited from a background note on the Transport Sector prepared by Henry Kerali, Motoo Konishi, and Loup Brefort. Training on oil and gas value chain analysis was provided by Gary Gereffi and Sheikh Jahan (DukeUniversity), and training on economic modeling i s beingplanned as a follow up activity. The peer reviewers were Peter Thomson (ECSIE), Michael Lewin (DECDG), and Ibrahim Ahmed Elbadawi (DECDG). Additional comments and guidance were provided by Samuel Otoo (ECSPE), Loup Brefort (ECCKZ), Maurizio Guadagni (ECSSD), and Michael Mertaugh (ECSHD). The team appreciated the various discussions and exchanges with Aasim M.Husain, Peter Keller, Tony Lybek, and Peter Lohmus (IMF). The team would like to thank Ainoura Alzhanova and Aida Mukhanova for their administrative assistance, and Linda Tatem for editing the final report. EXECUTIVESUMMARY Kazakhstan has made substantial progress in its economic transition andfaces a potentially brightfuture thanks to its oil wealth. The challenge is to increase the country's competitivenessand expand the benefits of growth, while avoiding the economic and social risks typically associated with oil wealth. i. Duringthepastdecadeoftransition,Kazakhstanhasmadecommendableprogressin stabilizing its economy and carrying out structural reforms. The country i s blessed with significant oil reserves that are now inthe process o f beingtapped through three large oil field development projects. Oil production inKazakhstan could triple to 3 million barrels per day within a decade and a half. The associated flows to the budget have been estimated to be as large as seven billion dollars a year two decades from now. .. 11. Against this backdrop, a vigorous debate i s taking place inKazakhstan over the strategic use o f its growing oil revenues and the challenge o f ensuring sustainable and broad-based economic growth. Many of the questions raisedby the oil windfall debate are not easy to answer: (a) how to increase the competitiveness of the non-oil sectors and diversify the economy; (b) how to transfer some of the forthcoming oil revenue to the population given that the oil sector only employs a handful o fpeople; (c) how to adopt world standards that would guarantee a presence inthe global economy; and, more generally (d) how to avoid the so called "oil curse"? iii. Thelastquestionisthemostcomplexinmanywaysbecauseitisheavilyinfluencedby political economy considerations. Oil has changed the policy environment inKazakhstan, and will do so more infuture. Oil has inparticular reduced cash constraints. But there are risks: volatility issues, quality o f spending, inflexibility inuncertain environment, and boomhust cycles that tend to plague oil-rich countries. Oil revenue relaxes the usual constraints on government expansion and, thus, oil rich economies runthe risk o f getting "too much government." Ingeneral, there will be a lot a pressure on governments to allocate oil funds to domestic investment. While clearly some increase in domestic investment i sjustifiable, inmany oil economies it tends to be excessive and strains domestic capacity so that the quality o f public investment falls drastically, i.e. both the ability to spend efficiently (for results) and effectively (least-cost). Another typical issue that oil economies face i s that it tends to exaggerate the role of government. While there will still be enough scope for government interventions inthe provision of basic public goods (health, education, infrastructure, and institutions), the temptation for the government to meddle with market driven allocation o f resources proves often difficult to resist. As a result, managingoil windfalls has not been easy for developed(UK, Holland and even Norway) and developing (Venezuela, Saudi Arabia, Mexico, and Nigeria) countries alike. iv. A key problem for oil rich countries i s the so called DutchDisease. Essentially as oil revenue increases, the associated fiscal, monetary, and credit expansions can `overheat' the economy, possibly leading to excessive currency appreciation (beyond the equilibrium exchange rate). Overheating exerts negative pressure on tradable sectors such as agriculture and manufacturing, whose output declines inrelative terms. It also creates bottlenecks for skilled labor, infrastructure, utilities (water, electricity, telephones), housing, and real estate. Often (e.g., Mexico and Holland), the fiscal expansion creates inflexible spending programs (social or infrastructure related), and almost always the quality o f public spending deteriorates (e.g., 11 Venezuela, Saudi Arabia, and Nigeria). Beyond these basic symptoms o f Dutch Disease, international experience suggests that windfalls also lessen the imperative to address corruption and other general business environment problems, which serves to further weaken investment and performance inthe non-oil economy. v. The GOK i s aware o f the pitfalls o f natural resources windfalls and looks to international experience for key lessons to guide its strategy and policy choices. Delegationsvisiting South Korea, Singapore, Norway, the European Union, the US, Ireland, Dubai, and other countries have enriched the debate as have returningKazakhstan national graduates trained overseas. The overarching theme of the report is how to exploit the strengths of the Kazakhstan economy in the new oil environment, while avoiding thepitfalls that oil income typically brings. vi. This report, which is the product of extensive consultations betweenthe GOK and the World Bank, does not try to provide unique answers to the questions raised above. Rather, it presents a framework that can be used by Kazakhstan's policy-makers and stakeholders to establish priorities and trade-offs among the various options, and draws on international experience to illustrate key points. vii. The report provides benchmarks for key aspects of competitiveness inKazakhstan vis a vis Ukraine, Russia, and the eight most recent members o fthe EUrather than with other rich countries. This i s done for two reasons. First, Kazakhstan's leadership has set as one o f its strategic objectives to catch up with the EUover the long runinterms o f living and production standards, and levels o fproductivity and income. The country wants also to compete for investments and markets with Ukraine, Belarus, and Russia. Second, because although oil and gas already represents a large proportion o f exports, this does not mean that the direct impact o f oil inKazakhstan i s as large as in, say, Saudi Arabia or Venezuela (see Background Paper No. 10). Infact, highproduction cost inthe oil and gas sectors, and a relatively diversified economy (although to a large extend this diversification i s towards other extractive industries), suggest Kazakhstan should follow the examples of Norway and Malaysia where non-oil sectors continue to develop, and their non-oil exports volumes to grow and increase in sophistication, even after oil took-off. Our analysis still draws upon lessons from oil rich economies, viii. Using oil revenues effectively. A key benefit o f oil wealth i s that it relieves fiscal and foreign exchange constraints. Whether it i s used effectively to diversify the economy and increase competitiveness innon-oil sectors will significantly depend on appropriately answering the following fundamental questions: a. H o w much should be saved or spent out o f oil revenues, bearing inmindthe macroeconomic consequences that such spending could bring about (Le. overheating, and Dutch Disease)? b. What are the long-term priorities for spending oil and non-oil revenues? c. What role should be ascribed to the government to increase competitiveness inthe non-oil sectors? And how much of that role i s to be played out through direct government spending 111 and how much through general policies and creation o fthe right enabling environment, i.e. removal o f obstacles? ix. Six areas for action. The policy agenda will, o f course, have to go beyond these fundamental questions and formulate detailed policies and public investments. Inthis regard, interventions in six broad areas must be developed and prioritized (see Background Paper No. 4)-in most cases bybuilding on and better focusing the already designed Public Programs (e.g., Rural Development, Food Security, Railway Development, Telecommunications Reform, Industrial Innovation, Housing, Health, Education, and e-Government). The six areas are discussed below. 1) Economic Policy x. Policies and oil have increased savings levels, but the drivers o f investment have been the oil and government sectors, while the investment ratio inthe non-oil tradable sectors has been falling since 2001. Highsavings levels must be maintained as they are essential for growth and productivity, but the policy mix (Le. combination o f fiscal, financial, trade, and monetary policies) must also care about stimulating private investments intradable sectors and increasing size and sophistication o fnon-extractive exports. This will require: (1) controlling aggregate demand (Le. rapid expansion inpublic spending or credit, which are the indirect result of the boom in oil and other commodity prices); and (2)maintaining the real exchange rate at around its long-run equilibrium trajectory. Only this way the country can avoid excessive volatility in prices and exchange rates and, thus, maintain the desired pace o fnon-oil industrialization. Instrumentsto smooth out the impact o f the oil cycles inthe economy include: 0 Anchoring fiscal policies on an improvedformula to regulate the amount o f oil revenues saved inthe NFRK and spent through the budget, and a budget rule under which the non-oil deficit (total or primary) i s financed exclusively by the transfer from the NFRK (i.e. no borrowing in net terms other than perhaps to cover interest payments). These measures must be complemented by: ( 1 ) a Debt Issuance Strategy that monitors the net savings o f the consolidated public sector, while determining gross borrowing and disbursements from domestic and external sources, and the actions that the state budget and other public institutions (e.g., SOEs, DBK, and the NBK) will be taking to facilitate the further deepening o f the financial sector; and (2) a limit, to be established through the budget formulation and approval process, on the Aggregate Investments and Borrowing levels that quasi-fiscal development institutions and SOEs could undertake (see BackgroundPapers No. 3,6, and 10). 0 Focusing financial sector policies on: (1) slowing down thepace ofcredit expansion (through reserve requirements on foreign borrowing, andpossibly measures to signal the need of prudent cross-border lending and commercial bank's offshore operations or, if necessary, by more direct means); and on (2)further strengthening the institutional set up within and across agencies (Le. MEBP, MOF, FSA, and NBK)that will needto serve as the "eyes" and "ears" o f the policy makers regarding structural and business cycle- related risks inthe financial sector. Emphasis will have to be given inparticular to supporting efforts o f the Financial Supervision Agency (FSA) to strengthen key functions iv including: comprehensive consolidated supervision, prompt corrective action and resolution (including the role of the deposit insurance fund), and onsite examinatiodoff- site analysis inthe case of both banking and non-banking services (see Background Paper No. 8). 0 Further developing instrumentsfor monetary policy. Monetary markets are shallow, and the NBK does not have instrumentsto affect interest rates inthe market posing an important agenda for the NBK.A t the same time, the NBK needs to formulate a clearer plan for intervention inmoney and foreign exchange markets (part o f which i s to be made explicit to the markets). 0 Resistingprotectionistpressures as well as the lobby for sector-specific subsidies or tax exemptions. Inthis regard, Kazakhstani s well placed to use the process o f WTO accession to drive an important domestic agenda that includes: (1) "locking-in" a much more transparent and simplified tariff regime than the one currently inplace; (2) modernizing the legal and institutional framework for standards; and (3) introducing important sectoral reforms in areas such as telecommunications, railways, and other services that are key for the competitiveness o f a land-locked and far from markets country. 2) HumanCapital xi. Kazakhstan's labor productivity has been stagnant inmanufacturing for the last three years (relative to the EU8 countries, Ukraine, and Russia); and in agriculture, which generates the livelihood for a significant part of the population, the picture is worse as productivity has been falling for over a decade. Trends inkey determinants o f labor productivity (e.g., health, education investments) are not encouraging, and the extent to which the current housing policy will facilitate labor mobility is unclear. Human capital investments enhance everyone's opportunity and, inthat respect, they are not only essential for productivity reasons but also needed to mitigate the potential worsening of income distribution that oil inflows may create. Successful competitive countries are those that investedheavily and well inhuman capital -not just narrow elite but broad-based. The emphasis here should be on quality rather than quantity of spending. For instance, there i s no reason to increase budget allocations for higher education or for hospitals before the ministries formulate a detail plan on how the higher education institutions (as well as hospitals) are to be reformed and in some cases downsized or restructured. Similarly, there are significant efficiency gains inthe procurement o f certain supplies (e.g., drugs) ifthe systems are systematically addressed. xii. Kazakhstan's educationprograms will need far more flexibility than they currently have and life-long learning opportunities will need to be developed rapidly in order to prevent skill shortages from emerging as a serious constraint to Kazakhstan's anticipated growth. The system-private and public-to provide basic health care needs to be significantly enhanced, while its affordability i s preserved for the poor. At the same time water and sewerage facilities are indire need o f rehabilitation and need urgent attention as indicated by the cases of hepatitis last summer. V 3) Infrastructure xiii. Kazakhstan's telecommunications system is both primitive in terms of choice and quality, and expensive relative to EU8 countries, Ukraine, and Russia; and, the road and air transport infrastructures are underutilized. Policies inthese sectors needto focus mainly on enlarging the market size and promoting new entry (domestic and foreign) and competition. These are the only sustainable ways to reduce the economic and money cost o f usingthe infrastructure. Unfortunately, the current policy stance underminesentry byprivate investors (domestic and locals) and constrains market growth: 0 For air transportation,the opening o f the Astana Airport and the possibility o f reconstructing the Atyrau facilities offer a unique opportunity for strategic decisions regarding the size of the air transportation market. Inparticular, adopting an open sky policy for cargo and passengers, coupled with strong competition among the country's airports for landings, i s likely to be the best path to enhance the countries transit and cargo potential, and lead to a truly globalization o f all the companies (air carriers, airport management, and ancillary service industries) inthe sector. 0 Inroad transportation, growingbudgetsfor O&M andconstruction also provide a uniqueopportunity to modemize the roadmaintenance systems by developing: (1) improved road management systems and introduction o f modem standards comprising a comprehensive asset inventory, annual condition surveys, traffic characteristics, unit costs o f maintenance, and other pertinent data; (2) efficient institutional, administrative and management arrangements for rural roads to ensure that towns, villages and local communities have all year access to markets for their inputs or products; and (3) better standards among local contractors through the introduction o fperformance based contracts and the delivery of targeted training and monitoring schemes and better capacity to supervise and hold them to account. The speech o f the President on the 2004 results highlighted a number o f important deficiencies inthe quality and cost o f road construction coming from the current process. The speech should be followed by the formulation o f a specific Action Plan to address those issues, and the World Bank could contribute to the preparation o f such plan ifdeemed appropriate.* 0 For telecommunications, the `infant industry' policy that i s currently followed mustbe abandoned. Currently KazakhTelecom (KT) i s protected from experiencing real competition and resources are transferred from the rest o f the economy to the company via highly distorted relative prices (Le. prices are too low for local calls and prohibited for international calls) inthe hope that these privileges will be usedby management to modemize and prepare well to compete inan open market. Although K T has private shareholders, highly distorted prices and monopoly rents will neither lead to the appropriate investment decisions nor position this enterprise for a more competitive environment. A three-pronged strategy i s advised: (1) a unifiedregulator must be created to focus exclusively on fostering competition (such regulator should not oversee shares o f the state inthe sector nor manage public administration reform programs such as the e- 'See the Thesis o f Speech M a d e by the President o f the Republic o f Kazakhstan at the extended Government session on Results of the Year 2004 (Astana, February 1, 2005). vi government program); (2) tariffs must be quickly rebalanced, and real competition for intemational and local calls must be introduced; and (3) the creation o f expensive public subsidization schemes must be avoided by piloting a system o f smart subsidies for services inrural areas once the sector i s liberalized or by carrying out international rather than national tenders (see BackgroundPapers No 9 and 11). 0 More generally, new ways tofinance infrastructure must be developed, including the possibility o f using selectively partial credit risk guarantees to foster public-private partnerships, or to enhance the financial conditions currently offered by the domestic and foreign financial markets to large infrastructure companies. Infrastructure financing does provide a perfect match for domestic institutional investors (e.g., pension funds), but that market will needto be developed. Investments by the electricity transmission and railways companies, if soundly assessed for their costs and benefits and with appropriate implementation arrangements, are prime candidates to develop new financial instruments. Needless to say, this focus on infrastructure finance will also help the purpose o f further developing financial instruments and capital markets (bonds, IPOs, guarantees, etc.). 4) PublicSector Institutions xiv. Progress made inthe past not withstanding, institutions inKazakhstan are still ill-suited to address the challenges posed by rapid economic expansion and oil wealth, and are well behind those inthe EUS-even ifthey score relatively well vis avis Russia. A selected set o f investments should therefore be launched particularly for those institutions that determine the quality o f public spending, and those institutions responsible for regulating business activities. Progress, o f course, has been made interms of improvingthe institutions for public spending (e.g., a new budget code was passed in early 2004), but the agenda i s still vast. For instance, while the new budget code requires that every investment program prepare a rigorous cost benefit analysis, inpractice neither the government nor non-government institutions have the capacity to do so inaccordance with international standards. Costing, inparticular, i s an area where current government investmentprograms will need greater attention, as well as the design of implementation arrangements. The Ministryo f Economy and Budget Planning should also be reorganizedto accommodate this new phase o fpublic spending. xv. Inadditionto the further solidification o fthe FSAas a single andindependent regulatory agency and the planned modernization o f custom administration, initself a must to facilitate trade, the initial focus o f these institutional investments could be: a The Ministry of Economy and Budget Planning and the Ministry of Finance, where highlyprofessional departments must be created inareas, such as: (1)public investment (including the monitoring, with a view o f possible inclusion into the budget, o f those made by SOEs); (2) debt management (including advising the government on the debt issuance strategy to be followed by the treasury as well as the broadly defined public sector); (3) monitoring the efficiency o f development programs (interms o f cost benefit and impact analysis, as opposed to the internal auditing currently carried out by the MOF); and (4) the revamping o fthe procurement and financial management structures under MOF. vii e The modernization of the civil service i s still a vast agenda, including enhancing the transparency of the system by rationalizing grades, the current bonus system, and by introducing an appropriate policy to compensate for regional differences. Inaddition, a proper payroll system i s urgently needed to eliminate the current practice o f appropriating wage allocation even for vacant posts. (see Kazakhstan Public Sector Wage Reform: Policy Note; forthcoming.) This and other structural measures to revamp the civil service, needs to be undertaken before any significant increase inthe remuneration o f civil servants. While some aligning of the public sector and private sector wages i s desirable this is, inand on itself, a challenge. First, overheating and other macro-constrains limit the scope o f adjustment that can be made every year-to avoid an unsustainable growth o f the government's wage bill. Second, issues o f incentives must be decided (e.g., whether the profile of payments over the overall employment term should be back-loaded or frontloaded, and even tied to important consumption items such as housing). Third, the degree o f wage compression must be decided for the short and medium term taking into account, among others, the need to compensate better management and strategic positions to attract the most qualified workers. e The recently adoptedE-Government Program needs to be an instrument for agencies to simplify administrative processes imposed on businesses and households, rather than a vehicle to computerize processes. To do this, the program must avoid becoming a vehicle to finance large investments in data-handlindrelated processes, and rather focus on providingtools to those agencies that are most critical to reducing transaction costs for the private sector (e.g. registration of land, real estate, vehicles, workers or individuals). e Kazakhstan will benefit significantly from joining theExtractive Industries Transparency Initiative (EITI). As Norway's experience shows, avoiding the oil curse requires the creation of institutions to inform and foster participation inthe decision making process by society as a whole. Inthis regard, Kazakhstan will gain a lot by joining EITI. Three obvious commitments can be made immediately: (1) unilaterally commit to disclose the oil revenues received by the treasury from each o f the 5 1legal entities operating inthe oil and gas industry (and any new one that may be established); (2) encourage each legal entity operating inthe sector, beginning with all the companies under the umbrella of Kazmunaigas and inthe operating companies where the government owns shares, to make available to any interested party the amounts o f tax they pay, as well as detail reports of their social and local content initiatives they pursue inthe fulfillment of their Production Sharing or OperatingAgreementswith the state; and (3) revamp the information base available to the general public on the National Fundo f the Republic of Kazakhstan, including publishingthe auditor's opinion and management letter, as well as detailed reporting of the financial results o f the fund. A second set o f steps to be taken over the next 1-3 years include: (1) create consensus among oil operators for the disclosure of the local content and social programs clauses o f the old and new PSAs; (2) require oil operators to subcontract annual evaluations (by civil society institutions) of their social and local content initiative programs; and (3) expanding the commitments made to non-oil extractive industries (e.g., copper, gold, silver, and other mining). These simple and cost-free measures could bring about viii significant positive reputation effects for Kazakhstan (both domestically and abroad), but more importantly would enhance the accountability framework for oil revenues. 0 Courts and Judicial System. The quality o f courts, measured as the percentage o f enterprises that think that court decisions are never or seldom impartial, comes out significantly worse inKazakhstan than inthe EU8, and at a similar level to Ukraine and Russia. The agenda o f strengthening the mechanisms to enforce the rule o f law has been also highlighted inthe February 18,2005 Address o f the President to the Nation. Like in the case o f roads a detail implementationplan to achieve the objectives laid out inthe PresidentialAddress would be needed. 5) Sectoral Policies xvi. Sectoral policies are needed (consisting both o f "carrots" and "sticks") to support the development o f those sectors where Kazakhstan has obvious strengths or potential, such as agriculture, services (including transport-cargo, business services), and oil field services. Inthis latter area, the international experience i s rich on win-win schemes to ensure maximum exposure of the labor force and local companies to the technology and standards o f multinational firms working inKazakhstan (e.g., joint-ventures, suppliers development programs, and centers o f excellence) (see Background Papers No. 2 and 5). Inparticular, Kazakhstanmust overhaul its current "Local Content Rules" which intheory are inplace to promote the development o f a local oil service industry but inpractice they mainly offer opportunities to extract rents and could only end up creating inefficiencies rather than economic de~elopment.~ Thus, a very strong case can be made for abolishing all local content provisions associated with oil operations and insisting instead on: (1) the use o f open and transparent tenders based on the publication o f procurement plans and public opening of biddings; (2) a revamped framework to foster joint ventures in oil service industries (with the supplies provided by these JVs counting as local content); (3) active programs to help local firms upgrade their skills and obtain the most relevant industrycertification for their products; and (4) a complete streamlining o f KMG, the country's main operator to ensure i t focuses on its core businesses while at the same time freeing up resources (such as research centers) that could work for any operator. The cluster initiative launched by the authorities, and administered by the Center o f Marketing and Analytical Research under the Ministry o f Economy and Budget Planning, could become an important instrument to understand the issues o f development faced by different industries. As such, consultations and problem solving mechanisms will eventually need to be institutionalizedmore formally through programs under the umbrella o f the SME department o f the Ministry o f Industryand Trade or the various development institutions. 'Therei s a strong correlationbetweenthe "supply" multiplier effect associated with direct oil expenditures and (i) the distance ofthe oil producer fromdevelopedcountry markets; and (ii) per capitaGDP of the producer. Inthe the UKithas beenreportedthat the multiplier effect associatedwith investment inthe North Sea was as highas 7, i.e. every dollar of direct investment generated 7 dollars o f associatedeconomic activity. InKazakhstan, such multiplier i s probably small (i.e., it was reported that every dollar spent by Tengizchevoil brought about 52 cents in outlaysby relatedindustries, see Chevron Texaco inEurasia www.chevrontexacom.com), suggestingthat the current state of developmentof oil field services is incipient. Ifthis diagnostic i s correct, Kazakhstanwould needto use instruments such as the promotion ofjoint-ventures and new entry over imposing rules on contracting for companiesthat might not yet exist. ix xvii. Other sectoral policies to promote industrialization should b e modeled after modem "business promotion" initiatives that provide assistance with the sole objective of increasing the productivity and competitiveness of domestically based firms. Ifthe k e y issue faced by S M E s are the lack of qualified personnel, then the authorities could for instance develop programs to compensate individual firm initiatives to train their workers (including the cost o f intemships in similar firms abroad) (see Background Paper No. 1).Inthis context, the recently created development institutions could play a significant role in identifying market imperfections and key constraints for new businesses and then developing the instruments to address them. These institutions should not take for granted that the key bottleneck faced by S M E s inKazakhstan is lack o f capital. 6) Innovationand R&D xviii. Kazakhstaninherited a number o f industries (metals, ores, uranium, and oil itself) that are intensive inR&D and new technologies to maintain production levels and increase efficiency. The country also inherited a defense-related scientific base from the former Soviet Union, some of which has been eroded through emigration and aging. There is therefore a need to determine whether the skills and systems of this scientific base could b e still adapted at reasonable cost to serve the needs o f the extractive industries or ifthe required expertise shouldb e sought from external commercial sources. Serious revamping o f higheducation system, at present completely "cut off' from industries and the needs o f the economy at large, is needed. Integration will require quantum leap intransforming scientific circles. xix. Inany case, Kazakhstaninclose partnership with the private sector must develop its scientific capacity in areas where the country has significant economic potential and whose technical challenges must be mastered by its enterprise and scientific communities (oil and gas, metallurgies and minerals). L o n g term research grants could b e provided to scientific teams (composed o f institute, university, and industrial scientists and engineers) to support graduate and post-doctoral studies and research. Such small grants could help attract a new generation of scientists to those fields, improve laboratory facilities, modemize teaching facilities and curricula, attract world class professors from abroad and meet other specified scientific and economic development needs. Small amounts of funding could also b e used to develop a pilot group o f government-sponsored incubators and techno-parks with a cadre o f internationally experienced consultants and mentors. These specialists would provide expert advice on such topics as marketing of R&D, management, business plan development, links to financing, and in- depth understanding of global business and industry trends. These and other small-scale interventions inthe area of competitiveness and innovation could b e carried out by the recently created development institutions, technoparks, incubators, research institutes, and u n i v e r ~ i t i e s . ~ The k e y here is to keep such initiatives modest interms o f financial costs and to target specific issues that promise very high externalities and scope for commercial application. xx. Sequencingthe agenda:the short vs. the long-term.With the exchange rate, real estate, and wages already pressuring the cost structure of enterprises based inKazakhstan, the short-term agenda is extremely important: Ongoing work inthese areas i s being carried out by the Innovation Fundand the World Bank. X 0 Quick payoffs interms of enhancing competitiveness o f all enterprises are most likely to come from an aggressive implementation of the telecommunication and transport agendas. 0 Further payoff may come from restructuring the e-government program to address real bureaucratic bottlenecks faced by enterprises (ideally by simplifying or eliminating excessive procedures rather than by simply computerizing them), and from measures on the modemization o f custom administrationthat can be applied early on. 0 Inthe short-run,the most promising sectoral policy is to overhaulthe local content policies for oil field service enterprises. 0 And o fcourse, the macroeconomic agenda-of which containing the fiscal expansion and improving the quality of fiscal spending are perhaps the most important o f all- could also have significant indirect impact on diversification as the experience o f the 1999-2001period suggests. 0 However, the ultimate determinant o f competitiveness i s always and everywhere the quality o f human capital, and the old soviet systems are now very inadequate for the needs o f the 21" century. Kazakhstan must start improving its human capital today, beginning with carefully-targeted interventions inhealth, education, and water. xxi. The agenda suggested inthis report i s very consistent with the lessons from international experience: a. Permanent gains in competitiveness will only be made if the county better equips its human capital base. Kazakhstanneeds to develop a productive labor force, at all skill levels, which i s more difficult thanjust creating an educated elite. This endeavor will require sustained efforts with an extended period before pay-off i s clearly observed. Investinginpeople is also essential to mitigate the rapid growth inincome inequalities associated with oil booms. b. Competitiveness can be increased in the short and medium term if the economic cost of linking suppliers and consumers movingproducts globally to markets (time and money) is reduced (e.g., telecom, customs, railways, irrigation); and, ifaccess to knowledge and international standards i s improved (e.g., for agriculture). Efficiency gains (i.e. cost reductions) inthese and other sectors will not be achieved just by allocating funds to a sector to "fix" its problem. c. Prudent macroeconomicpolicies are essential. Oil-rich countries have often found it difficult to maintain budget discipline and the quality o fpublic spending. Increased spending levels contribute to the overheating o f the economy, and ultimately create too much real exchange rate volatility. The government will need to better manage the upcoming monetary and fiscal shifts resulting from changing oil prices and production levels; an excessive appreciationo f the exchange rate that will make non-oil exports less competitive in international marks. Prudentmacro policies should, nonetheless, be x i accompanied by pursuit o f an active structuralreform agenda and appropriate sectoral policies to enhance the productivity o fthe non-oil sector. d. Three major risks must be avoided: (1) overheating the economy (Dutch Disease) through fiscal, financial and local content policies; (2) ignoring growing vulnerabilities that are typical of booms (e.g., worsening o f the quality o f fiscal spending, and unsustainable expansion inthe financial sector); and (3) the temptation to use interventionist measures for quick but unsustainable results (e.g., creating state entities and administrative mechanisms to foster the goal o f diversification and competitiveness). xxii. Summary of recommendationsand next steps. The matrix below outlines priority areas for action and suggestednext steps. Some recommendations are under implementation, in some cases with World Bank support (e.g., new savings rules for the NFRK). The range o ftopics covered inthe matrix i s by no means exhaustive. For instance, there i s limited or no discussion of foreign direct investment policies or policies affecting such high-value service sectors such as tourism. More detailed further work will also be neededinmany areas (e.g., public expenditure management, air, road, railways, and on the vast agenda o fhuman capital investments). Nevertheless, it i s hopedthat this report and the associated background papers will prove helpful to the ongoing debate on a broad strategy to achieve efficient diversification o f the Kazakhstan economy and sustainable growth inthe competitiveness o f its non-oil sectors. Summary of Diagnostic: and Recommendations Elements of Competitiveness Recommended Next Step 1.Economic manataement: The main objective i: '0minimize economic volatility, avoidoverheating, and create an environment to foster privi ? investments in non-oil tradable sectors. 1 Maintain budget discipline and quality of public Introduce balance budget rule, new NFRK spending; use financial assets to help smooth rules, and a revised asset management policy, consumption out of oil. with the 2006 budget. 1 Focus the 2006-08 MTFF on non-oil deficit, real growth of public spending, sectoral priorities for government spending, and key elements of the fiscal/monetary policy coordination. Monitor the overall savings of the consolidated public sector (State, NBK, National Companies, and State Financial Institutions), and add an addendum of this to the 2006 budget. 1 Develop a blueprint for assets and liabilities management and an overall debt management strategy for the public sector. 1 I f a small government is to be maintained, Reduce vulnerabilities in the financial sector. . commission a report on the effective ways to reduce taxation for non-extractive sectors. Curtail rapid credit expansion, currency mismatch, and excessive rate of leveraging. 1 Strengthen financial sector supervision. . 1 Use trade as yardstick for measuring success in Resist protectionist pressures (which will diversification. emerge as the exchange rate appreciates). Simplify current tariff schedule, and adopt standards for trade (e.g., valuation) that are WTO compliant. 2. Labor Droductivitv:Develop stronger base for human capital. Create a highly productive work force at all 1 Make sure that human investments are a key levels through health and education policies; priority for the budget over the next 5-10 and, ensure labor mobility IS not a constraint to years (education, health, and water sector growth and competitiveness. . reforms). Commission a report to assess labor productivity, level of structural unemployment, and bottlenecks that may arise in regions or in professional skills. Review the immigration framework for attracting key skills from abroad. 1 Review the housing program to ensure it will facilitate labor mobility. * Steadily reduce costs (time and money) of . Develop a comprehensive transport sector moving goods and increase quality of service. . strategy; avoid committing to large investment programs. Create opportunities for public/private partnerships in rail, air, and roads. Focus CES on liberalizing the process of moving qoods through Ukraine, Russia, and Kazakhstan with minimal disruption. Reduce costs and increase aualitv of I1 Strengthen the requlatory framework (tariffs communication services; create opportunities rebalancing, interconnection regime,' and for private investments within a competitive management of spectrum). framework. 1 Rapidly phase out monopoly rights and liberalize entry. 1 Modernize KazakhTelecom with or without privatization (but with demonopolization). 1 Continue to improve quality of basic 1 Supply of power (distribution), water, trash infrastructure (at national, oblast, rayon, and collection, gas distribution, and others merit a city levels). review at the relevant government level. 1 Further improve the tariff and regulatory framework (telecom, railways, electricity) Elements of Competitiveness Recommended Next Step rregulatingbusinesses Close unnecessary government institutions that 1 Introduce a program to semi-annually monitor deal with businesses, and improve services of progress in the government's regulatory those that are essential. framework and service provision. This could be in the form of a survey of all enterprises. 1 Remove obstacles and opportunities for rent- 1 Introduce downsizing or modernization seeking behavior. programs for 'worse offenders' (e.g., gostandards) . 1 Make tax and customs administrations friendly to business, and focus CES agenda on the integration of customs administrations. 1 Expand the capacity of the court system to handle contract and economic issues. 1 Improve quality of public spending and general Continue work on civil service incentives administration, through better policies and (including remuneration policies) and training. greater accountability for key institutions. 1 Modernize policies and institutions for 1 Improve capacity to better link inputs and procurement, financial management, and outcomes and measure impact of public program evaluation. spending. 1 Build capacity (in and outside the government) for evaluating investment projects. 1 Build debt (liability) management capacity, . including MOF/MEBP/NBK issuance of joint debt issuance strategy. Avoid expensive computerization initiatives, unless they are used to drive a true simplification of processes imposed by government on enterprises. Increase competitiveness in agriculture. 1 Review aaricultural suDDort t)olicies (trade and fiscal) with a view `of formulating a clear strategy to increase the competitiveness of the sector. 1 Introduce win-win schemes to foster Promote joint ventures. interaction between oil companies, and local 1 Improve business environment, competition, suppliers, workers, and research institutions. hard budget constraints and exit mechanisms. 1 Develop three-pronged strategy to: (1) train and develop skills for Kazakh workers irrespectively of whether they work for a supplier or an operator; (2) simplify rules and regulations about local content imposed on operators; and (3) institutionalize best practice supplier development programs. 6, Innovation, R&D: Better use of Kazakhstan's scientific ootential and create available environment for firms to innovate. Att, ct FDIin key sectors. . 1 Promote R&D and enterprise innovation in Creation of Centers of Excellence in such Kazakhstan, starting with the most obvious disciplines as petroleum extraction, metallurgy, strengths of the economy (agriculture, metals, biotechnology, and environmental science. etc.). Develop clear technology commercialization programs and processes that would inter alia link Kazakhstani scientific output to foreign and domestic markets; identify specific commercialization strategies for each commercially viable technology; provide management and entrepreneurship support for incubators that would support small, innovative enterprises, and link entrepreneurs with appropriate sources of finance. I. CONTEXT:ATASTEOFTHEFUTURE A. TRANSFORMING KAZAKHSTAN WITHIN A DECADE 1. A difficult transition.From 1991to 1995 real GDP fell by 39 percent and exports collapsed (Figure 1).Fiscal and external imbalances led to hyperinflation which peaked in 1994, and there were widespread arrears inpensions and wages. Production ties with the Commonwealth of Independent States (CIS) were severed, which created massive underemployment - particularly indefense-related industries where those ties were strongest. Livestock became the main safety net for the rural population. Its exports - among the highest in the CIS - collapsed (World Bank 2004b). 2. Thegovernmentfocused on the most obvious comparative advantages. Aggressive efforts were made by the government to attract investments into mineral and energy resources, and to provide opportunities for the country's relatively well-educated population (Figure 2). Between 1994 and 1996 the country liberalized most prices, imposed hardbudget constraints on enterprises and banks, reducedtrade distortions, and privatized all small and most medium-scale enterprises. Vigorous banking and pension reforms followed, together with liberalization and unbundlinginthe electricity sector. Late inthe 1990s, the government beganto concentrate its efforts on institutions. The framework for public resource and civil service management was introduced; and, inmid-2001, the National Fundo f the Republic o f Kazakhstan (NFRK)was set up-an important, albeit initial, step towards oil revenue management and transparency. 3. Strong supply response after the regionalfinancial crisis. A vigorous recovery started in2000 andhas continued through 2004, ledmainlybythe oil sector (Figure 3). Oilproduction increased from 0.5 million barrels per day (mbd) duringthe 1997-99 period to one mbdin 2003, with substantially more to come inthe future. This and the global increase incommodity prices (e.g., grain, steel, copper and gold) had important spillovers into the non-oil sectors. The food and construction industriesand financial and business services sectors experienced true development, even if from a very small base. 4. Stability was achieved, butpressuresfrom capital inflows began. Since 2001, inflation has beenbelow ten percent. Between 2000 and 2003 the real exchange rate index depreciated against the euro and the ruble, and appreciated against the U S dollar. This stability was underpinned by a cautious fiscal stance, duringwhich about half o f oil revenues were saved in the NFRKabroad, and government's spending levels were kept to approximately 22.5% o fGDP (Figure4). A sharp real appreciation vis a vis the U S dollar has occurred over the past year, despite interventions by the National Bank of the Republic o f Kazakhstan (NBK).Ifdefined as the relative price o f tradable to non-tradable goods, the real exchange rate has followed a trend similar to that o f the tenge/dollar although not as accentuated (Figure 5). The pressure on the exchange rate, due to ongoing capital inflows, continued as o f end-2004. 5. Increase in savings. The savings rate, driven by fiscal surpluses, has more than doubled since 1997 (Figure 6). The government accounted for one-quarter o f the country's savings in 2003, and its assets inthe NFRK reached US$5.0 billion by last year (12 percent o fprojected GDP), an amount similar to the country's total (external and domestic) public external debt. 2 Private savings have also increased, with deposits incommercial banks and pension assets reaching 23 percent and 9 percent o f GDP, respectively, last year. Given this pace o f asset accumulation, credit rating agencies have continuously upgradedKazakhstan's sovereign-bond ratings (Moody's:Baa3; Fitch:BBB-; S&P:BBB-). Investments are also up, but this increase has been drivenby o i l and the state investment programs (Figure 6). 6. Simple recipefor success. First, the overall macro-economic framework was put inplace through hardbudget constraints and a fiscal policy that restrained aggregate demand. Second, opportunities for private (domestic and foreign) investors were quickly created in all sectors, including strategically important ones, such as electricity generation. Finally, key government institutions were strengthened. Maintaining these three policies i s a precondition for continued success. But as will be discussed later, the road ahead requires efforts inother areas as well. B. 2004: THETwo FACES KAZAKHSTAN OF 7. Financial indicators are strong, but the country's manufacturing base remains weak. While Kazakhstani s modernizing its extractive industries -a process helped along by high commodity prices-there i s significantly less economic activity outside o f miningand metals. Construction, trade, commerce, transport, and financial services are all increasing, but these trends are likely to be the result-directly or indirectly-of the demand generated from highoil investments and spending. This poses the question o f whether growth inthese sectors can be sustained when the oil boom recedes, as one day it must. Naturally, the country's economy i s now heavily dominated by oil and gas, mining, and metals, which directly accounted for thirty percent o f GDP (Figure 7), nearly 80 percent o f industrial output, and more than 80 percent o f exports. But exports inall other industries have been stagnant at approximately US$2 billion dollars since 1997 (Figure 8). This weak manufacturing base hampers illustrate the magnitude of challenge to diversify the economy. 8. Social indicators. While the percent o f the population that can not afford a minimum amount of food has fallen from 18% to 12% between 2001 and 2003 (although mainly inurban areas); nearly 27% of the population lives in crowded conditions with less than 6 square meters per person. Also, an estimated 11% of the population i s poorly educated- defined as those persons 15 years or older who at most have completed primary school (World Bank 2004a). The trend for income inequality i s unclear, but since oil i s the driving force o f the economy authorities should expect it to worsen and prepare to mitigate its effects through human capital policies (e.g., health and education) and by strengthening the taxation o fproperty (housing and vehicles). 3 -- Gross ~ ~~~~~~ .. .. . . . ~ ~~ ~~ ~ .. ~ Figure 1: Kazakhstan'sTwo Transitions Figure 2: Kazakhstan ForeignDirect Investments, 1993-2003 ~~ ~~ 0 1 - . 0 3 - 0 2 . -3_ --> ~- .. ~ ?< * ..-. ~= -g ~ ,n x > r/ I' 3 3 -- - -2 m zc g F 2 ~'I ~ w w g ~ = = 1993 1991 1995 1996 1997 1998 1999 ZOO0 2001 2002 2003 I RealGDP (1990=1) -Per Capita GDP inUS%(aperage for new EU counhies = I) 1 -. - _ _ _ _ _ ~ ~ ~~ ~ I F~gure3: Kazakhstan: RealGDP GmwZh Figure4: Kazakhstan-Oil Rekenue Savedand Spent, and 11' (I%,change over previous penod) Total SpendingLevels u5 0 011revenue L_._ _. saved 2003e 0 011revenue 2002 spent 2001 0Total 2000 n6 1 eqendaure _.^ " 0 0 1999 I O 123 I 199- 1998 19YY 2000 2001 2002 2103 20041. 2 0 0 ~ Percent o f GDP G E D P &Total GDP- ~~~ Figure 5: Kazakhstan- RealExchange Rate Index Figure 6: Kazakhstan- Savingand InvestmentRatios (Dec 2000 = 100), down=appreciation II> 30 ~ 110 111) Ill0 p i 911 85 XI) ," 7 i . j -~ ~~~- ~ ~ i 1997 1998 1999 1000 2001 2002 2003 Figure 7: Kazakhstan:Structure ofGDP2003 I Figure 8: Kazakhstan: Exports of selectedgoods (US$bilhon) products - ~ ~~ - EFenousmetals ~~ 7% '0 '"'O ~ 0Copper and honoil m m g Construction copper 3% 4% 6 products 5 011services Trade commerce 43 0 Gam 12% 13% 011and gas * 12% 1 9 8 i IWR 1999 m n 2 n i i >no? mi 2003 m EOther Public sen,ices Othersewices Ic% 5% .. '%Share ofoil andgas,ferrous mtala,copper,andgrain in total .. ~ Sources: Annex Tables 5, 6, 7, and 8. 4 9. Health indicators are not good either. Life expectancy at birth i s lower than the average for the CIS, while adult mortality rates are higher. Part o f the healthproblem results from low access to safe water, particularly inrural areas where only 6.4 % o f households have access to pipedwater (44 % ofthe population lives inrural areas). The country also faces major health threatening environmental challenges, relatedto water availability, water and air pollution, and a legacy o fmismanagement of natural resources. Problems inthe water and sanitation sector are already at critical levels as suggestedby the multiplehepatitis outbreaks during last summer. 10. Negative consequences.Were these health and social trends to continue, it i s likely that labor productivity will stagnate or fall over time, affecting the overall level of competitiveness in Kazakhstan. Oil inflows will clearly lead to real exchange rate appreciationover time, which in turn will pushwages costs up insectors that have no direct or indirect link to the oil industry. Thus, unless labor productivity increases, it will betoo costly to produce goods without link to the oil industry inKazakhstan. 5 11. CATCHINGUPWITH HIGH-MIDDLE INCOME ECONOMIES A. THECHALLENGE'S PERSPECTIVE 11. The three strategic objectives. The authorities have set up very clear long term objectives. First, to catch up with the EUinterms o f living and production standards, levels of productivity, and income. Second, it also wants to compete for investments and markets within Ukraine, Belarus, and Russia-exploiting current and earlier links as well as vicinity and by creating a common economic space. Third, Kazakhstan aims at becoming a transit hub between East and West, i.e. between China and Europe. Given these objectives, it i s appropriate to benchmark Kazakhstan against: (1) EUcountries, and, inparticular, its eight new members (EU8);5 and (2) Ukraine and Russia (U&R). 12. The objectives in perspective. Kazakhstan's income i s already at the level o f Ukraine and not far from Russia's, but whether Kazakhstanmanages to outpace these two countries will depend on its overall competitiveness. As for the EU8 countries, even ifKazakhstan's per capita income would grow twice as fast as income inthe EU8, it will still take it 20 years to catch up to them.6 (Figures 9 and 10). I Figure 9: GNI per capita in new ELIand Common Figure 10: Kazakhstan' ConFergence Challenge Economic Space Countries, 2003 I I 1 1 .. 12000 .. I O . loo00 0 9 0 o x 0 8000 0 7 c 0 6 . 0 5 * 0 4 0 3 0 2 13. Growth without development. As difficult as it seems (i.e. 20 years o f growth at twice the pace o f EU8 countries), catching up with the income o f the EU8 i s achievable based only on the prospects for oil exports, and the subsequent boom inpublic spending (by the state, SOEs, and state agencies), and non-tradable sectors. Of course, such a scenario assumes that there will be no macroeconomic disruptions, natural disasters, conflicts or other major negative shocks. But these sources o f growth are unavoidably temporary, and will anyhow not be enough to get Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia. Inconstructing Figure 10; we assumeda 10%growth inKazakhstan, vis a vis 5% inthe EU8. Average annual growth o f dollar income per capita innew EU countries has been 13% between 2000 and 2004, while in Kazakhstan it has been 19%. 6 Kazakhstan where it wants to be. For instance, rather than becoming a long term hub between China and Europe, the oil boom could well lead to a more narrow focus on moving imports and consumption goods associated with the oil boom-unless appropriate sectoral policies are adopted for, inthis example, the transport sector. Inthat case, transport related sectors will fade when the oil bonanza recedes. Thus, an excessive focus on the oil industrymight lead to a highly volatile development path, as for example Venezuela demonstrates. 14. Venezuela easily tripled its income per capita within an eight year-period (see Table 1 below). This was led by the upsurge in exports created by Figure 11 FuelEyorts m Selected 011 Countnes high oil prices, and the associated (percentage ofuerchandisebo,orts) increase inpublic spending. In hindsight, it is clear that such an increase inincome was unsustainable. Non-oil GDP in Venezuela grew mainly to the oil and consumption .. industries, and did not achieve productivity gains inthe agriculture or manufacturing 0, sectors. Non-oil exports in -+-Venezuela -+-Kazakhstan Indonesia \omay -~ -~ - Source: World B a n k databases. Venezuela never increased during the 1970s (Figure 11). 15. Venezuela tried to diversify its economy, and in fact it used its oil money to "industrialize" and for "large-scale infrastructure projects," rather than for human capital (note the rapid expansion of SOEs inVenezuela inTable 1).Inthe end, the country had little gains in social indicators, and the country did not achieve its diversification goals. As a consequence, Venezuela fell on hard times when oil prices went down: by 1990 income per capita had fallen back to only about US$2500, although it has recovered somewhat more recently with the new oil bonanza. 16. The real challenge. Similar to Venezuela inthe 1970s, Kazakhstan i s expected to triple its income per capita by 2007 on the basis o f oil and gas exports. But Kazakhstan would like to avoid the vulnerability to oil price declines that has caused so much adversity inVenezuela inthe period after the oil booms inthe seventies and early eighties. Income per capita can certainly continue to grow on the basis o f increased volumes o f oil exports, unless oil prices collapse. But ifKazakhstan'scatchingupwiththeEU8ispurelybasedonitsoilexports,theprocessmaybe hard to sustain through periods with low oil prices, and such periods will come. The authorities are therefore rightly looking for ways to foster competitiveness inthe non-oil sector. Achieving highincome growth, while maintaining a certain degree o f diversification inthe economy's structure, i s the real challenge for policy makers. 7 Table 1: Performance in Venezuela and Kazakhstan Venezuela .. Kazakhstan __________- ----I_- 1973 1981 1999 2004 2007 Actual Actual Actual Prelim. Proj. a GDP per capita, current US$ 1,693 5,026 1,130 2,714 4,170 Exports of goods and services, US$ bn 5.0 20.9 6.9 22.4 23.4 Gross domestic savings, % of GDP 39.3 29.4 20.1 30.5 27.3 Total expenditure, % of GDP 21.0b 30.0 23.1 23.4 24.0 Investmentsby SOEs, % of GDP 5.5 9.0 n.a. n.a. Operatingspendingby SOEs, % GDP 6.0 11.0 n.a. n.a. Life expectancyat birth(total) ,years 66.0 68.8 65.7 65.8 Health, education, andhousing, YOof total expenditure and net lending 34.5 26.0 e 26.4 27.2 32.9 Source: World Bank staff estimates based on official statistics for Kazakhstanand various databases for Venezuela. Most projections for Kazakhstan are taken from the Country Partnership Strategy, 10/08/2004. a/ 2005-07 Medium Term Socio-Economic Development Plan and 2005-07 MTFF (updated in March 2005 to include possible budget amendments following the February 2005 Address to the Nation). b i From WE! Country Economic Memorandum (1995), "Living with Oil", Chapter 3, Figure 3.7, Report No. 12849. c/ Data for 2003 d/ Average for the 1971-73 period. e/ Average for the 1974-81 period. f/ Average for the 1997-99 period. g/ Average for the 2000-04 period. h/ Average for the 2005-07 period. i/Excludesinvestmentsinthe petroleumsector.A significant part ofthe spendingin SOEs was financed frombudget transfers.Note that the upsurge in both operating and capital investments reflected investments in industrial, mining, and petrochemical sectors. Data from WE! Country Economic Memorandum (1995), "Living with Oil", Chapter 4, Figure 4.3, Report No. 12849. n.a.: not available. 17. Initial conditions are against the country. First, most competitiveness and diversification indexes place Kazakhstan behind Ukraine and Russia inmany respect^.^ Second, location and market size are a disadvantage. Third, Kazakhstan will unavoidably increase its dependence on oil and other extractive industries at least for the next 15 years. This makes it more susceptible to "Dutch Disease" phenomena, the adverse impact on non-oil sectors o f oil induced real appreciation (see IMF 2004). Moreover, oil economies are highly volatile, which inturn makes it evenmore difficult to develop a favorable environment for investment and growth intradable sectors. However, these adverse initial conditions can be overcome with good structural policies and other elements that are reviewed below. B. THEKEY INGREDIENTS OFCOMPETITIVENESS INKAZAKHSTAN 1. The Framework 18. Toolsfor diagnosis. There i s an extensive literature on the key determinants o f competitiveness. However, factors limiting competitiveness are country specific, so any program 7 One of the only indexes that include these three countries i s the UNIDO Competitive IndustrialPerformance Index, which rankedKazakhstaninthe 79'hplace (out of 155 countries), behind Russia (53rd)andUkraine (34'h). (See http://www.unido.org/doc/5156.) Kazakhstan is not yet rated inthe Competitive Index of the World Economic Forum, which list Russia and Ukraine. 8 to boost competitiveness will always be country specific. Insome countries, the `digital divide' (the gap between those that have access to the information highway and those whose access i s limited or obsolete) may be the most important obstacle to competitiveness; while inothers it may be the infrastructure for research and development (R&D) or for moving goods (ports, railways, air), or the macroeconomic framework, that needs the utmost attention. It i s therefore essential that a thorough diagnosis o f the various strengths and weaknesses o f Kazakhstan from the competitiveness point o f view i s made. 19. Such a diagnostic exercise could most usefully focus on six main areas where improvements are likely to have a major impact on Kazakhstan's competitiveness: a. The macroeconomic environment, in light o f the challenge that oil revenue management will impose on the country; b. The quality ofthe country's labor force, inlight o fthe deteriorating social indicators discussed above on the one hand, and wage pressure likely to emerge from the oil boom on the other; c. The cost and quality o f infrastructure, given that the country i s remotely located and landlocked; d. The efficiency of government institutions, particularly those responsible for regulating businesses (small, medium or large) and those responsible for the quality o f public spending (especially investments); e. Sector policies, particularly inthose sectors where Kazakhstan has an advantage or significant potential, such as agriculture; and inoil and gas where Kazakhstan needs to develop the technological capacity to meet the technical challenge that it will confront for many decades to come; and f. The framework for innovation andR&D;this is particularly important becauseKazakhstan inherited a high quality scientific community without, however, the experience to commercialize its services, and that i s not involved in finding solutions to the technical challenges posed by the extraction o f oil and minerals. 20. Diagram 1outlines these 6 areas and provides examples o fpolicies that would need to be developed within each area. 9 Diagram1:A Frameworkto Study Competitivenessin Kazakhstan + + Health/water + Housing, labor market Education (pre-sckol, policies elementary, vocation; + Fiscal policy -- + Regulation policies NFRK rules\ J (telecom, railways, air) Non-oil deficit + Private-public partnerships Public investment programs Public guarantees + + Role of development institutions Monetary and + Regulation of financi Trade policy (WTO/C@ 2 '"uurrrrrrJ ss I- AT + Oil and gas -- ------P Corruption (civil servants' local content compensation, procurement) linkages (R&D) + Regulatory framework + Agriculture t - Support policies --- Standards and certification Licensing, inspection regimes + - role of government + Technology Entry, exit, competition Credit and financial sector policies commercialization - CaDital market develoment + Innovation system (enterprises, + Legal and ]udiciary system / - Contract enforcement. collateral + - Credit to SMEs I universities, research centers) + Tax and customs administration Clusters (Tourism, Textile, Oil + Intellectual property rights - Trade related regulations/processes services, Construction, Food Industry, Transport/cargo) Source: Backgroundpaper No. 4. Note that this framework was updatedfrom the one presented in that paper 2. A Simple BenchmarkingExercise 21. Given the objectives stated inParagraph 11above, this section benchmarks Kazakhstan against the EU8 and U&R for the first four areas inthe above framework. In each case, a few simple indicators are selected and compared with similar indicators inthe EU8 and U&R over time. The comparison i s done by 'normalizing' the indicators inKazakhstan by either the average o f the EU8 or the average of the U&R (averages for these two groups o f countries are weighted by population). Inthis way, when an indicator i s equal to one, it means that the value o f such indicator for Kazakhstan i s equal to the value for the average o f the EU8 (or the U&R). a. Economic Management 22. Good saving rates, weak non-oil investment rates. Kazakhstan's total savings and investment ratios have outperformed the EU8 since 2001, and are close to U&R rates (Figures 12 and 13). While accumulating savings i s an achievement, it i s the investment ratio that determines future growth. Unfortunately, the investment ratio for non-oil sectors (Le. non-oil investments over non-oil GDP) inKazakhstan i s only about 60 percent o f the EU8 and about 70 percent o f U&R (Figure 14). The upward trend since 2001 is encouraging, but Table 2 below (and Figure 6 inSection I) that this trendhas beendriven by government investments. Infact, the suggests level o f investments intradable sectors has been stagnant at about three percent o f GDP. The only other thriving investments are in infrastructure where national SOEs dominate. Whether public investments (state government and SOEs) are or are not complementary to private 10 investments i s an issue that will need to be investigated more carefully.* A further concern i s that the bulk of investments outside oil and government have been going into non-tradable sectors since 2001. These trends are determined by the relative price o f non-tradable and tradable goods. As this relative price increases, non-tradable sectors become more profitable relative to tradable sectors and, naturally, enterprises and banks invest inthem. Thus, it i s the economic policies (financial, fiscal, and monetary policy) rather than the banks' lending policies, which excessively increase the profitability innon-tradable sectors and send signals to private investors to move resources into them. Table 2: Kazakhstan:Compositionof Investmentin FixedAssets, 1999-2004 (% GDP) Yo GDP 1999 2000 2001 -- 2002 2003 20046m Total Investments 18.3 22.9 29.0 29.1 28.8 16.6e Non-extractive sectors 5.6 6.4 7.2 6.9 7.7 6.6 Tradables a 2.3 2.9 3.3 2.9 3.0 2.3 Non-tradables 3.3 3.5 3.9 3.9 4.7 4.3 Oil, gas and miningd 9.1 13.6 16.9 16.3 14.8 10.0 Infrastructure 1.6 1.7 2.5 2.6 2.7 2.0' Public services 2.0 1.3 2.5 3.3 3.6 2.7' Memorandum item: Tradable % non-oil GDP 2.8 3.6 4.1 3.7 3.8 -- Source: Statistics Agency o f the Republic o f Kazakhstan, National Accounts o f Kazakhstan. a Includes non-oil manufacturing and agriculture. Includes trade, hotels and restaurants, construction and real estate services, and services to enterprises. Includes power, non-oil transportation, communications, and other infrastructure. dIncludes oil & gas extraction, services incidental to oil & gas extraction, whole mining, geological exploration & engineering related to oil & gas, and transportation via pipelines. The latter includes fixed capital for the CPC 'construction. Dueto procurement and other reasons, public investments usually take place during the 2"dhalfo fthe year. As an indicator, the total investment rate for the first six months o f 2003 was only 19% (the annual one was 29%) due mainly to public services and infrastructure. 23. Low exportperformance (outside extractive industries). Another worrisome sign that the various economic policies are not supporting diversification i s that exports o f non-extractive commodities have been stagnant at about $2 billion for the last three years, as was shown in Figure 8. These exports, which include manufacturing commodities as well as processed agricultural products (other than grain), are more likely to respond to domestic relative prices (e.g., domestic economic policies), than exports tied to world commodity prices. As such, enhancing this export base i s an important indicator to monitor. Needless to say, the export base has been very dynamic in a country like Hungary, both interms of levels and degree of diversification, as well as inmost o f the other EU8 countries. * The Government i s planning to hire an external evaluator for the Innovation Industrial Policy, which created a series o f state-owned financial enterprises. A broader evaluation on whether the activities o f these institution and other SOEs contribute to private investments should also be carried out. 11 I Figure 12: Kazakhstan's Savmgs Raho Figure 13: Kazakhstan's Investment Raho I O 4 - - ~ 0 4 -~ ~ ~~ 1995 1996 1997 1998 1999 2000 2001 2002 2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 _ - hew EL8=1 -Russia and Ukrame-1 -- \ e u EL8=1 -Russia and Ukrame=l Figure 15: Kazakhstan's Government Spending 0 7 ~ 0 7 - 0 6 1 ~ 1: _--- / / / // ~ - 0 4 2000 2001 2002 2003 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 -- Yew EL8=I -RussiaandUkrare=l -- \ew EL8=1 -Russia and U k r m = l -~ ~~ Flgure 16: Kazakhstan's Manufacmg Labor Produch\ity I (perworker) (per worker) 1 5 - 0 60 0 50 ----, /---- 040 - \ / .--- 0 30 1 -/4- /- -'/ 0 20 0 I O 0 3 -- - 0 00 -~ - - 0 0 ~- 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 -- Yew US=] -- New EU8=I -Russia and Lkrame=l I' -~~~ - - ~ ~ _ _ _ _ _ - Source: Annex Table 10. 24. Volatility is down but not to EU8 levels. It i s also important to benchmark economic volatility, which i s the main channel through which the economic framework affects the investment climate for all private enterprises (whether intradable or non-tradable sectors), Table 3 below shows the standard deviation o f nominal and real exchange rates, and inflation. It was calculated over the last 7 years, and thus includes the volatility generated during the regional financial crisis because this i s something that investors (local or foreign) review when making decisions. Inall cases, Kazakhstan's volatility i s lower than Russia's, and almost always lower than Ukraine's (except for the real exchange rate). This i s the result o f good economic management vis a vis these two countries. However, volatility inKazakhstan has been twice as highas inthe EU8 countries. 25, Kazakhstan lacks an anchor to control expectations. Investor's decision may be affected by their future expectations about volatility rather than by events over the past 7 years. Inthis case, there i s an extensive body o f literature suggestingthat such expectations are affected by the credibility o f the institutions responsible for economic policy (fiscal and monetary policies). In 12 tum, such credibility depends on the "anchor" these institutions use to `tie' their hands and fulfill their commitment. For instance, the most recent eight members o f the EUhave anchored their fiscal policies to the EuropeanMonetary System, and have adopted the euro as their currency which ineffect means they have given up monetary policy altogether. Given that a lot o f what investors will be looking at i s the relative price of tradable and non-tradable sector, which inturn i s determined by the pace at which oil revenues are spent, Kazakhstan clearly needs a strong `anchor' for fiscal policy (e.g., a balance budget rule, like in Chile, which can be combined with more credible mechanisms for deciding how much to spend or save out o f oil revenues). As for monetary policy, the NBK i s making an effort to replace the nominal exchange rate as an anchor (used, explicitly or implicitly, for over 6 years) with a pre-announced target on inflation. For this to work, the NBKR will need to establish a strong reputation in fighting inflation, together with buildingappropriate mechanisms o ftransmission through interest rates. Table 3: Volatility of Exchange Rates and Prices (YO),January 1997 to September 2004 Kazakhstan Russia Ukraine E U 8 Nominal Exchange Rate Depreciation a - Mean 12.9 46.7 21.6 1.4 - Standard deviation 24.0 92.3 32.2 9.2 Real Exchange Rate Depreciation - Mean 1.1 0.6 -4.4 1.1 - Standard deviation 12.4 19.1 6.3 3.5 Inflation - Mean 8.1 29.9 12.7 5.2 - Standard deviation 4.1 31.5 9.8 2.8 Source: IMF International Financial Statistics andNational Bank of the Republic of Kazakhstan. Note: The mean and the variance are calculated on the first difference of each variable (e.g., for prices it refers to the average inflation and its standard deviation). Data is monthly and the first difference is taken against the same month of the previous year, a/ vis a vis US dollar bi real effective exchange rate c i Simple average for all EU8 countries, except for the real exchange rate which does not include the Baltics. 26. Small government. Kazakhstan does have a fundamental advantage over the EU8 and U&R: its govemment is approximately 40 percent smaller (Figure 15). This implies that Kazakhstan can sustain lower marginal tax rates on labor and capital for its non-extractive industries than the two sets of benchmark countries. This i s a strong advantage as the experience of, for example, Ireland suggests. However, since Kazakhstan has expanded its public spending by 21% in2003, by 17% in2004, and by an estimated 18 % this year, all inreal terms; the size o f the government may actually end up closer to the EU8 and U&R five to ten years from now eroding this advantage. 27. Overall macroperformance does notyet outperform the EU8. On the basis o f the past performance o f private investment levels, low export diversification, the observed levels o f volatility, and the current expansionary trend o f the public sector, it i s clear that Kazakhstanhas much to achieve before it outperforms the EU8 countries. Inaddition, Kazakhstanwill increasingly be exposed to the vagaries o f intemational oil market developments. T o escape the associated Dutch Disease problems, the government will need to manage the upcoming monetary and fiscal shifts, resultingfrom changing o i l prices and production levels well through the 13 introduction o f credible fiscal and monetary anchors. These issues are discussed inChapter I11 below. b. Labor Productivity 28. Laborproductivity trends are not encouraging.Kazakhstan's labor productivity, measured as dollar value added per worker, inmanufacturinghas improved relative to the EU8 duringthe strongest period o freform (1996-2001) andreachedhalfthe level ofthe EU8in2001 (Figure 16). However, productivity has remained stagnant at this level since 2001. Inagnculture, labor productivity (when normalizedby either the EU8 or U&R) has beenfalling for more than a decade (Figures 17). These trends should be of significant concern to policy makers, as clearly the country is movingina direction that is opposite to the established goals. It also suggests that ifatrue CES were to be establishedwithU&R, Kazakhstan's localproducers will losemarkets due to the relative uncompetitiveness o fthe labor force here. 29. Explaining labor productivity trends. Key determinants o f labor productivity are: the quality o f education, health and water services, the quality o f investments taking place innon-oil sectors (which may not do enough to lift labor productivity), labor market policies (including policies to increase mobility), pace of technological change, and Dutch Disease problems (through which labor i s drawn into sectors where productivity i s not increasingmuch). A detailed analysis would be neededto understand which o f these factors most explains the above trends for Kazakhstan. 30. However, it i s safe to say that the quality of the health and educational systems in Kazakhstan may not be contributing as much as they could to enhance labor productivity. Figures 18 illustrates how health indicators inKazakhstanhavebeen systematically worsening relative to both the EU8 and U&R for over the last fourteen years. Similarly, efforts to increase the quality o f education. A crude measure o f effort inthese areas, i.e. per capita spendingin education and health, shows a disappointing trend (Figure 19). -~ ~~~~ ____ ~ _ _ _ _ F~gure18: Kazakhstan'slnfant Vortahtj Rare Figure 19: Kazakhstan'sPer Capita PubbcSpendlng m (per 1,000 tibe births) Educationand Health I O 1 1 . ----..---- 8 A:---. / II( * I( o x - - - - \ 0 7 \ 0 6 0 5 0 4 - 1990 1995 2000 2002 1995 1996 1997 1998 1999 2000 2001 -- New E M = ] -Russia and U G " 1 -- \ew EL8=1 -Russia and Lkranie=l ~ ~~ ~-~~ ~ ~~ - ~ ~ Source: Annex Table 10. c. Infrastructure 31. Overcominggeography. Kazakhstani s both landlocked and remotely located relative to large markets. This disadvantage for competitiveness can o f course be corrected by reducing economic costs. The important element i s not the physical distance, per se, but the economic 14 distance from markets, or the sum o f all the differenttime and cost expenditures o f moving a consignment to a particular market, and the ease with which people can communicate and access information through the telecommunication network. This measure o f economic distance reflects all the time and money expenditures that are related to the movement o f a consignment to a particular market, or linkingwith the rest o f the world via voice or data. Thus, a reduction in economic distance can be realizedby not only improving physical infrastructure, but also by improvinginformation flows, simplifyingprocedures, or reducing corruption. Inthis way, even remote landlocked countries like Kazakhstancan transcend their physical disadvantages and reduce their `economic distance' to enhance their competitiveness. 32. A significant infrastructure policy agenda. Kazakhstanlags behindthe two sets o f benchmark countries intransport infrastructure. Figure20 illustrates this point with a few indicators for use of roads and air infrastructure, and cost o f communications. Each bar shows the ratio o f a given indicator inKazakhstandivided by the average for the same indicator inthe EU8 or U&Rcountries. Anything below one for the first four indicators, and above one for the last two, signals that Kazakhstan i s behindthese two groups o f countries. 33. Underutilized transport infrastructure. Figure20: Kazakhstan SelectedBenchmarksfor Transport and - Telecommunications Infrastructure,2002/2003 Kazakhstan's road and air 4 0 infrastructure i s usedless ___ - ~ _ _ _ _ intensivelythan inthe 3 5 - - ~ benchmark countries. While 3 0 ~~~~ ~~ ~ ~~~~ ~ ~ it is easy to conclude that this i s the result o f geography and the country's size, it is more likely that Kazakhstanis in this situation by its own choice (Le. due to bureaucratic barriers and misguidedsectoral policies). Goods hauled Aircraft Air freight Telephone Mobile Cost of call io lntemet For instance, it i s worth (million ton- departures (million ton- mainlinesper phones per U S (3 (Total km) (000s) km) I000 people 1000people minutes. in monthlyprice asking if a policy o f open 0RatioofKazakhstaniAverageof EU8 20 hours of use. in US%) skies and the professional and independent management (3Ratioof KazakhstaniAverageof U&R of the country's largest airports Source: World DevelopmentIndicators and World Bank staff competing with each other for calculations. landing would result inmore aircraft departures and air freight than the current policies. Such a policy would be a win-win situation since it would lower costs for all businesses and, by enlarging the `pie,' it would also increase profits for all market incumbents, including the national operator. Dependingon the selected strategic direction, the national carrier could become aglobal operator (Le. a relatively small company ina very large global market), or a national monopoly (i.e. a large company in a very small market). Either way, it appears that Kazakhstanhas scope for intensifythe use o f its air and road infrastructure. 15 34. Railways'performance is difficult to benchmark. In2002, the average commercial speed o n the railways was approximately 40 kdhour. This suggests that on a 24-hour travel basis a speed of nearly 700 km/day could b e attainable. Unfortunately, the real performance is far below this level: the average transit speed of container shipments o n selected routes can fall to less than 200 km/day, far below the rates attained by maritime or road transport. From Istanbul to Almaty, the transit time for conventional rail transport varies between 30 to 35 days, giving a commercial speed of a little more than 150 km/day. Ifthe commercial speed were 700 k d d a y , as it is technically achievable, the shipper would save up to 22 days. The financial value o f the time saving is estimated to be almost 20 to 22% of the transport cost. The message here is that policy implementation will necessarily have to precede large investments because it i s inpolicies where the larger social payoff is most likely to be.9 35. Telecommunications is underprovided and expensiveto use. Access to telecommunications services inKazakhstan i s lower than inthe E U 8 and U&R, as measured for instance by the number of lines (including both fixed and wireless lines) per 1,000 people. This measure, of course, masks the fact that a third of Kazakhstan's fixed lines are not digital and that access to broad bond services is extremely limited and costly. Thus, in addition to lagging in access, Kazakhstan also lags inquality of service. Furthermore, the cost o f calling from Kazakhstan abroad is significantly higher than inthe E U 8 and U&R.This is not the product of distance or geography, since a three minute call from Australia to the U S costs 1/6thof the cost of a similar call from Kazakhstan. Rather, these costs are associated with a lack o f reform inthe telecommunication sector (see Part C of Section 111, below). As inrailways, policies must precede investments-but inthis case there is littlejustification for an active role for the government (or an SOE) in investments. d. Institutions 36. Competitiveness requires that key govemment institutions function well, particularly those that affect the cost of doing business. Essential among these institutions are customs, tax administration, the courts, and the staff of the line ministries, agencies and, more generally, the civil service." There i s a number of additional institutions whose reform i s equally important for Kazakhstan, such as those related to the quality of spending (procurement,' 'public investment management, financial management, and local governments), but here w e focus only on the first group. It should, however, be notedthat technically feasible speeds are never achievedonrail networks where passenger and freight flows share a network as they slow each other down enormously. loKazakhstanstill faces a significant agenda to modernize its civil service as outlined in"Kazakhstan Public Sector Wage Reform: PolicyNote.", forthcoming paper for the Public Expenditure and InstitutionalReview under the Joint Economic ResearchProgram. " Onprocurement,seetheforthcomingpaper"Republic ofKazakhstan:AssessmentofEfficiencyofPublic ProcurementSystemFor Public Expenditure: Findings and Recommendations" and "Kazakhstan Electronic GovernmentProcurement(e-GP): Contribution to the Efficiency Study of the Public Procurement System". These two reports were producing under the forthcoming Public Expenditure and Institutional Review of the Joint Economic andResearchProgram. 16 37. The benchmarks in Figure 21 below are based on five questions taken from the 2002 Business Environment and Enterprise Performance Survey (BEEPS) 11:l2 i.Unofficialpayments,measuredasthepercentageofenterprisesreportingasalwayspaying 11. Tax compliance, measured as the percentage of enterprises reporting that the typical firm in .. bribes, frequently, or usually paying bribes; 111. Business regulations, measured as the percentage of enterprises reporting that more than ... their business reports less than 80 percentage o f their sales to the tax authorities; 10 % o f senior management's time i s spent interpretingregulations or maintaining access to public services; iv. Customs processing, measured as the percentage o f enterprises reporting that it took more than 10 days to clear customs; V. Quality o f courts, measured as the percentage o f enterprises that think that court decisions are never or seldom impartial. 38. Similar to R&U; worse ~ ~______ ~______ than the EU8. Inall cases, a Figure 21:Institutional Framework, 2002 large number represents the Unofficial proportion of enterprises that 40& consider the services of the underlying institutions as bad. Kazakhstan's business regulations, tax compliance and the quality o f the courts, are similar to those inUkraine and Russia, but the country fares slightly better than these two countries interms o f unofficial payments and customs. EUaccession Kazakhst Kazakhstan fares worse than -- the EU8 for all indicators. Russia and ~~ ~ ~~ ~~ Source: BEEPS 2002 39. Left behind (potentially). Institutionalreform is an area where the EU8 countries have made a sustained effort prior to joining the EU, and these efforts will continue. For instance, the EU8 countries neededto meet a set o f minimumstandards inrelationto its customs system prior to accession, and Hungary has been twinning key institutions (e.g., the accounts committee) with the best around the world for a sustained period of time. Evidence is accumulating that quality o f the institutional environment is a key determinant o f economic growth. Thus institutional reforms are likely to have a pay o f f that is high, although difficult to quantify precisely. I'BEEPS i s jointly owned by the European Bank for Reconstruction and Development (EBRD) and the World Bank Group. It is accessible through the web site: www.worldbank.org 17 40. Based o n the background studies, we suggest that the government: 0 Refocus its e-government program away from the increasingconnectivity between large data bases (e.g., tax payers records) and towards smaller - agency-by-agency driven - investments inthe areas that will ease business regulations, and reduce unofficial payments. Good candidates for this include all the registries (for land, titles, permits, etc.) as well as local offices handling driver licenses, id cards, permits. 0 Just like inthe cluster approach, some institutions should be selected for intensive modernization and investment efforts. Likely candidates should include: (i) the Ministry of Economy and Budget Planning and the Ministry o f Finance, which need strong departments for public investment management, debt management, internal evaluation o f programs, and procurement and financial management; (iii) consolidated supervision in the financial sector; (iv) the civil service; (v) the regulatory agencies, particularly the InformatizationAgency, which need to lead Kazakhstan towards the information highway of the 21" century; and (vi) local governments which implement the bulk o f social spending. e. Summary 41. Reverse trends against theEU8; outperform U&R.IfKazakhstan wants to catch up to the EU8 ina sustainable way, it must outperform U&R and reverse the trends inrelation to the EU8 inall o fthe four areas covered above. This also needs to be done inthe two other areas not covered by the benchmarking: (1) the infrastructure for innovation and R&D; and (2) sectoral policies. 42. Maintainingfocus and resolve will help. The government i s aware o f Kazakhstan's great potential from its past reform efforts, its large amount o f non-oil natural resources (e.g., extensive pasture land and reserves of ferrous and non-ferrous metals), its resourceful people, and its strategic location between the East and West. But they also understand the challenges. First,the country is behindits trading partners and competitors, although more insome areas than others. Second, the experience of some o f the oil-rich economies have not been good (e.g., Saudi Arabia and Venezuela), despite commendable goals that these countries adopted (Figure 22). Inparticular, the gains inincome per capita and diversification could not be sustained because the various policies did not match the goals that were set. Unfortunately, because o f the long business cycles observed by oil prices, it was only after more than a decade that these countries realized their economic policies were not working. Long periods o f highoil prices m a y mask underlying problems for a long time, only for those problems to come back with a vengeance once fortunes are reversed and prices go into a prolonged slump. It i s thus key to push through the reform process ingood times, so as not to be caught out when revenues slump and harsher measures will have to be taken when times are bad already. 18 Figure 22: Growth Experience in Selected Oil Rich Countries enezuela Productrvrtyper worker mthe norroil economy Saudra Araba PPP per capaa 4 u s i 7J l e O Q l - ~ __ 1950 lexico: PPP GDP per capita Indonesia:PPP GDP per capita d 6467 4 R i782 'I1 Source: Hausmann R., Rigobon R. (2002), "An Altemative Interpretation o f the `Resource Curse"' Theory and Policy Implications", National Bureau o f Economic Research, Working Paper No. 9424. 19 111. THE STRATEGIC POLICYAGENDA A. POLICYCONTEXT 1. Current Policy Stance 43. Plenty of initiatives. To achieve their strategic goals (Paragraph 11) the government has launched an ambitious policy agenda summarized in long-term plans (Kazakhstan 2010 and 2030), and inthe Indicative Plan o f Social and Economic Development for 2005-2007 (IPSED),13 Medium-Term Fiscal Framework for 2005-07 (MTFF),Basic Directions for Monetary Policy for 2004-2006, and sectoral programs such as: Rural and Agricultural Development Program Industrial and Innovation Program Reform and Development o fthe Public Health System Development o fthe Educational System Development o f Science and Innovations Telecommunication Program Housing Policy Development o fthe City of Astana e-Govemment program 44. Strategic choices still unclear. While the objectives and principles that have beenlaid out inthe various programs are appropriate, three strategic questions have not been addressed directly: i.Howmuchoftheoilwindfallwillbesavedandhowmuchwillbespent? ii.Whataretheprioritiesforspendingthoseamounts(togetherwithgovernmentrevenues from other sectors)? ... 111. What role should be ascribed to the government to increase competitiveness innon-oil sectors? And how much o fthat role i s to be played through expenditures as opposed to policies? 45. The answers to the above questions are important for two reasons. First, they will help the authorities balance efforts among the six buildingblocks o f competitiveness presentedin Chapter 1. Second, they will help select the types o fpolicies that are supported within each individual area o f competitiveness. l3Key elements of the IPSED for 2005-2007 include, inter alia, WTO accession, intemational standards in the financial system, regulatoryprinciples that stimulate the adoption of power and resource-savingstechnologies, and improving the economic and social infrastructure at the aul (village) level. In addition, the IPSED also envisages that comprehensivemeasures will be taken to: (1) implement the Agro-Food and the Industrial and Innovation Development Programs; (2) modemize the science, education and professional development systems of the population; ( 3 ) develop industrial and social infrastructure; and (4) foster small businessesdevelopment. 20 46. The evolution of spendingpriorities. Choices have, o f course, been made inthe past few years inregard to the above three questions, and future directions are indicated inthe MTFF and IPSED. On the base of these we can characterize such choices as follows: Cautious steps: the 2001-03period. This period can be characterized by frugality and cautious public spending choices. As illustrated inTable 4, Kazakhstan saved 63% o f its oil-windfall inthe NFFK, which by all standards represents a remarkably prudent fiscal stance. As for the priorities, public investment was boosted from 2 to 4% o f GDP during this period. These investments focused on roads, rural and agricultural development and, the capitalization o f funds and enterprises under the industrial policy. To achieve this within a relatively tight level o f spending, recurrent outlays were compressed. Consequently, real wages and pensions were kept relatively constant between 2002 and 2003. Growing confidence: the 2004-05period. Judge against the recently approved budget for 2005, tight fiscal policy has been abandoned. Only one third o f the o i l inflows are expected to be saved and government's debt i s expected to increase as a share o f GDP. However, since oil price assumptions inthe budget are conservative, it i s likely that ex- post the level o f overall savings achieved could be slightly higher than what has been projected. At the same time, the focus on transport, agriculture, and industrial policy are expected to be maintained, but housing has become a stronger priority-its allocation was raised to the level o f that o f agriculture. Although the importance of industrial policy inthe budget decreased, the focus on it has not. Instead o freceiving further capitalization, institutions like the Development Bank o f Kazakhstan (DBK)have started to raise capital overseas. Inaddition to an increased level o f spending for 2004, non-oil taxes were reduced and thus the non-oil deficit increased. For 2004 tax reductions were across the board (VAT, and social tax). Further tax reductions for non-oil sectors were recently approved, and were targeted to specific economic industries (e.g., petrochemicals) or to firms located incertain areas (e.g., technoparks). for various targeted populations ~ ~~~~ ~~ ~ ~~~~ ~ ~ Figure 23 Kazakhstan'sState Budget SpendingIn Major Categones (disabled, newborns, etc.). As a 800 - m IhlCrCIl consequence, pressures to increase 700 001herimcl Vel expenditures are mounting. 600 - B 500 0 Trmspon and 47. Figure23 summarizes the E cOnlIunrdilOn 400 changes inthe level o f spending as 5 300 well as the shifts inpolicy priorities for ?O0 the entire 1997 to 2007 period- 100 - 0 21 dollar has not eroded as much. Table 4: Kazakhstan:Use of OilInflowsand OverallSpendingPriorities,2000-2007 2000 2001 2002 2003 2004 2005 2006 2007 Actual Actual Actual Actual Prelim. Proj. - a Proj. a Proj. a Total oil inflows, YOGDP 3.2 8.0 5.0 7.4 6.1 5.9 4.7 4.0 Total oil inflows, % of total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Saved inNFRK 0.0 70.9 54.6 63.7 40.5 21.1 6.3 -2.7 Spent through budget 100.0 29.1 45.4 36.3 59.5 78.9 93.7 102.7 Total expenditure, YOGDP 22.8 23.0 21.4 22.5 23.4 25.6 24.1 24.0 Total expenditure YOof total d, 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Economic classification: Current expenditures 91.8 90.7 83.8 80.2 76.5 71.9 75.4 76.9 Capital expenditures 8.2 9.3 16.2 19.8 23.5 28.1 24.6 23.1 Functional classification: GPS e, Defense, Public order 17.9 21.1 20.7 21.4 20.9 20.6 20.8 21.6 Education 14.7 15.2 15.6 15.6 15.3 14.8 15.3 16.7 Health 9.4 8.9 9.2 9.4 10.5 11.5 12.3 12.5 Social security and welfare 29.7 26.7 25.9 25.0 21.9 21.8 22.5 21.6 Housing 3.8 4.4 3.2 3.6 5.5 7.0 6.8 6.7 Agriculture 2.0 3.3 3.7 4.9 5.8 6.6 6.8 6.2 Industryand construction 1.2 4.5 2.1 6.5 2.8 5.2 3.4 2.8 Transport and communication 6.6 6.3 7.4 8.6 8.4 7.4 8.1 7.9 Other 14.6 13.4 13.7 11.0 11.5 10.4 7.6 6.7 Memorandumitems: Total public debt to GDP, YO 25.5 20.4 17.7 15.0 12.1 12.3 11.4 10.5 Average monthly pension 4462 4565 5011 5964 6570 8762 8560 8367 Average monthly wages g, 9669 11238 12109 12478 14835 ... ... ... Source: World Bank staff calculations based on the official data from the Kazakh authorities, ai 2005-07 Medium Term Socio-Economic Development Plan and 2005-07 Medium Term Fiscal Framework (updated in March 2005 to reflect possible amendments to the 2005 budget). b/ Oil tax revenues(CIT, excess profit tax, royalty, bonuses and PSA receipts), investment income and capital revenue (sale of oil shares and similar transfers) saved in the National Fundof the Republic of Kazakhstan (NFRK). c/ Oil tax revenues (CIT, excess profit tax, royalty, bonuses and PSA receipts) spent through the State Budget. di ExcludingNet lending. e/ General public services. fiIncludingFinancialassetsoperationsiCapitalizationofdevelopmentinstitutions. gi Constant tenge of 2000. hi Public sector, including civil servants, and health and educationworkers. 22 2. Additional Considerations 48. Positive savings by the state budget. The increase in spending over the past four years has beenbased o n slowing down the pace of savings, rather than on borrowing against future oil income. The government's consolidated fiscal balance has been in surplus since 2001, and the overall level o f public debt has fallen as a share o f GDP. 49. But the net savingsposition of thepublic sector is unclear. Although the State Budget remains in surplus, the public sector as a whole may not be. Given that the Development Bank, the Mortgage Corporation, the national companies, and the NBK,have all increased borrowing, the overall public sector's savings could well be falling or even be negative. The Economic Council o f the government needs to carefully monitor and evaluate these trends. Since there i s no central quality control on the expenditures financed by the aforementioned institutions, the expenditures may not all have an equally sound pay-off, nor i s it clear that they reflect the country's policy priorities. 50. Role of the Government. Findingthe appropriate role o f the government inpromoting competitiveness will still require further analysis at general and specific levels. The evolution of spending suggests that the government has gravitated towards a greater role for itself (Le. spending levels have increased from 22% o f GDP in2000 to 26% o f GDP in 2005). The number of state-owned financial institutions has also increased and with that the scope o f extra-budgetary financial interventions. A greater role may bejustified for those situations (e.g., agriculture, transport, health, and education) where the government may have previously withdrawn to an undesirable extent. However, a proliferation o f extra-budgetary activities has inmany countries eventually led to loss o f fiscal control and serious adverse macroeconomic consequences. The trend i s certainly worrisome. 51. Quality ofpublic spending. The quality o f spending is more likely to deteriorate when spending grows too fast. This i s especially true if concurrent investments ingovernment capacity to prioritize and manage public spending programs are not made (e.g., local governments, line ministries, public investment management). The rapid increase inpublic spending may well be straining the Government's capacity to implement the new policies without jeopardizing the quality o f spending. Effectivenessof spending programs of course not only depends on the quality o f the institutions that manage the funds, but also on the quality o f the underlying sectoral policy. Clearly, just increasingresources to, for example, agriculture or education may in fact lead to more waste and less growth when the underlying sectoral policies are misguided and/or not yet reformed. (see Boxes 1 and 2). 52. The importance of settingpriorities. Since the various initiatives (whether health, education, or e-government) add to claims on scarce public resources, both human and financial, it is important to prioritize. While at first sight it may appear that thanks to highoil revenues there are no trade-offs. However, trying to implement too many programs at the same time will unavoidably reduce the quality and depth o f the work. Building consensus around the most important elements o f competitiveness is, therefore, o f the utmost importance to ensure resources remain focused on areas with the biggest payoff. 23 53. Defining implementation arrangements. At the general level, it i s important to define the role o f the government in addressing key bottlenecks to competitiveness. Insectors such as telecommunications and transport, much can be accomplished through policies that attract investments from the private sector; but, funds need to be given to strengthen specific functions o f government, such as regulation. Inmost cases, impediments to competitiveness can be addressed by policies rather than by more money. Since, thanks to oil, fiscal revenues are not likelyto be a tight constraint inthe short run,there will be a temptation to resolve problems by simplyby allocatingmore funds, through the budget, SOEs, or through other mechanisms. At the specific level, it is important that specific agencies be made responsible for specific pillars or spendingprograms, to avoid bureaucratic delays and redtape (see Box 3). 54. Building consensus. When making decisions about the level o f savings, spending priorities, and the role of government, sufficient national consensus needs to be built. Building consensus increases sustainability. This i s not an easy task, and inmany ways the right process to derive answers to these questions may bejust as important as the answers.I4 Since concentrated efforts over long periods o f time will be needed to `fix' any one area (e.g., infrastructure or human capital). The downside o f not setting clear priorities i s that the country i s loosing and will continue to lose. 55. Inthe next section below we discuss ingreater detail the policy options for two o fthe six areas o f competitiveness: (1) economic management; and (2) sectoral policies, inparticular, focusing on two specific areas: the linkages between oil and non-oil sectors and telecommunications. l5 14This issue refers to the political economy o f fiscal policy and economic management inoil exporting countries, for which there i s an extensive literature (see, for instance, Eirfert, Gelb, and Tallroth, 2002). It is also important for modern industrial policies, where the diagnostic and the process o f consultation are often as important as the actual choice o f promotion tools and policies. I'Under this year Joint Economic Research Program, the World Bank is preparing sector policy pieces for transport, education, and health. 24 _ _ ~ -_- __ Box 1: What Kind of State Support for Agriculture? While the oil sector generates high revenues but little employment, agriculture i s at the other end of the spectrum. Since agriculture has below average productivity, it generatesrelatively more employment (22% o f the total) than revenue YO of the total GDP). Inaddition, agriculture is pro-poor as it generates employment inrural areas where poverty is concentrated.This, and the fact that a volatile real exchangerate threatens this important source of employment, is a powerhl argument for justifying investing part ofthe oil revenueto support agriculture. In Kazakhstan,the agricultural budget has increasedsevenfoldduring the past 5 years. Inrelative terms, it increased from one percent of the national budget in 1998 to eight percent in2003. Yet, inthe context of the discussions leading up WTO accession, and during budget hearings, the debate on what kind of support the government should provide to the sector is ongoing.No one disagrees with the objective of boosting agricultural productivity so that agribusinessremains competitive even with a stronger exchange rate, but the means for doing this are not clear. Many developedcountriesprovide farmers with avariety of budgetarysubsidies(e.g., for inputs. for prices, for production) and strongtrade protection. Their aim is to compensatefor the shortfalls incompetitivenessthat local producershave relative to foreign ones. Subsidiesare relatively easy to implement even with weak institutions and are politically appealing.But it creates "welfare dependency" and destroys all incentives to innovate. An alternative approachhas been followed by New Zealand, Australia, Chile and others, whose agricultural sector becamevery competitive without introducing any major subsidization scheme. Fromthe start, the budget ofthese countries was tight; they could not afford expensivesubsidies schemes. These countries also did not want to reduce the incentivesthat entrepreneursneed to achieve efficiency. Thus, public support inthese countries focused mainly on assistingfarmers through the provision of public infrastructure (e.g., irrigation, feeder roads), research and development, farmer-driven extension services and quality enhancement mechanism, insurancefor a very specific set of risks faced by farmers, and helping farmers to organize themselves in associationsthat provided certain services (e.g., milk collection centers and marketing). In a country expecting a significant oil windfall, with limited institutional capacity, and facing pressure from rural areas due to the real exchange rate appreciation, it will be difficult to avoid adopting the first approach.Still the risk is there that agriculture will become permanently dependent on transfers from oil and other sectors and will not survive inthe event of a fall in oil prices. To avoid this, Kazakhstanshould not overlook the strategy followed by the second set of countries.In both cases, it will be spendingsignificant amount of resources in rural areas, but one may Drove to be more sustainable than the other. 25 , ..........................,... , ........................... ........................................ .................... ..................................... ......................... ... ................... ......................... ........................................................................ .... ........... ....... . ... ....... .................................................. , Box 2: Strengthening the Contribution of Education to Kazakhstan's Economic Transformation I Aggressive exploitation of Kazakhstan's petroleum resources will involve much sharper changes in labor-market skillneedsthan the other CentralAsian countries will face. Kazakhstan'scurrent educationand training systemis ~ still characterizedby rigidities inherited from the soviet system. Educationprogramswill needfar more flexibility than they currently have, and life-long leaming opportunities will needto be developedrapidly in order to prevent skill shortages from emergingas aserious constraintto Kazakhstan'santicipatedgrowth. The goals of the education reform. Kazakhstan's educationreform aims to supportthe country's economic transformation by: a) movingto a new concept of lifelong leaming, and b) making Kazakhstan's educationsystem i appropriateto the "global educational environment". The second of these objectives has two aspects: - First, to develop an educationsystem which supplies the labor-force and life skills which will make Kazakhstancompetitive inthe rapidly evolving global economy, in which Kazakhstan's role focuses on high- ' I technology industries andhigh-value exploitation of its natural resources -- especially, its petrochemicalsand mineral resources, and 8 - Second, to equip its citizensto function effectively inthe new information age. All of the transition countries aspire to these objectives. But few of Kazakhstan's neighborshave the means to achieve themthat Kazakhstandoes. Fewer still have focused on these objectiveswith the same level of commitment and determination that Kazakhstanhas. For these reasons, this educationreformplan is a crucially important opportunity for the country. Apart from the benefits that it should provide to Kazakhstan's people, it could serve as an exemplar for educationreform in all the transition countries. But the educationreform will be more likely to attain its objectives if it includes a serious effort to address the following needs. More resources for core education programs and inputs. Kazakhstan'sinherited education system is traditionally very strong inbasic science and math skills. But the quality of basic science and math programs has beenundermined by resourcedeprivation and neglect over the past decade. The lack ofbudgets to maintain science and laboratory equipment inschools is part ofthe problem. The decline ofteacher salaries - both in absoluteterms and inrelation to other professionswhich use the same skills - i s even more serious. It has made it difficult to attract and retain competentteachers. It has also required many teachers to take on additionaljobs in order to supplementtheir income from teaching, effectively marginalizing and de-professionalizing their teaching. This decline inteacher salaries will underminethe educationreform unless it is reversed. More attention to educational approach. At present, the educationreform is too focused on structural change, and gives too little attentionto the content and approach of education. It also gives too little attention to the incentiveswhich are necessaryto bringabout the neededchange. The provision of education is focused on accumulation of knowledge intraditional areas and gives too little attention to the skillsthat are in greatest demand inthe global economy. The current educationreformsees this problem largely interms ofthe needto add new subjects to the curriculum. It is of course important to develop and strengtheneducationprograms innew subject areas like economics, business, information technology, and it is entirely appropriatethat these programs are expanding. But a more basic question i s how the teaching and leaming processesneedto change in order to equip school leaverswith the skills they will needto adapt successfullyto rapidly evolving skill requirementsinthe labor market. Increasingly, success inthe global labor market will require higher-level skills insynthesis and application skills for problem solving. It will also require more emphasis on teamwork and communication skills, including effective communication in foreign languages. Formal education and life-long leaming needto stimulate inquiry, critical thinking, teamwork, and application skills. They needto encourage peopleto ask the right questions and to equip them to find the right answers to those questions. 26 Box 2-Continued A new role for teachers. These changes inthe approachto teachingand learning imply a fundamentally transformed role for teachers. Getting teachers to take on this new role and to do it well will require a major effort to change pre-service and in-serviceteacher training andteacher support. It will require a new generationof educationmaterials. Most importantly, it will require the professionalization ofthe teachingprofession, involving new performance standards for teachers, new forms of supportto equip them to attainthose standards, and better material rewards (including higher salaries which are linked to teachingperformance). Providing the incentives for change. Incentivesare akey instrument for successful educationreform. Salary and professional incentives for effective teachingunderthe new approachare crucial. Another powerful incentive instrument to drive education reform i s the use of external assessment of student achievement. Ifimportant outcomes like university entrance, or teacher salaries, or school budgets -depend on the results of external - examinations, examinations can be usedto bring about desiredchanges in learning outcomes. Inthe United States, for example, secondary schools stress application skills becausethey figure prominently inthe examinationswhich most universities use to admit new students. Participation inthe OECD's PZSA international student assessment would help motivate the new application-oriented approachto teachingand learning. Improving education equity. Inall of the transition countries, decentralizationof education management and the diversification of education financing (including requiring parents to purchase or renttextbooks that formerly had beenprovided free) have led to increasingdisparities in school resources and school performancebetweenricher and poorer communities. Rural and remote schools are consistently less well equippedand perform at lower levels than urban schools. Rural schools suffer from smaller community contributions and higher unit costs (because of smaller class sizes) than urban schools. The educationfinancing formula and other elements ofthe education strategyneedto specifically provide for the needs of rural schools and schools inpoor communities. Integrity. Integrity has suffered inthe educationsystems of all the transition countriesbecausethe collapse of resourceshas caused some teachers and school administratorsto solicit informal payments in order to finance essentialeducational inputs and to supplementtheir income. Often, this situation leads to perverseincentives, including the incentive to teachers to withhold part ofthe curriculum inorder to motivate paid tutorial instruction. Sometimes, it leadsto clearly corrupt practices, such as selling grades or admissionto university programs. These practices are detrimental to any educationsystem. They underminethe credibility of education and deny serious teachers and students the recognition that they deserve for their efforts. The elimination of these practicesshould be aprominent feature of the Government's educationreform. Determining university admissionthrough high-quality external assessment is one instrument for restoring integrity in educationprograms. Another is to publicize and enforce strict sanctions for abuse. Less obtrusive interventions should also be used, such as raising schools' accountability to local communities by publicizingthe amounts and uses of finds received from parental and community contributions, and developing a self-managedaccreditation process for higher education institutions. 27 ,,.......... ,.,..... ........,.....,., ........... ...... ........ ............................... , , , ............................ .............., ......... ........ . ... ............. .......,..,. . , ...................... .,......................... ,...., ........... .....,... . .. ... ....... ....,. ., ,...........,.. I Box 3-Approaches to Industrial Policy Available savings and the level o f financial intermediation inKazakhstanhave both improved significantly over the i last few years. However, investments innon-extractive industries, which are essential to reduce the volatility I associated with oil prices and to spread the benefits o f growth to the population, remain stagnant. Rightly, the : authorities' objective i s to accelerate the pace o f economic diversification. For its industrial and diversificationpolicies, Kazakhstanneeds not to follow the example set by East Asian countries 50 years ago, nor that o f LatinAmerica around the same time. Instead, the country should develop an "industrial policy" along the basis of: (1) modem "business promotion" initiatives; (2) good macroeconomic management (interest rates, taxation, and conservative management o f the oil fund proceeds), and improved infrastructure. Modem "business promotion" initiatives focus on issues (Le. promoting steady gains inproductivity and competitiveness inthe non-extractive sectors) rather than sectors. I The first task o f industrialpolicy is to gain greater understanding about the reasons why credit and capital markets j are not channeling greater amounts o f resources to non-extractive industries and, what i s most important, to outline and rank the most significant (non-financial) bottlenecks faced by non-extractive sectors. Then interventions can be developed-hosted by the newly created development institutions, such as: ~ ! 1) Fostering opportunities by improving business environment and trade policies, while at the same time develop an i infrastructure to assist micro and SMEs to adequately use these opportunities. The subset o f proactive policies that j appears most relevant for Kazakhstan's present conditions are related to promoting: -The creation, integration and strengthening o fproductionchains (starting, butnot limited, to oil and other extractive industries and government procurement); - Technological modernization (equipmentand know how); - Private sector investments inhuman capital and research and development (R&D); and - Assistance to collective arrangements o f micro and SMEs, such as policies to support including integration o f production chains, clustering, and network o f enterprises (groups o f firms using combined resources to cooperate on ,i joint projects). 2) Giventhat the non-oil industries inKazakhstan are dominated by a few conglomerates, and key other sectors are i still based on highly integrated industries, it also appears to consider the need to promote and protect competition through: - Strengthening the institutional arrangements to enforce anticompetitive provisions ~ i - Promoting spinning offs inprivate conglomerates , 3) Targeting specific industries under the umbrella o f "production chains", rather than under the umbrella o f i . investment and credit policies. For instance: - Mexico targets the production chains o f eight sectors: 1) high-technology industries; 2) the automotive industry;3) light manufacturing; 4) the petrochemical industry; 5) mining; 6) agribusinesses; 7) forestry; and 8) public sector providers. - Colombia targets significant non-traditional exporters that are threatened by external competition (e.g., cotton- fibers-textile-apparel, leather-leather manufactures-footwear, automotive parts-cars, sugar cane-sugar- confectionery-chocolates, oleaginous seeds-cooking oil-fats-soap, aquaculture, tuna production, toiletries, cleaning products and cosmetics, and potatoes and their industrial processing), and those value chains that generate important linkages and are significant inthe country's intemal trade (petrochemicals and plastics; steel; electric and electronic appliances; forestry, wood products, and furniture; vegetables; fruits and their industrial transformation; cocoa and chocolates; beans; rice; shrimp; fish; cereals; dietetic foods; poultry fanning; porcine production; dairy fanning; medical services; engineering services; consulting services; software; tourism; jewelry; and crafts). 28 Box 3-Continued 4) Developing new avenues to increase the access o f m c r o and SMEs to credit and know-how including fostering FDIto non-extractive sectors and, as mentioned earlier, by evaluating options to foster R&D andhuman capital investments by private firms. It should, however, be noted that the most obvious policy interventions to promote competitiveness (or offset the potential loss o f it that could come from Dutch disease type o f developments) will need to be used first, such as reducing inflation and the cost of capital (through monetary and fiscal policies), and the cost o f doing business (through reductions in taxes and red tape). The govemment must also carry on well its normal duties: (1) tax policy and collection; (2) provide key infrastructure (following strict Economic Rate o f Retum analysis), education (with some specific initiatives to match skills with labor demand), health, and social protection; and (3) safeguard macroeconomic stability by maintaining its conservative approach to fiscal management, the management o f oil revenues, and the regulation o f pension funds. Against these vast needs of legitimate public interventions, there appears to be a need to temper the expectations about the amounts of resources that the Government of the Republic of Kazakhstan can in reality devote to actively promoting industrialpolicies. Modern "business promotion" initiatives are in any case relatively cheap (if appropriately monitored and supervised during the implementation phase) although intensive in process. B. THEECONOMICMANAGEMENT FORCOMPETITIVENESS16 AGENDA 1. The OilWindfall: Benefits andRisks Figure 24: PotentialOil Production 1999-2035 56. Kazakhstan i s at the front 1 4 0 - end o fits oil windfall (Figure 24). The windfall i s a net benefit to society since oil revenues will lift the traditional constraints that availability o f fiscal revenues and foreign exchange pose to development. But oil i s often a mixedblessing, because the $9 %@ ~ .$+P associated capital inflows and fiscal 1 &)"%@ $+ +dQ@9 .e." revenues complicate fiscal, I 0 On-shore OfFshore policies-and monetary, andoften financial sector I - ~- weaken public Source: World Bank staff calculations. policies and institutions 57. Estimates ofthe oil-related wealth." These range from US$ 27 billion to US$ 96 billion, dependingon the specific path o f key variables over the next 20 to 30 years including, among others, oil prices, total economic reserves and extraction profile, cost of extraction, pace of company-level investments, and the rate of return on the assets inwhich oil-related wealth i s maintained (see Table 5).lS Converted inper capita terms, this wealth ranges from US$1,800 to l6This sectionbuilds on BackgroundPapers No. 3 andNo. 6. "Defined as the net present value of oil-related fiscal revenue flowing into the budget or the NFRK, plus the current level of assets in the NFRK, and minus the public and public guaranteed debt. ''This work is basedon the IMF (November 2004) and the WBiIMF oil-fiscal model. 29 average annual rate o fretum o f about 4 percent can be achieved on this wealth, Kazakhstan could increase its level o f spending by between $72 and $260 per person a year. This i s not large relative to the expected per capita spending o f about $750 in2005 (see Figure 23 inthe previous section). 58. Wealth is small and uncertain. Oil wealth inKazakhstan i s small inper capita terms, even ifreserves prove to be large and prices end up being high. This i s because Kazakhstanhas relatively high extraction and transportation costs, currently ranging from between $10 to12 per barrel. Also, most o f the oil wealth comes far inthe future and i s subject to highlevels o f uncertainty: it changes significantly with relatively minor changes inkey parameters. Clearly, the priority for oil and gas sector policy makers inKazakhstani s to ensure that the expected oil production materializes as planned, without technical or transportation disruptions. This way, the uncertainty of oil wealth will be reduced mainly to that coming for world conditions and oil prices. Table 5: Kazakhstan:end-2002 Net Wealth Under Alternative Assumptions Constant US$ million at 2002 prices Total Oil Reserves' Oil price (Brent), Net oil Net oil wealth Annuity US$/bbl' wealth per capita per capita3 ~ HighCase: 7.4 bln tons or 21 960S8 6490 260 53.9 blnbarrels 19 75576 5107 204 16 47716 3224 129 Base Case: 4.8 bln tons or 21 67012 4528 181 35.2 bln barrels 19 52012 3514 141 16 33543 2266 91 21 47160 3186 127 L o w Case: 4.1 blntons or 29.6 blnbarrels 19 38631 2610 104 16640 I800 72 ~ I 6 Source: World Bank staff calculations. Note: In addition to the assumptions about oil prices and exploitable oil reserves, the above simulation makes assumptions on the profile of the extraction, the pace of investments,the taxation regime in the PSAs, and the financial and operational decisions of the operators. Each ofthese may change the path of revenue to the govemment. ' Onshore petroleum reserves are estimatedto be 2.5 bln. tons (without taking into account the possible upward revision ofthe Tengiz oil reserves); Kashagan alone is estimatedat 1.7 bln. tons. In addition, the oil recoverable reserves in Kazakhstan'ssector of the Caspian Sea are estimated at 4.4 bln. tons according to the Caspian Sea Development Program. Thus, the working assumptionfor reserves ofthe government is about 6.9 bln tons, or close to the high case. Proven reserves are much lower as Kashagan has not yet come on-stream. Of course, whether these reserves are economic or not-particularly those offshore-will depend on oil prices. We assume oil pricesto be between SI6 and $21 per barrel of Brent over the long term (20 years), which is an interval that contains the average and median prices for oil over the last 50 years. This annuity can be interpretedas the sustainable level of per capita spending.The assumption is that oil wealth will yield an annualreturn of 4 %, and that the discount factor is also 4 percent. 59. But associated capital inflows will exertpressure on the macroeconomicframework. By the time production peaks in2020 the country could potentially receive betweenUS$ 3 to US$ 7 billion annually for well over two decades." Kazakhstan has begun to face, and will 19See IMF Country Report 041362, November 2004, and, inparticular, Chapter 111,An Analysis o f Kazakhstan's Petroleum Potential (www.id,org). 30 continue to face, the economic pressures that actual and potential future oil-related capital inflows pose to the macroeconomic framework. 60. The downside of spending. While Kazakhstan's social or economic needs are high, care should be taken not to spend too much in good years, only to have to cut back severely inbad years. Such a volatility of public spendingcreates real exchange rate volatility, damaging the investmentclimate innon-oil sectors. And excessive spendingin"good" years may leadto overheating and the associated "Dutch Disease" problems. As oil income i s spent inthe economy (either through fiscal, monetary, or credit expansion), the local economy could `overheat', which inturnmay leadto excessive exchange rate appreciation. The extent o foverheating will o f course dependon the degree o f unusedcapacity inthe economy (labor and capital), and the degree o f development o fthe economy (the greater the level o f industrialization, the greater amounts o f oil inflows that the economy can absorb productively). 61. Once oil spendingtakes off excessively (i.e. above levels that can be sustained once oil prices come down), real wages and the exchange rate rise (appreciate) above sustainable levels. This will exert pressure on agriculture and manufacturing, whose output will decline inrelative terms. The demand that oil-financed spending supports, also tends to create bottlenecks in skilled labor, infrastructure utilities (water, electricity, telephones), housing, and real estate. Often the fiscal expansion creates inflexible social or infrastructure related spendingprograms (e.g., Mexico and Holland), that are difficult to adjust when oil prices fall; and almost always the quality o fpublic spending deteriorates (e.g., Venezuela, Saudi Arabia, and Nigeria). 62. Overheating in Kazakhstan is possible. Since the non-extractive economy inKazakhstan i s relatively shallow and its labor force small and expensive (relative to its productivity), the country i s at tremendous risk o f overheating despite its recent good macroeconomic performance. There are currently three major drivers o f increased demand pressure: (1) large (FDIfinanced) oil investments,(2) fiscal andpublic sector expansion (Le. the government and SOEs); and (3) a credit-fueled private boom. 63. Ongoing investments inthe oil sector are estimated to be US$4 billion per year for the rest o f the decade. While much o f this spending i s on imports and hence does not put pressure on domestic resources; there i s in fact, a domestic component that i s both direct and indirect (inter alia, through the domestic expenditures o f expatriate workers). At the same time, public spending by the Government grew 21 % inreal terms in2003,17 % in2004 and is expected to grow by 18 % inreal terms in2005 (see Table 6). 64. Also, total loans by commercial banks, in constant prices, grew by about 42 % last year (see Table 6). This i s a major credit boom by international standards and, unlikethe growth in 2000 and 2001, cannot be explained as a rebound after a currency collapse. Inpart, this expansion i s accelerated by capital inflows, which are attracted to Kazakhstan given the improvement ineconomic prospects. Dollar-denominatedborrowing i s also stimulated by the fact that expected real appreciationmakes the anticipatedreal interest rate on dollar loans very low. 31 Table 6: Kazakhstan: Key Economic Indicators, 2000-2007 2000 2001 2002 2003 2004 2005 2006 2007 Actual Actual Actual Actual Estim. a Proj. a Proj.a Proj.a 1.Fiscal Indicators : Overall fiscal balanceb, % GDP -0.1 5.4 3.1 4.0 2.3 -0.6 -0.3 -0.7 Non-oil deficit `, % GDP -4.2 -3.2 -2.6 -3.7 -4.0 -6.6 -5.0 -4.7 Real growth o f spending, % change 12.7 16.1 2.2 20.8 16.8 18.2 1.0 6.6 2. Monetary and financial indicators, YOchange: Inflation (pa) 13.2 8.4 5.8 6.4 6.9 7.0 7.0 7.0 Nominal appreciation (-) (pa) 18.9 3.2 4.5 -2.4 -9.1 -4.4 0.0 0.0 Real appreciation (-) (pa) 8.6 -2.0 0.3 -6.2 -12.7 -8.9 -4.7 -4.7 Real average wage growth (pa) 4.5 16.4 10.6 7.0 14.3 15.2 10.1 13.3 Real broad money growth (eop) 32.0 36.4 24.6 18.9 27.3 16.3 11.5 12.0 Real banks' lending growth (eop) 80.9 66.7 28.8 36.2 41.8 19.7 13.9 14.3 Source: World Bank staff calculations basedon the official data from the Kazakh authorities. a/ 2005-07 Medium Term Socio-Economic Development Plan and 2005-07 MediumTerm Fiscal Framework (updated in March 2005 to reflect possible amendments to the 2005 budget). bi Including privatization to the budget and total savings inthe National Fund of the Republic of Kazakhstan (NFRK). ci Excluding oil revenue. di Period average exchange rate, KZTIUSD. 2. Policy Choices a. Fiscal Policy 65. The challenge.Fiscal policy will be the main channel through which the oil boom has its impact on the economy. This i s because the budget inKazakhstanwill be the main recipient o f Kazakhstan's oil income, either inthe form of tax revenue or, some time inthe future, dividends from shares inthe three major fields. There are also fiscal add-on effects, since imports of consumer goods increase, which inturn increases collection o f trade, excise and value added taxes. Oil inflows also fuel spending inconstruction and services such as transport, whose tax payments to the budget increase. Inthe face o f so much oil related public income, Kazakhstan may find it difficult to maintain: (1) budget discipline; and (2) the quality o f public spending. This has been a major problem inother countries after sudden upsurges o foil- and non-oil revenues. 66. Maintaining budget discipline. There i s a clear conflict between expansionary fiscal policy and maintaining a competitive exchange rate. While the fiscal expansion o f the past two years i s by no means a sign o fbudget indiscipline, it has fuelled demand for non-tradables, hence puttingpressure on their price and thus on the (real) exchange rate. A modest fiscal policy-one where growth in spending does not exceed real growth o f the economy, and the non-oil deficit is maintained, say, below 4 percent o f GDP'O-brings a number o f indirect benefits to the non-oil economy. First, it helps to implement monetary policy by not puttingtoo much pressure on the *'Amore rigorous calculation would need to be performed to determine the level o f the non-oil deficit that can be consistent with a relatively tight fiscal policy stance. 32 exchange rate; there will then be less need for sterilization and other interventions, so the NBKR can ease up on interest rates. Second, the economy will be shielded from the volatility inoil income. Third, by maintaining a bindingbudget constraint, it will force public choices and thus a better use o fpublic funds. 67. Thepolicy dilemma. Kazakhstan needs to find an appropriate balance between spending now and spending inthe future when deciding on how to use its oil windfall. On the one hand, the windfall could be used to support an expansionary fiscal stance that will aim at addressing bottlenecks, redistributing the oil wealth, or addressing social imbalances, but this could lead to overheating and reduced efficiency o f public spending. I t could lead to substantial waste if spending systems and the policy framework are inadequate. On the other hand, spending can be containedto help the economy cool down (like in China), but then Kazakhstan will, to a certain extent, be postponing the need to address important needs. Economic theory provides no guidance for finding such balance. Certainly, a well designed public investment program (on the basis of a full economic cost benefit analysis and in line with the absorptive capacity o f the economy and the Government's implementation ability) should proceed. Monetary authorities should only neutralize the macroeconomic effects o f an expanded investment program when these are expected to be transitory. 68. Instrumentsfor making choices. The government has two key instruments to reach consensus on the degree o f budget discipline: (1) the MTFF; and (2) the rules for accumulating savings inthe NFRK. 69. The MTFF needs to clearly focus on the choices that are made inrelation to: 0 The real rate of growth of total public spending (including local governments and, ideally, SOEs), inparticular, as it compares to the rate at which the economy can absorb the increase (e.g., vis a vis the expectedreal growth o fthe non-oil economy). 0 The magnitudeof the non-oilpublic sector deficit, as defined by the total expenditures minusnon-oil fiscal revenues; this is the proper measure o fthe external resources (from oil revenues or borrowing) that are being injected into the economy in a given period- either through an increase in spending or through a reduction inpublic non-oil revenues. 0 The priority spending areas over the medium-term(includingeasing the tax burden on non-extractivesectors). To do this, an effective systemto cost the various programs (most o f which are expected to take around a decade to complete) needs to be developed. Inthisway, the tables o ffunctional classification o fspending will accuratelyreflect the likely path of some programs-and provide an estimate o f the headroom for changing policy priorities. 0 The balancebudgetrule. As will be argued below, rules for the NFRKwithout clearly pinningdown the overall deficit position o fthe government will not work, as the government can save and borrow at the same time. T o avoid such case, the government will need to commit to runa budgetbalance under which the primary deficit (the overall deficit o f the state minus interest payments) i s equal to zero. This, in other words, imply 33 that oil will finance the entire non-oil deficit except for interest payments (currently at about 0.5% o f GDP) that could be financed through borrowing. 0 Ideally, the MTFF will bejointlyformulated with the monetary authorities to ensure close coordination o f fiscal, financial, and monetary policies. 70. Current NFKR rules should be improved. The current rules for placing resources inthe NFRKwould allow the government to deplete the balance ifprices were to fall significantly below $19 bbl., the rules are not applied consistently, as the definitions o f oil income and oil enterprises can b e easily changed ifthere i s the intent to save less or more than the rule currently commit the government to. Finally, although the rules look simple it i s actually quite difficult to compute: establishing the trigger point for contributions to the NFRK requires an estimate o f oil- related revenues, taxes, bonus payments, etc. that will be transferred to the Treasury by each o f the nine companies reporting to the NFRK currently. That the saving rule alone i s not enough to maintain fiscal discipline has been shown in2004: inflows to the NFRK are expected to be the lowest since its creation although oil prices are at their highest levels in a decade. 71. A much more important shortcoming of the current rules is that they can be undermined by the debt-issuance policy o fthe government. Thus, the govemment has occasionallyboth contributed to the NFRK and borrowed at the same time, thereby de facto reducing net savings below the level o f contributions. Infact, such behavior i s expected to take place inthe 2005 budget, when the debt o f the government i s expected to increase but there will be positive contributions to the NFRK. Obviously, if as much debt i s issued as i s contributed to the NFRK, then no net savings takes place; moreover, since the cost o f debt most likely exceeds the return on NFRK assets, issuing debt while contributing an equal amount to the NFRK deteriorates the position o f the budget even when it does not increase net debt. There are two possible balanced budget rules that will "tie up the hands" o f the fiscal authorities to some extent: 0 A balance budget rule under which the non-oil deficit o fthe state is financed entirely out of the NFRK (in fact it i s given by the formula explained below and, thus, given a level of revenue collection effort from the non-oil sectors expenditures will be determined residually). Inthis case, the level o f govemment debt (currently about $5 billion) will be constant indollar terms (except for real exchange depreciations o f the currency pool), but will fall rapidly as a share o f GDP. The pace o f gross borrowings-and inturnthe new commitments-will be primarily determined by the debt service due, but can also be influenced through debt swaps (e.g., extemal for internal debt, short term for long term) and re-openings. 0 A slightly softer variation o fthe above rule, under which the transfer from the NFRKwill finance the primary deficit (overall deficit minus interest payments), so the primary deficit, and not the overall deficit, will be zero. Inthis case, the level o f government debt will growth by an amount up to the interest payments, but it will still fall as a share o f GDP as long as the GDP continues to grow. 72. Inboththe above cases the deficit must be balancedover a business cycle rather than year by year. However, since oil-related business cycles could be unpredictable, the adjustment 34 for the business cycle could be made on the basis o f a simple three-year moving average. Obviously, control should be also exerted over the borrowing policies o f the rest o f the public sector (i.e. quasi-fiscal financial institutions and SOEs) because they, and not the state, are likely to account for the bulk o f the public sector's borrowings. Reporting to parliament their basic operation i s one way o f introducing some control ifparliament i s authorized to set an overall limit for their aggregate borrowing. 73. Thus, the current rules should be improved to adhere to the following objectives: 0 Maintain a rainy day fundthat will ensure the financing o f the budget duringbad times (Le. when oil prices are low or when export volumes are disrupted); 0 Stabilize the level o f government spending inorder to reduce real exchange rate volatility; 0 Save a part o f the oil revenue for future generations, inparticular those that will come after the oil boom; 0 Provide some control over the long-term level o f the fund (addressing the question o f how much money can a political system stash away without creating excessive pressures to change the rules); and 0 Facilitate the management o fthe Treasury and the conduct o f monetary policy within a givenyear. 74. Suggestedchanges. Rulewith the above properties i s described indetail inBackground Paper No. 6. The rule i s a combination o f two well-known approaches on how much to save and how much to consume out o f oil revenues: The Bird-In-Hand (BIH) rule where only the income earned by the NFRK will be consumed (Le. around 300 million dollars in2003); this i s the rule that Norway would like to eventually adopt, but it may be too restrictive for a country with vast development needs like Kazakhstan; and The Permanent Income (PI) rule which effectively suggests that the long-term returnon total oil wealth (whether this wealth i s already inthe NFRK or still underground) can be consumed (Le. between 1to 3 billion dollars a year depending on the assumption; see Table 5). This rule would lead to spending ahead o f oil revenues when oil revenues are expected to rise substantially; but such a rule would create major problems ifthe anticipated rise does not take place or comes later and/or i s less than expected. 75. Under such ahybridrule, combining the BIHand PIU approaches the annual amount spent out of oil revenues for a givenyear can be calculated with the following formula, where Y i s the amount spent out o f oil income annually, A i s a parameter estimated on the basis o fwhat can be consumed out o f total wealth, b i s a coefficient between 0 and 1,and F the level o f assets 35 saved inthe NFRK (at the end o f the previous year). By setting the parameterb to be equal to the expected long-term rate o f retum on assets, this part o fthe formula reflects the BIHrule: Y(t) =A +b * F(t-1) 76. By selectingvarious parameters for the rule, the government would be able to decide how much o f the oil windfall would be spent-and leave as a residual the amount to be saved (Figure 25). The specific value for the parameters will determine how much o f the volatility inprices and quantities will be transferred to the economy via the fiscal framework. 77. The asset management strategy. Since Figure 25: A Simulation of the new Saving Rule ~~~~ ~~~~~~ ~~~~~~~~~~ ~ ~~ ~~~~~~~~~~~~~~~~ Kazakhstan i s likely to accumulate sizeable Total Oil Revenue(T), Oil Revenueto the Budget (Y). and NFRK Assets (Ft). in billions of US$ resources inthe NFRK, it i s important that these (b=0.04) assets be invested wisely. The current 307 140 arrangement i s that the Ministry o fFinance (MOF) owns the NFRKbut it is managed by the NBK.This is a goodarrangement. Ifthe suggested rules are adopted, the organization o f the NFRK will need to be adjusted somewhat. The NFlUSwill need to be divided into two parts: one part that would be transferred to the budget during the year, and the other part would be the rest o f the fund. This i s because the new rules would require that all oil revenues go first Source: World Bank staff calculations. to the NFRK, and from there, a certain amount (given by the above formula) be transferred to the budget. Thus, the current division of the NFRK into savings and investment portfolio would disappear. 78. Under these new conditions, the entire balance inthe NFRK can be managed as `stabilization', except for the part that the budget will need to receive during the year (which would be known when the budget i s approved). To invest this `stabilization' part o f the NFRK, the NBK and the MOF would need to choose a set o f financial assets that would smooth the consumption out of total oil revenue-as opposed to only its financial component. This approach i s elaborated inBackground Paper No. 7. The key to this approach i s that the NFRK would be invested inthose countries and currencies that correlate the least with oil prices and, thus, hedge the country against oil fluctuations. 79. Safeguarding the quality ofpublic spending: creating the ability to spend efficiently ($or results) and effectively (least-cost). Despite an overall fiscal rule, and a rule for saving and spending out o f oil revenues, spending can be expected to increase and, therefore, the time i s now to ensure that its quality will be safeguarded. Progress has o f course been made interms o f improvingthe institutions for public spending (e.g., a new budget code was passed in early 2004), but the agenda is still vast. For instance, while the budget code requires that every investment program be subject to rigorous cost benefit analysis, inpractice neither government nor non-government institutions have the capacity to do so in accordance with international standards. Costing, inparticular i s an area where current government investment programs will need greater attention, as well as the thinking that needs to go into designing sound 36 implementation arrangements. The structures o f the Ministry o f Economy and Budget Planning should also be changed, as investments programs are the responsibility o f the debt management unit. The Ministry o f Economy and Budget Planning lacks also capacity to evaluate the various flagship programs o f the government (industrial development program, housing program, e- government program, health program, and education program) not for their merits, but for the results and effectiveness. Such capacity must be created for ongoing as well as new programs. 80. Other steps to be taken include allocating sufficient budget for the preparation of programs (e.g., a World Bank financed investment program usually requires between $300,000 to $500,000. The bulk o f it i s really for the government to prepare the program, including procurement and implementationplans, and cost it appropriately). Second, the pace o f spending should not grow too fast (both in sectors as well as in aggregate), as this always leads to a lower quality o f spending. Third, institutions for public spending must be strengthened, through, among other way, determined efforts to modernize and build capacity inthe civil service, line ministries, and local governments. The training o f civil servants should be revamped to focus on public expenditure management issues, such as procurement, financial management, evaluation of investment projects, and the monitoring and evaluation o f public interventions. Finally, regulations and institutions responsible for procurement, financial management, and accountability must be strengthened.21These are all areas where Kazakhstanwill need to make significant efforts not only to catch up with the standards adopted by the EU8 countries, but also meet the challenge of maintaining good spending policies. 81. Of special importance are the institutions responsible for the preparation o fpublic investment programs and asset and liability management, both o fwhich must be strengthened. The recently approved Budget Code includes a number o f sound steps for preparing and reviewing public investments o f the government; but, inmost cases neither the line ministries nor the economic authorities have the capacity (financial or human) to rigorously implement those steps with sufficient quality. 82. Afew safeguards for taxation. N o w is a good time to simplify taxation for the non- extractive sector, and possibly also to reduce the overall tax burden. However, if such a reduction i s based on a sectoral case-by-case approach (for certain industries or certain places), the integrity (and discipline) of the tax system i s jeopardized, creating loopholes and facilitating tax avoidance. Infact, this i s an additional lesson from countries that were unable to manage their oil-windfalls well: they loose control not only over spending, but also taxation. A detailed tax policy strategy needs therefore to be developed, which will consider the pros and cons o f the various options for reducing the tax burden innon-oil sectors. Our preference i s to continue to reduce taxes on labor and capital across the board and to widen (rather than reduce) the tax base for all taxes, including the VAT whose base i s eroded by a number o f key exemptions. A broader tax base will allow lower rates, which inturn will improve taxpayer's compliance, as Russia has shown clearly. As part of this general direction, the consolidation o f the social tax and income tax should be considered, with the bulk o f the collection staying with local govemments. But this issue requires further analytical work, specification and discussions. *' TheWB andthe MEBP have agreedto produce a Public ExpenditureandInstitutionalReview (PEIR).During the firstyear, the PEIR will focus onthe policies and institutionsfor the managementof civil servants, procurement, and intergovernmental relations. 37 b. Exchange Rate Policy 83. Oil income has a major impact on the exchange rate and the prospects o fthe non-oil sectors. Oil income will unavoidably exert upward pressure on the exchange rate unless every penny o f it i s invested abroad; and even then anticipations o f future spending may lead to upward pressure today. The issue i s not whether or not the exchange rate will appreciate, but rather the pace and manner at which it will do so, and the volatility that it displays inthe process. Inthe face o f a commodity inflow, many countries have seen their currencies become overvalued only to experience a foreign exchange crisis afterwards. This i s the type o f volatility that destroys manufacturing and agriculture. 84. Duringits short history as an independent country, Kazakhstanhas already experimented with a variety o f exchange rate regimes. The 1994 stabilization programwas successful because o f a credible monetary policy entirely built on the exchange rate as an anchor-an almost fixed exchange rate regime of a crawling peg type. This policy was maintained-with various minor adjustments-during the East Asia crisis in 1997, and the Russian crisis in 1998 in spite o f the large Ruble devaluation inmid-1998. Kazakhstan then made the strategic mistake o f maintaining a fixed exchange rate regime despite the significant loss o f competitiveness against Russia and countries that devalued with it. The overvaluation o f the exchange rate inthe 10months that followed the Russian currency crisis untilKazakhstan let the exchange rate float to find a new equilibrium inApril 1999, caused a severe recession. As a consequence, the NBK hesitates to claim it has any exchange rate target (implicit or explicit), although it admits that exchange rate stability i s a priority. 85. However Kazakhstan i s now, and will be inthe coming decade, in an entirely different situation than the one it found itself in after the Russia crisis. Rather than capital flights, fiscal deficits, and uncertainty, Kazakhstan i s facing a period o f strong confidence, fiscal surpluses, and growing capital inflows. In 1998, the monetary authorities faced the question o f how much to let the exchange rate depreciate, while today the question i s how much to allow the exchange rate to appreciate. While the pressures generated by capital inflows could be addressed by means other than the exchange rate policy (e.g., by controlling capital inflows), n o w i s the time to review the pros and cons o f different exchange rate regimes and the associated attitude towards capital flows-including the role that an (implicit or explicit) target on the exchange rate could play. 86. The current monetavypolicy stance is ambiguous. As highlighted inthe Basic Directions for Monetary Policy for 2004-2006, the NBKhas openly announced that it will begin to base its monetary interventions on a system o f inflationtargeting rather than "stabilizing" the nominal exchange rate and offsetting the impact of capital inflows through a policy o f sterilized intervention. However, actual practice has focused much less on inflation than on stabilizing the exchange rate for a weighted basket of currencies. The NBKhas tried to offset the ensuing capital inflows through sterilized intervention, buying large amounts o f reserves while issuing domestic debt. Outstanding NBK notes increased from a minimumamount in2001 to about $2 billion now. Thus, monetarypolicy and exchange rate objectives seem inconsistent. This ambiguous policy stance, combined with the rapid pace o f asset accumulation inthe government and the pension funds, has created significant expectations o f a strong currency revaluation-1 0- 15 years before the true oil windfall. 38 87. Current policies are unsustainable because Kazakhstan may end up facing two forces that lead to real appreciation beyond the long-run equilibrium level (initself not constant): loose fiscal policy (putting pressure on non-tradable prices) and tight money (appreciating the nominal exchange rate). Inthe end, the attempt to compensate expansionary fiscal policy with excessively tight money can cause a recession that not only stops the growth process but also destroys the non-oil tradable sector. The key i s to resist strong fiscal stimulus, by avoiding a widening o f the non-oil deficit and moderatingthe pace at which aggregate spending grows inreal terms. c. Supervision and Regulatory Policy and Policies towards CapitalInflows 88. The set o f rules and practices associated with official oversight o f financial institutions is very relevant in the context o f managing the oil boom. International experience suggests that large and volatile capital flows can exacerbate existing weaknesses inthe financial systems (see Background Paper No. 8). 89. The international experience. Prior to the 1997 crisis, East Asian financial institutions suffered from excessive rates o f leveraging, unhedged foreign currency debt, weak corporate and financial sector governance, and ineffective official supervision. InMexico, credit was growing eight times faster than GDP prior to the 1994 crisis. InArgentina, currency mismatch was extreme prior to the 2001 crisis. This i s not the case inKazakhstan, but it is not difficult to imagine this type o f behavior occurring amid the euphoria o f an oil boom. 90. Ifcommercial banks' in-houseriskmanagement systemswere developed, andifthe regulatory and supervisory frameworks were uniformly effective, the concerns that a country's banking sector would be adversely affected by the oil-related capital inflows would be much less, But the international experience suggests that these are not really prevalent conditions in most middle income countries. Some countries tend to allocate a fixed proportion o f loans to particular sectors (heavy industry, agriculture) on non-commercial terms, and this behavior i s worse ifthere exist ownership links betweenbanks and those sectors, or where government intervention or pressure i s strong. Economic policies that increase prices o f non-tradable goods will, inany case, provide incentives for banks to concentrate their portfolios on sectors (such as construction and real estate) that are known to be vulnerable to interest rate and cyclical fluctuations. 91. Kazakhstan is at risk. Banking supervision systems have beenput inplace rapidly in Kazakhstan, and the country i s following intemational trends to move to a fully integrated and independent financial supervision authority. Commercial banks are also making efforts to improve risks management systems. However, the financial sector inKazakhstani s at a cross roads. It can be a leader inthe CIS, but, at the pace that credit i s expanding, Kazakhstan' financial sector could also be tripped up by its o w n success. Part o f the expansion o f non-oil GDP is due to a credit boom fuelling private expenditure. At about 40 percent inreal terms, bank credits are accelerating at a very fast clip, raising a whole series o f financial sector issues in addition to concerns about the real exchange rate impact o f a sharp rise in expenditure stimulated through this credit boom. 39 92. Fast credit growth raises questions o f risk exposure bybanks; ifcredit expands too fast, quality control i s likely to slip. New loans (and the companies or persons taking them out) would beharder to screen, as the monitoring resources o fbanks are stretched. Inaddition, ingood times, it is easy to appear solvent, but this may change ifthe economic situation deteriorates. Findingout the capacity of firms to actually generate cash is compromised bythe fact that the banking system as a whole can capitalize all interests owed and still expand credit, without requiringfirms to actually give cash back to banks. Collateral appears ample as asset prices are high and rising. These factors can change very quickly once the economy enters into more difficult times. Firms' cash flows suffer, asset prices decline, thus collateral value decreases, and interest rates go upjust as the capacity o f firms to repay i s compromised. Indicators o f credit quality can turn from rosy to worrisome ina very short period o f time. Inthis context, when the situation turns bad, concentrated exposure to particular sectors, such as real estate, may cause serious banking problems. 93. Moreover, much o f this credit boom i s financed by foreign borrowing, leading to a significant exposure to foreign exchange risk. Although some o f the foreign borrowing by commercial banks i s siphoned off through NBK's sterilization operations, a substantial part of it i s passed on, apparently to a large degree as dollar-denominated loans. Ifthe foreign loans are on-lent inTenge, the bank may loose its capital ina currency crash, as the value o f its assets would decline relative to that o f its liabilities. Ifinstead, it lends indollars to firms that sell inthe domestic market it may achieve a mostly spurious degree o f coverage as currency risk i s disguisedinthe form o f credit risk.Firmsmay find themselves unable to pay dollar debts when the currency crashes. Inanticipation o f this concern, depositors may run on banks ifthey perceive a highrisk o f currency depreciation. Inthe end, the bank i s exposed to an exchange rate riskinspite o ftheir apparent coverage; exchange rate relatedriskis transformed into commercial risk,but it is still exchange rate related. On top o fthat comes the fact that Tenge-denominated loans are increasing even faster than dollar-denominated loans, which obviously directly poses exchange risk exposure issues. 94. To mitigate exchange rate and credit vulnerabilities, there i s a need for the fiscal, monetary, and financial regulation authorities to: 0 Adopt a packageof measures to slow down the pace of credit growth and banking sector expansion including, inter alia; the introduction ofreserve requirements on - foreign borrowing, and possible measures to signal the need for prudent cross-border lendingand commercial bank's offshore operations. These measures may increase lendingmargins inthe banking sector inthe short-term (on average), which initself are desirable, as it would reinforce the need to contain credit growth. Giventhe large availability o f capital inthe market, it i s unlikelythat such an increase inmargins will affect medium or large enterprises-but it may affect smaller business borrowers. 0 Make a concertedeffort to strengthenthe institutionalset up within and across agenciesthat will need to serve as the "eyes" and "ears" ofthe policy makers regarding structural and business cycle-relatedrisks inthe financial sector. Emphasis will have to beplaced on supporting efforts of the Financial Supervision Agency (FSA) to strengthen key functions including: comprehensive consolidatedsupervision, prompt corrective 40 action and resolution (including the role of the deposit insurance fund), and onsite examinatiodoff-site analysis inthe case o f both banking and non-banking services. Some elements o f the regulatory framework merit a review to ensure the F S A has authority to oversee and effectively control lending to related-parties, sectoral exposures, and loan classification and provision requirements. Institutional development i s also needed for the FSA to b e able to address some complex issues associated with non-bank regulatory design (e.g. pension, collective investment schemes, securitization, and annuities regulation). 95. Other issues relevant to the financial sector (e.g., greater domestic intermediation o f pension assets, capital market development, and regulation of the pension system) are discussed inBackgroundPaper No. 8. c. THESTRUCTURALREFORMAGENDAFORCOMPETITIVENESS 96. As was illustrated inDiagram 1(Chapter 2), there are five potential areas inwhich structural reforms will need to be formulated to increase sustainable competitiveness in Kazakhstan: (1) human capital, (2) infrastructure, (3) government institutions, (4) R&D and Innovation, and (5) sector (industry)policies. For each o f these five areas there are a number o f sub-areas. Inthis section we would focus on two specific areas: 0 Infrastructure-but only on the sub-area o f telecommunications sector reforms 0 Sectoral policies -but only on local contentpoliciesfor oil and gas 97. These two cases were selected for two reasons. First, they provide good examples o f areas where large efficiency gains can be induced innon-oil sectors without the need to spend government funds, or at least not inany significant amounts. Second, these two areas are important to the overall agenda o f the government. 1. Infrastructure: the Case of Telecommunication Reform 98. Strategic context. Both government officials and business people are well aware o f the important central role that the telecommunication sector plays in fostering diversification and competitiveness. This role i s also well documented inthe international context.22 99. There i s also awareness o f the fact that Kazakhstan has still a long-way to go before it can exploit the advantages o f modem Information and Communication Technology (ICT). Benchmarking exercises provided in Chapter 2 and Background Papers No. 9 and 11suggest that Kazakhstan performs reasonably well inthe regional context interms o f growth o f access but performs poorly in a wider group of peers. For example, while the GDP per capita inKazakhstan 22See, for instance, the recent edition of 'death o f the distance' which highlights how the rapidtechnological change inthe sector has dramatically reducedthe costs of communications andoftransporting ideas andinformation http:'iwww.deathofdistance.cod. There is also empirical evidence to suggest that flows of Foreign Direct Investment(FDI) are higher ineconomieswhere telecommunications intensity (measuredas a proportion of GDP spent on telecommunications). 41 i s twice that o f Ukraine, Ukraine has twice as many telephone lines per 100people as Kazakhstan. This state o f affairs produces a "digital divide" within Kazakhstan between those locations with adequate access and those with little or no access. 100. TheReform Agenda. The telecommunication agenda o f the Government o f Kazakhstan (GOK) includes: a. Market liberalizationto promote greater access by licensing additional fixed and mobile operators; b. Tariffrebalancingto encourage sustainable investment and market entry; c. Interconnection to facilitate market entry and greater access; d. Establishingroles and responsibilitiesamong different agencies, most notably the creation of an independent regulator inwhich the market has confidence and preparing KazakhTelecom for a liberalizedmarket; and e. Universal Access andlor Service involving: o subsidies to existingrural consumers to maintain existing levels o f access o expansion o fthe network to unserved areas 101. This is a comprehensive agenda and some pieces are already being implemented (e.g., tariff re-balancing, determining interconnectionpolicies and prices and market liberalization), W e discuss some o f the above steps. a. Market Liberalization 102. The negotiationposition o fthe GOK inWTO accession talks has been to maximize the period for exclusivity rights for the current operator. Inthe narrow context, this i s a justifiable negotiation strategy as it ensures that the timetable for the liberalization o f the telecommunication sector i s dictated domestically rather than from outside. However, it could be argued that such a position undermines the timetable for the implementation o f the Telecommunication Program, but signaling that change will only come several years after accession. 103. It is important that the GOK'hannonizeits negotiationposition with WTO and its Telecommunication Program; and make a clear public statement that it i s doing so. Drastically shortening the offer by WTO ( e g , to the point o f accession) will likely facilitate accession, but more importantly, it will provide a strong signal to domestic players to prepare for a liberalized market. All operators inthe market should know that changes are coming and that they must respond in some way. Investors will need to receive assurances o f greater security and predictability inthe rules-based environment that WTO membership represents. Users and consumers should also be clear that they will receive a greater variety o f choices and, at least, reducedprices for long distance services. 42 b. Tariff Rebalancing 104. The current high(substantially above cost) tariffs for intemational calls will attract numerous new entrants whereas the local call market (where tariffs are below costs) will not attract new entrants. The investment decisions o f new entrants will be based on inaccurate price signals and there will be over (and non-sustainable) investment in some markets and under investment inothers. Equally, the investment decisions based on distorted tariffs (as described above) are unlikely to bringabout any extension o f access to unserved areas so that the Universal Access and/or Service component o f the telecommunication reform agenda will not be fulfilled. 105. The direction of tariff rebalancing i s clear for everyone, i.e. the GOK should proceed to reduce tariffs for intemational calls and increase tariffs for local calls. The final (end point) prices to be charged for local and intemational calls are less clear. Inthis respect, the GOK i s advised to: P Develop a suitable methodology for domestic tariffs (e.g., flat fees, time-relatedprices, two part tariffs) and make it public in draft (for discussions and comments) before it i s finally adopted. > Develop a simple financial model o f the telecommunication sector to calculate the possible end-point for domestic and internationaltariffs. The purpose o f such model i s primarily to check the consistency o f the various cost components o f tariffs that are under the control o f the regulators (e.g., interconnectionprices with user tariffs). A five-year (rolling) tariff rebalancingplan should be prepared and made public before its adoption, Naturally, the rolling nature of such a plan should be emphasized, inthat the regulator will maintain its right to update its rollingplan. C. Interconnection 106. There are many types of telecommunicationsnetworks and services, and to the extent that they are interconnected, the economic and social benefits o f investment inthese networks and services will be greater. The Annex and Reference Paper for WTO accession specify some basic principles to ensure transparent, reasonable and non-discriminatory interconnection services. The issues o f cost-oriented interconnection at any technically feasible point that i s sufficiently unbundledis part o fthe Reference Paper and applies mainly to the monopolyprovider (KazakhTelecom inthe case o f Kazakhstan). Interconnectionprices are the wholesale prices paid by one operator to another for the provision o f essential services, such as call termination. The nature o f the interconnectionmarket and the level o fprices i s a key determinant o f the nature of investment inthe market by new players. Typically interconnection prices are set on the basis of costs or estimates of costs established, for example, through benchmarking studies. 107. The principles of interconnection prices take into account three basic cost elements: one- time start up costs, cost of network elements that incumbents make available to new entrants, and contribution to the funding of universal service. Placingtoo high a price on any o f these elements (singly or incombination) can make it difficult or impossible for long-term sustainable competition to take root. 43 108. InKazakhstan, there are two keyissues that needto be addressedwith regardto the interconnection market. The first i s that the current structure o f retail tariffs has an adverse impact on the opening up o f the market through the creation o f a price squeeze between `cost' based wholesale prices (Le. interconnection prices) and artificially low retail prices. N e w entrants will b e unwilling to pay interconnectioncharges that are above retail tariffs. Consequently, where the retail charges o f KazakhTelecom are below costs (e.g., for local calls), any wholesale price, based on costs, will be above the retail prices, thereby making entry uneconomic regardless o f the efficiency o f the new operator. Conversely, where retail prices are significantly above costs, cost-based interconnectionprices can support inefficient entry. In effect the unbalanced retail tariffs can create inaccurate price signals inwholesale markets which can result innon-sustainable and distorted investment to the detriment o f the development o f the sector. 109. The progressiverebalancingo f tariffs - including access charges -to the level where tariffs cover costs for each service will send accurate signals to the market leading to economic investment decisions. Where access and usage charges reflect costs, investments by all players may substantially extend access and thereby contribute to improved competitiveness and the broader economic objectives o f the GOK. 110. The second issue i s the continuing presence o f the exclusive rightsheldby KazakhTelecom inthe interconnectionmarket. With regard to calls originating and terminating on mobile networks these exclusive rights result in a premium beingpaid o f up to 5 cents per minute for `transiting' the KazakhTelecom network. The mobile operators suggest that this fee artificially inflates retail prices, in some cases, by some 20%. Inthe fixedimobile market interconnectionprices account for approximately 30% to 50% o f the retail price. Cost based interconnectionprices and increased competitive pressure will result in lower retail prices and stimulate the demand for services. 111. The reformo fthe interconnectionregime is an important early step inthe liberalization of telecommunicationsmarkets. It i s clear that the interconnection market inKazakhstan needs to be reformed based on the principles o f cost orientated, non-discriminatory, and transparent prices. The adoption o f cost based tariffs requires the collection o f considerable data which i s currently unavailable. The initial reform could be based on the adoption o f intemational benchmarkedprices. Reform of the interconnection regime has been identified as a key priority through discussions with the Agency for Informatization and Communications (AIC) and the Agency for Regulation o fNatural Monopolies and Competition Protection (ARNMCP). 112. However, the effective implementation o fthe liberalization agenda, supported by the issuance o fnew licenses, tariff re-balancing and interconnection will not resolve all the items on the telecommunications agenda o f the GOK. The govemment i s right to be concemed about customers who will not be able to afford the access provided by market forces owing to their l o w income or location (e.g., the rural poor). This issue is discussed in Section e below. 44 d. Roles and Responsibilities of Different Players 113. An effective regulatory environment. The effective implementation o f a 21Stcentury regulatory environment that promotes private investment, competition increased access, and supports the sustainable development and diversification objectives o fKazakhstan is a key priority. Inaddition to the actions on tariffs and interconnections, a number o f actions are requiredinthe areas o f licensing, spectrum, and institutional building: 3 The establishment oflight-touch licensingor authorizationproceduresto promotethe rapid market entry for service and infrastructure provision without any Universal Service Obligation (including the removal o f a Universal Service obligation to KazakhTelecom). 3 Theneedto establish anopen and competitivetenderprocess for the licensingofathird GSMoperator. 3 A continuing needfor capacity buildingfor the relevant regulatoryagencies to ensure their credibility to all market players and customers. This involves not merelytraining, but also the introduction of some o fthe important elements of an independent regulator. The continuing involvement o f the AIC inthe management o f KazakhTelecom through the membershipo f its board i s one example where the existing institutional arrangements do not meet best international practices. Further, the adoption o f a more open and transparent process o f consultation with regard to the AIC decisions would more closely align it with best international practices. 3 The management ofthe spectrum will require somebasic steps to outline the steps forward: o Subcontracting a segment to review andrationalize spectrum use inKazakhstan, including development o f a spectrum allocation plan, a database o f spectrum use and the potential for creating additional usable spectrum by re-farming the existing assignments; o Structure an open and transparent policy for the use o fthe spectrum; o Develop a spectrum pricing and trading policy; o Training for relevant agency staff inaddressing spectrum management and monitoring issues; and o It i s likely that the relevant agency will needto procure and implement a Spectrum Management and Monitoring System(SMMS) so that it has the tools to effectively manage the radio spectrum. Consultants should be hired to assist the relevant agency inthe development o f technical specifications for the SMMS, preparation o f biddingdocuments, bid evaluation and contract administration o f the system. 45 114. The modernization of KazakhTelecom. Reform o f KazakhTelecom inlight o f a changing market environment i s an important corollary to sector reform. The company is, and i s likely to remain for some time, the country's leading `hi-tech' vehicle and the supplier o f most o f the country's electronic communications infrastructure. Consequently, decisions made by the company have an impact across the entire economy and on the broader economic objectives o f GOK. At a strategic level, the current decision makingprocess, such as the approval o f investment decisions and the reform o fworking practices to increase productivity, are influenced bybroader concerns about the sector as a whole. Moreover, the interdependency betweenthe government, the regulator, and the firm are reflected inthe composition o f the board and the approval of board decisions by government departments. Reform o f the governance structure o f KazakhTelecom may well increase its ability to respond to a competitive environment. 115. A t an operational level there i s some prima facie evidence that the processes o f the company are not yet adapted to the requirements o f a competitive market. The financial systems o f the company are undergoing reform, but as o f yet, good cost data i s unavailable. Network modemization i s incomplete and provision o f per secondhtemized billing is not common. Headline measures of productivity, such as lines per employee, suggest that there are significant deviations from international best practices. 116. As a matter o fpriority it is suggested that resources be devoted to the review o f KazakhTelecomto help establish it as a world class operator. Inthis context the GOK should consider hiringthe services o f international consultants to develop and implement, invery close co-operation with the management o f KazakhTelecom, a forward looking business plan that will enable the company to not only become "the supplier o f choice" in an open and competitive market but also an active contributor to the achievement o f diversified and sustainable growth in Kazakhstan. The implementation o f such a business plan would add to the value o f KazakhTelecom and make it more attractive to private investors inthe event that the GOK decides to further reduce its shareholding inthe company. Any further sale o f shares would have positive secondary outcomes. For example, it would add substantially to the volume available on the Kazakhstan equity market. This would inturn provide an outlet for funds generated by private and public insurance schemes. 117. Alternatively, the revamping of KazakhTelecom into world class operator could be the objective o f a further sale o f the company by GOK. e. Promoting UniversalAccess in Rural Areas 118. The liberalization o f the market would extend access to commercially viable customers and, inthe case o f Kazakhstan, this increase o f the customer base could be substantial. But, as in many other countries, certain groups o fpotential customers are not sufficiently economically attractive to private investors. 119. Inthe Bank's experience, incircumstances such as these, targeted rather than generalized initiatives provide the best solutions. One form o ftargeted initiative - "the smart subsidy" approach - see Background Papers No. 9 and 11.Noticeably, where the smart subsidy has been used, the actual subsidygranted following a tender was below the maximum allowed. Inthis 46 way, the economic objectives o f the government (social inclusion, competitiveness) were achieved with efficient and minimumsubsidies. 120. Generally, about 2.5% of GDP i s spent on telecommunications services. Inpoor rural areas, 2.5% o f income i s not likely to be commercially attractive to private investors to provide access to individual customers. However, aggregating the demand o f individual customers in specific locations with that o fthe private and public sector may result in "public" or "shared access" (to electronic communications including the intemet) becoming commercially viable, or at least becoming so with a relatively small subsidy. The smart subsidy approach mobilizes private investors to provide shared or "Universal Access". 121. The government would needto formulate the following action plan: > Develop preparatory demand studies; 9 Design andimplement the `smart subsidy' approachto asmallnumberoftargeted pilot projects (with the World Bank's assistance). The implementation o f the pilots would provide the GOK with cost estimates for scaling up the operation (see below); and P Scale up o fthe smart subsidyapproach by GOK to provide UniversalAccess throughout Kazakhstan and therebypromote social inclusion, narrow the digital divide and fulfill the broader economic objectives. 122. The implementation o fthe suggestedaction plan would ensure that in conduction with enjoying the benefits of market liberalization and the necessary tariff re-balancing, `at risk' geographic markets would gain access to ICT and telecommunications infrastructure and services. This would facilitate widespread improvements incompetitiveness and support diversified and sustainable growth. 123. The preparatorydemand studies entail producing a distribution o fthe proportion o fthe population without access residing within various distances from the nearest access points to one o f the electronic communications networks (including, for example, those operated by the railway company, the oil and gas company, and the mobile phone companies), where the networks are those o f existing suppliers or potential new entrants. 124. The studies would then be refined to take into account population densities and potential aggregated expenditureby distance from the nearest access points and the cost o f network expansion relative to potential income. 125. Based on the information gathered inthe preparatory studies, it would be possible to categorize different rural communities along these dimensions (for example, there may be four categories o f community ranging from most easy to most difficult to provide access on a commercialbasis). The design and implementation o f pilot projects for each category could then be undertaken by applying the smart subsidy approach. 126. Importantly, the use o f `smart subsidies' to provide access inunprofitable areas allows the GOK to implement a policy o f universal access without encumbering KazakhTelecom with a set of unprofitable obligations that would distort its ability to compete. Thus, a policy o fmarket 47 liberalization, that would address the `market gap', can be implementedwithout having to directly accommodate the distortions that can be created by the obligation to extend network coverage to unprofitable areas. 127. The results of the pilot projects (interms o f required subsidies) would then guide the GOK in scalingup the initiative and thereby strengthening the prospects for the fulfillment o fthe broader economic objectives o f GOK. Further, the wider economic impact o f the pilots could be assessed interms of the development o f small and medium enterprises, firm, product or process innovation, distance learning, e-health and e-government, and the benefits of these additional outcomes could be factored into the scaling up process. Box 4: StrategicDirectionsfor Telecommunication Reformsand the Vehicles to Achieve Them Kazakhstan has commendable objectives with regard to its telecommunication sector as it wishes to: Position well the sector (and its main operator, Le. KazakhTelecom) for an enlarged market, when and ifthis becomes a reality, such as the creation o f a CES with Russia, Ukraine and Belarus Position well the sector (and its main operator) inthe global economy, particularly in the transit and routing markets between Asia and Europe Secure some level o f basic telecommunication services for the entire population-i.e. inpoor rural areas. A program has beendesigned including elements o ftariffrebalancing, liberalization, and universal access provision, This program, nonetheless is a good example o f infant industry policies as it supports: A highly distorted price regime over the mediumterm, which redirects significant resources from non- telecommunication sectors into the telecommunication sector. The use of a small part o fthe rents to heavily subsidize local calls for richand poor households alike and for all types o f business. But the bulk o f the rents are left with the main operator (KT), for it to make sound investment decisions. Limited competition, by imposing strong restriction on entry, and restriction o n foreign ownership, and by constraining the type o f licenses that operators owned by foreign investors can obtain. Heavy dominance o f KazakhTelecominthe market i s further secured via its ownership incellular phone suppliers, A strong dominance of the sector by the state (inaddition to KT which i s owned partially by the state, two SOEs own telecommunication companies, the gas transportation company, and the railways company); however, it i s unclear whether or not the state i s truly able to represent the interest o f the population as it i s susceptible to "state- capture" by the conglomerate that holds 49% o f the shares in KT. Keeping the formal representatives o f the GOK inthe industry `weak,' by fragmenting policy making over three agencies, and by given the InformatizationAgency, the key agency o f the three, significant functions outside its core mandate (e.g., the administration o f a large e-government program). The implicit strategy is, thus, one inwhich enough financial resources and protection are given to the incumbents, primarily KT, inthe hope they will be carrying out the investments and modernization that i s necessary to compete inthe global market when and ifliberalization takes place. Inthis context, the following questions arise: Would the corporate govemance structure, and the distorted relative prices provide the demand signals that KT requires to make efficient investment decisions? Would the diffused regulatory environment be able to implement the public c o m t m e n t o f introducing a fully liberalized regime, or would their efforts be permanently blocked by the current incumbents? Who are the winners and losers o f the current situation, and is the current situation fostering or preventing the diversification and industrialization policy that the government wants to pursue? 48 2. Sector Policies: The Case of Local Content for the Oil and Gas Sector a. Background: Partnering with Multinationals 128. Kazakhstan already has significant foreign direct investment (FDI) concentrated primarily inoil and gas and other natural resource extractive industries.Now the govemment's goal i s to maximize the economic development benefits o f that FDI.23 the case o f Kazakhstan, In this means getting more thanjust tax revenues and direct employment benefits. 129. Win-win schemes. It should, however, be said upfront that oil operators (foreign or local) have a `reservation price' for the total requiredpayments they will make for their license to operate, whether inthe form of taxes, social programs, petty corruption, or uneconomical local content development. Thus, GOK must decide how to balance these payments, but should expect that more pressure inone area will leadto less focus by oil companies on other areas.24Clearly, only ifthe government asks oil operators to carry out economically viable local contents developments, they will regardthese outside the "reservation price". Only schemes that are win- win for the government and the operators (inthe sense of truly reducing the operator's costs, while generating an increased amount of spillovers for the non-oil economy) will qualify as an economically viable proposition. Inthis case, local companies can truly become competitive with their intemational counterparts. Theywill win contracts on the basis o f cost and quality. Ifthere i s a business case for sourcing content locally, Kazakhstan will benefit both from required payments and contracting to local companies over and above these payments. 130. This means ensuringthat Kazakhstani workers, managers, and enterprises have the skills and capability to provide highwage, highvalue added goods and services both to foreign investors and to such dynamic Kazakhstani firms as KazMunaiGaz. IfKazakhstani companies can supply highvalue added goods and services to global firms operating inKazakhstan, there i s no reason why they cannot also supply similar goods and services to firms operating inthe greater Caspian area as well as throughout the world. Inother words, Kazakhstan should strive to become a global supplier of knowledge-intensive value added goods and services to the global extractive industry-a specializationwhich can endure long after local oil and gas resources are depleted.For example, Houston, remains a center o fthe oil industryeven though East Texas oil fields were depleteddecades ago. This section outlines a strategic direction for how this can be ac~omplished.~~ 131. To foster the competitiveness o f firms in any sector requires: Of course, attracting FDI innon-oil and non-extractive sectors (e.g., pharmaceuticals, tourism, plastics) is a goal of its own that Kazakhstanhas not explicitly set for itselfyet. 24 A case inpoint i s the draft law onproduction sharingagreements which suggest that tenders for exploitation of oil field maximize both local content efforts (e.g., an investment ina petrochemical plant) and tax, bonuses or royalty payments.Clearly, oil companieswill see these two eligibility criteria as substitutes and most likely reduce the amount of revenues they will have leave to the government inthe absence of any local content criteria. Fromthe budgetperspective,this clear industrial policy i s therefore being implemented through a `quasifiscal' instrument, since a tax concessioni s in fact being given to subsidizethe developmentof certain industries. Of course, if the tax regimei s binding (like it i s currently is), many players may restrain from participating inbids of new exploration sectors. 25 The World Bankhas done similar work inother parts of the world, most notably, From Natural Resources to the KnowledgeEconomy, which looks at these issues with regard to Latin America and the Caribbean. 49 0 A friendlybusiness environment inwhich local firms can be set up and operate under low administrative costs and redtape; 0 Strong competition betweenlocal firms, and betweenlocal firms and similar foreign firms, to ensure that only the `fittest' survive; and 0 Ease of exit, as some local firms will naturally have to go bankrupt while others will grow and prosper and even conquer markets inneighboring countries. 132. However, the focus of this section i s not on the above fundamental preconditions, but rather on the types of technical assistancethat the govemment could provide to ensure that some firms will adopt the business and management practices they need to effectively apply either the technology they currently possess or they might acquire inthe future. Today, many Kazakhstani firms lack the capability, interms of both technical and business processes, to access international oil companies (IOCS),~~and the national oil company (KazMunaiGaz-KMG) value chains. Selected technical assistancewill give them the capacities that they need to build linkages. While technical assistance and buildinglinkages with IOCs and KMG are not synonymous processes, they are mutually reinforcing, as greater capability enables firms to win oil company tenders, while the experience of working with oil companies enhances the capability o f firms. Diagram 2 illustrates in greater detail some o f the key actors inthis market. 6. Obstacles to Domestic Supply into the Oil and Gas Sector 133. InKazakhstan, as inmany oil producingcountries, there are five major obstacles blocking local firms from becoming suppliers to the oil and gas sector: 1. Dominance of global over local supply chains. IOCs prefer to deal with their global suppliers for a number o f well justified reasons (including the fact that they do not have the infrastructure to deal with small suppliers in many countries). For cost-savings reason, they are reluctant to break these supplier relationships inorder to source locally in each country where they operate. Kazakhstani firms will need to offer sufficient value, in terms o f local expertise and cost, ifthey want to have a chance o f breaking into these supplier relationships. As explained below, forming ties with global suppliers is one way inwhich many Turkish firms have become global suppliers.InKazakhstan, for example, Enka, one o f Turkey's largest construction companies, has formed an alliance with Bechtel, a key global supplier to ChevronTexaco, to supply the TengizChevrOil project. 2. Difficulty identzfiing where to enter the value chain. IOCs often contract out project management and award major service contracts to specialist firms like Parsons, Flour, and Daniel (PFD), Schlumberger, and Halliburton whose reputation and capital will guarantee a sound product or service. These are normal practices for industrieswhere for 26 `IOCs' refers only to international oil companies, while `oil companies' refers to both Kazakhstani and international oil companies. `Operator' refers to the oil company or oil companiesthat operate the field TengizChevrOil for example i s operated by ChevronTexaco, although a number of other oil companies also own a share of the project 50 which the reputation o f a supplier to provide quality goods and services in a timely manner and o f following the strictest environmental and working standards i s o f the essence, The best option for local companies i s usuallv to become a supplier to a supplier, not directly to an oil company. Inthe case o f drilling fluids, for example, IOCs operating inKazakhstan source the bulko ftheir drilling fluids from M-IDrillingFluids,an international firm. As shown inDiagrams 3 and 4, Kazakhstani firms often try to access the upstream value chain by appealing directly to 100, while it would often be easier to access the value chain by going to a PFD, Schlumberger, or M-I,as the case may be. For example, the Kazakh Institute for Chemical Sciences unsuccessfully bidto supply TengizChevrOil ( K O ) with corrosion inhibitors, despite the fact that the Kazakhstani corrosion inhibitors were cheaper than its international counterpart. The Institute would likely have been much more successful had it approached an international supplier o f oil field chemicals, such as M-I.GYPS, an Aktobe producer o fbarite, another oil field chemical, was able to enter the value chain by selling directly to M-I. 3 . Information gaps. It i s often difficult for many oil companies, both international and Kazakhstani, to identify and assess the suitability o f Kazakhstani suppliers as these unknown have very short track records (reputation) or little equity substantiate up their offers. At the same time, it i s also difficult for Kazakhstani suppliers to know about opportunities to supply goods and services to IOCs and KMG. This lack o f information on both sides prevents suppliers from identifying projects for which they might bid and makes it both costly and difficult for oil companies to identify local contractors. 4. Standards. Standards o f quality and safety are major concerns for oil companies. Accordingly, oil companies are often hesitant to source from a local firm that has not beengranted international certification, such as ISO, API, or ASME, regardless o fthe quality of the firm's work. Insurance requirements and concerns for the environmental integnty of the work, among others, motivate oil companies to source only from internationally certified suppliers. 5. Safety and Environmental Concerns. Local firms need to be able to accommodate IOC and KMG concerns about safety and working practices, including environmental working practices, as no operator can afford human or environmental casualties. TCO, for example, requires that all personnel, whether local or international, have three weeks o f training in safety and business practices before entering the TCO work site. This requires that local contractors working on the site maintain continuity o fpersonnel, as all new personnel will be required to undergo this training to ensure that they meet TCO's standards for health, safety, and environmental protection. 134. DifJicultlyJinding highly skilled local labor. Highly skilled labor often i s not available locally, particularly those with engineering and management skills. This hurts local companies in two ways, On the one hand, they may have difficulty finding local engineers who are qualified in the technical disciplines needed to supply the oil and gas sector. On the other hand, it raises the price of skilled labor. When a particular skill i s in short demand, workers with this skill will demand higher wages and are more likely to be poachedby firms looking for that skill. Training workers would be very expensive for firms, because they may have difficultly retaining these 51 workers. As such, the scarcity of skilled local labor both imposes greater costs on local firms and provides an incentive for firms to train as few workers as possible. c. A Three-ProngedStrategy to Foster Competitivenessof Suppliers 135. The key policy objective mustbe to maximize the direct exposure o f the local laborforce and local suppliers to the technologies and standards o fmultinational firms. The government should reward efforts by multinationals to create opportunities for local employees to acquire skills and, over time, to gain managerialresponsibilities. 136. Local suppliers able to link with foreign investors inthe oil & gas sector will have the best opportunities to reach intemational quality standards. Opportunities for local suppliersto link-upwith foreign companies can bepromotedthrough a variety o fmeans. The most important o f these are the formation of Joint Ventures.But for this the government will needto remove disincentives to set up local companies (Le. V A T exemption for foreign purchases); more broadly, structuring arrangements that make it attractive for internationally recognized companies (e.g., Halliburton, FMC, PetroKazakhstan, PFD) to make the investment to set up a more permanent suppliers and service business inKazakhstan. 137. A number of other changes will need to be enacted to foster the competitiveness o f local suppliersto the oil and gas industry.The remainder o fthis section leaves aside the general but important preconditions (e.g., ensuringcompetition, and improvingthe overall business environment for firms inany industry) and focuses on three fundamental pillars to promote suppliers to the oil and gas industry: 0 Training and skills for Kazakhstani workers regardless o f whether they work for a supplier or an operator; 0 Rulesand regulations on local content imposed on operators; and 0 Best practice supplierdevelopment programs. 1. Training of a Kazakhjtani cadre of specialists 138. Kazakhstan needs a cadre of local specialists to support the oil and gas industry.These specialists need the business skills necessary to runlocal suppliers and to interface successfully with oil companies and the technical skills to use and apply intemational oil and gas technologies. Training this cadre of specialists will require strong academic institutions in disciplines relating to oil and gas, strong connections between these academic institutions and business, and opportunities for Kazakhstani professionals to work with their intemational counterparts, both inKazakhstan and abroad. It i s beyond the scope o f this paper to assess how much o f this infrastructurei s already inplace, or is beginningto be put inplace, and only needs fine-tuning. 139. Strong academic institutions inareas such as petroleum engineering, geology, and businessmanagement are crucial to train local professionals. Kazakhstaninherited strong institutions o fbasic science from the Soviet period. These disciplines remain strong, including those in sciences relating to oil and gas, like geology and chemistry. However, assessmentsmade by the World Bank inother CIS countries suggest that this infrastructure lacks the fundamental 52 links with industry. Also based on the World Bank experience inother CIS countries, it is likely that Kazakhstani institutions lack experience with international equipmentand standards, and that courses inthe petroleum sciences do not incorporate the latest international best practices. As such, training and education programs need to bedeveloped inapplied technical subjects, such as petroleum engineering andpetroleum geophysics, which incorporate the latest intemational processes, theory, and technology. 140. Working alone, however, academic institutions will fail to adequately address Kazakhstan's training needs. More and stronger linkages are neededbetween academia and the business community. Such linkages would enable universities to offer courses o f study that produce candidates who meet the needs of oil companies; and, would help universities participate inthe research and development processes o f oil companies. Oil production in Kazakhstan, particularly offshore production, poses major technical challenges that will require new research and development to solve. Both Venezuela and Norway have derivedbenefits from their natural resource endowments by ensuringthat a portion o f the research and development needed to cope with their unique geology was done locally. InNorway, new techniques for offshore gas extractionwere developed, while Venezuela developed oriemulsion, a new technology for exploiting its heavy crude reserves. Kazakhstancould similarly develop new technology for the shallow water offshore drilling needed inthe North Caspian. Kazakhstani academic institutions can play a role by conducting the research necessary to solve these problems and training the engineers who will apply that research. 141. Academia, however, i s only one part o f the training picture. It i s also important that Kazakhstani professionals have the opportunity to work alongside international specialists both inKazakhstanand abroad, learning from them as theywork. Kazakhstancanbenefit enormously from the international work and training experiences available to employees o f international oil companies. Foreign direct investmentby intemational oil companies opens a wide range o f international on thejob training opportunities to Kazakhstani professionals that will enable them to leam international best practices and then apply them it inKazakhstan. 142. Norway has beenparticularly successful insuch training programs. It has a policy o f promoting centers o f excellence inoffshore technology and has encouraged oil companies to collaborate inR&D projects with Norwegian firms. Norway has recognized that a highly skilled workforce inthe petroleum sciences i s a crucial prerequisite for the growth of local firms inthe oil and gas sector. ii. Rules and Regulations regarding local content 143. Kazakhstan needs to ensure that its rules and regulations for the oil and gas industry facilitate local content growth (see Diagram 5). Incentives to international companies to invest in Kazakhstanmust not disadvantage local companies nor go beyond industry standards for operators. Rather, rules and regulations should be designedto provide incentives so that oil companies will look for local suppliers as part o f their operational work rather than as an add-on administrative requirement. Inorder to do this, local content requirementsshould be stable and predictable throughout the lifetime o f each project. Stable and predictable rules and regulations 53 encourage oil companies to invest time, effort, and money indeveloping new processes to encourage local content. Today, Kazakhstan's rules and regulations: 0 Provide disincentives for IOCs and KMG to use local firms inmany areas (e.g. VAT exemptions, and local firms are subject to Kazakhstani and international standards); 0 Are excessively administrative innature, and create significant room for bargaining and disagreements ininterpretationbetween companies and regulators (e.g., work permits, reporting requirements, and procurement rules); 0 Are unstable-this is a corollary o f the above point, as there i s significant room for interpretation; and 0 Lack transparency-Local companies do not know about the potential opportunities, particularly local content requirements that a given PSA has provided to them, and must resort to government administration to find out. When local companies do bid for contracts, opaque decision making processes at oil companies hinder their ability to learn from failed bids. iii. Supplier Development 144. There are three major areas that a supplier development program should address. First, few Kazakhstani firms have received the international certifications necessary to work for IOCs. IOCs are often unable to employ local firms that have not received international qualification because they are concerned about quality and also have insurance policies that require that subcontractors be internationally certified. Second, Kazakhstani firms also need assistance with business practices. Many Kazakhstani companies are lacking inbusiness and management practices and need assistance inthese areas. InAzerbaijan, the BP Enterprise Centre goes so far as to explicitly separate two different work streams-one looks at capacity building and focuses on certification and training while the other looks at business assistance, chiefly identifying opportunities for local supply and offering ad hoc assistance inresponse to particular needs. Third, inKazakhstanoil companies and local suppliers often lack information about one another. Many Kazakh firms do not know how and where to integrate into the supply chains o f oil companies, while oil companies lack information about local firms and their competencies. 145. Helping local firms become internationally certified requires structured programs to identify firms for technical assistance and target that technical assistance to key areas for improvement. For example, the Czech government introduced a Pilot Supplier Development Program inthe electronic industryin2000-2002 to spread the benefits o f incoming FDIto the rest o f the economy. The Czech program workedjointly with local firms and transnational corporations (TNCs). A survey was conducted o f local firms and TNCs, which showed that local f i r m s and TNCs identified different areas as important for technical assistance. Inparticular, while local companies thought that their greatest deficiencies were technical, TNCs identified deficiencies inbusiness and management practices. Thus, it was found that local companies did not understand the needs o f TNCs. Once local companies did, they could identify those areas in which they needed to improve. The government organized a series o f seminars to help the firms improve incertain areas, and gave them intensive management training, with experts visiting them to help them develop concrete improvement strategies. Then a small subset o f the most 54 successful firms was given intensivetraining for further improvement. The program was successful inhelping firms get more contracts inthe long term. 146. Meanwhile, assistance with business practices i s often needed inboth a structured manner and on an ad hoc basis, inresponse, for example, to the announcement o f a particular tender. InAzerbaijan, the BP-funded Enterprise Centre has runa successful series o f seminars, under the broad heading, "How to do Business with Oil Companies," which covers topics ranging from the I O C biddingprocess to steps to I S 0 ~ertification.~'The Enterprise Centre coordinates its training programs with a range o f development organizations such as the German development agency GTZ and certification institutions like Moody International. The Enterprise Centre also provides targeted assistance to individual firms. It begins by assessing the suitability o f a firm to supply the oil and gas sector. Ifthe firm i s suitable to supply this sector, the Enterprise Centre identifies particular areas where the local firm would benefit from technical assistance. These needs are then addressed both through customized technical assistance and the seminars discussed above. Once the firm i s judged able to successfully complete projects, the Enterprise Centre will identify tenders that the firm might be able to win. It will walk the firm's management through the tender process, providing assistance with both technology and business processes necessary to complete the tender. These programs have been successful in linking more firms into oil and gas supply chains, upgrading the technical capabilities o f local firms, and supporting innovation by local firms. 147. Both types of assistance help local firms better understand oil companies and would assist local firms with promoting themselves to oil companies. Once local firms understand the importance o fpromoting themselves, they will begin to market themselves to oil companies on the basis o f certifications, competencies, and past work. Inthe best case, this information would go directly to the databases of local firms that oil companies use to identify suppliers. 148. Finally, it is important to bear inmind that technical assistance, technology upgrading, and supplier development are about more than technology acquisition. That is, the hardware side o f the equation and it i s undoubtedly important. But even more important are managerial competence, planning, quality control, skill development for workers, and assistance identifying where to integrate into energy industry supply chains. Academic work on Kazakhstan and Azerbaijan suggests that successful and unsuccessful local suppliers are differentiated not by their technical capabilities but by the quality of their management and business processes. Technical assistance programs thus should focus on these areas. `'In May 2004, for example, the EnterpriseCentre conductedthe following seminars: "IS0 9000 Internal Auditor course" on May 10-14, "First Steps of the process owner and his staff' on May 17-21, "Engineering methods in quality management" on May 31-June4, and "IS0 14000 Internal auditor course" on May 31-June4. c 5a .3 ,0 a c 50 CJ 5 $5m V a, U + L / I / M E .I e L .m ep c, E Q) \ 6a e 0 .I e - ep *= & E g & 8 E rlll .rl Q) E sB cd E cd c, Q) m 3 c, cd E u Q) s 0 c, Y E Q) k 4 Q) I I .. v, E a k w a .rl n I L 9 Y z 3 .-E0 crl c, 7- crl f w .y Q) E \ \ 3 \ \ 29 c, e e8 v E 0 .3 Y a f f 0 Q) 0 c, E 0 U 00 ANNEXTABLE:KAZAKHSTAN\SKEYECONOMIC 1 INDICATORS, 1999-2004 1999 2000 2001 2002 2003 2004 Actual Actual Actual Actual Actual Prelim. I 1 National income GDP at current prices, billion tenge 2016 2600 325 I 3776 4612 5543 Oil 21 196 365 427 537 66 I Non-oil 1820 2235 !824 3240 395 I GDP at current prices, US%billion 17 I 8 22 25 31 41 Oil 2: 2 3 3 4 4 Non-oil I S 16 19 21 26 Real GDP growth, '%I 2.7 9 8 13.5 9.8 9.3 9.4 011 21 18.6 26.5 23.2 12.9 10.5 Non-oil I.5 8.0 II9 9.3 9.0 Prices and exchange rates CPI inflation (pa), 'XI change 8.3 13.2 8.4 5.8 6.4 6.9 REER (up=depreciation), 2000=100 31 94 IO0 101 10.6 1 1 1 I07 USD 92 IO0 98 98 92 SO EUR I07 IO0 93 98 110 105 RUR 89 100 II2 119 I 2 6 I28 Monetary and financial sector ('% of GDP) Broad money, M 3 14 15 I 8 20 21 28 Deposits in the banking system 8 II 14 16 16 23 Commercial banks' lending 7 I 1 I 5 18 21 27 Pension fund accumulations 3 4 6 7 8 9 External sector Current account balance. USBB -0.2 0.6 -I.2 -0.8 0.04 0.2 Exports ofgoods, f.0.b.. USBB, ofwhich 6 0 9.3 8.9 10.0 13.2 20.3 Fuel and oil products 2.3 4.8 4 8 5.6 7.9 9.0 41 Ferrous metals 0.9 I.z I.o 1.1 2.1 2.4 41 Copper and copper products 0.6 0.7 0.7 0.7 0.7 0.8 41 Imports ofgoods, f.o.b., USBB, ofwhich 5.6 6.8 7.6 7.7 9. I 13.3 Food 0.3 0.3 0.4 0.4 0.5 0.3 41 Other consumer goods 2.2 ?.I I.4 I.5 1 .z 0.8 4' Petroleum and energy products 0.3 0.6 0.8 0.8 0.9 I.2 41 intermediate goods 1 .I I 8 2.3 2.2 3.0 2.0 4: Capital goods I.7 2.1 2.6 2.9 3.6 4.0 41 Gross F D I inflows, '%I ofGDP 11.0 15.2 20.6 16.7 14.9 13.2 4/ Oil and gas 9.2 12.8 16.6 12.2 10.8 10.4 41 Non-oil-and-gas 1 .8 2.4 3.9 4.4 4.2 2.8 41 Government finance, of G D P (except otherwise specified) Total budget revenue 17.9 21.9 22.1 21.1 21.5 23.0 Budget oil revenue 0.7 3.z 2.3 2 3 2.7 3.6 Budget non-oil rewnue 17 2 18.6 19.7 18.8 18.8 19.4 Total budget expenditure and net lending 23.1 22.8 23.0 21.4 22.5 23.4 Education 3.9 3.3 3.3 3.2 3.2 3.4 Healthcare 2.2 2.1 I.9 I.9 I.9 2.4 Social security and welfare 7.9 6.6 5.7 5.3 5.2 4.9 Agriculture 0.3 0.4 0.7 0.8 I.o I.3 Transport and communication 0.6 I.5 I.4 I.5 I.s I.9 State Budget balance. deficit(-):surplus(&) -5.2 -I.o -0.9 -0.3 - 1 .o -0.3 Yon-oil balance, deficit(-)lsurplus(+) -5.9 -4.2 -3.2 -2.6 -3.7 -4 0 NFRK savings 0.0 0.0 5.8 2.9 5.0 2.5 N F R K oil reYenue 0 0 0.0 2.3 I.2 2.7 2.3 NFRK non-oil revenue 0.0 0.0 0.2 0.2 0.3 0.0 N F R K capital rebenue 0.0 0.0 3.3 I.5 2.0 0.2 Budget capital rmenue 1.7 0.8 0.5 0.5 0.1 0.1 Consolidated budget balance. deficit(-)Isurplus(+) -3.5 -0.1 5.4 3.1 4.0 2.3 Labor market Employment, thousand people 6105 6201 6699 6709 6985 7148 Employment growth. I%, -0.4 I.6 8.0 0.2 4.1 2.3 Unemployment rate, 'X, of labor force 13.5 12 8 10.4 9.3 8.8 8.6 Participation rate, labor force as '%of 66.0 66.0 70.2 70.1 70.0 70.6 population at the age 15+ Real average wage growth, 'X 11.0 4.5 16.4 10.6 7.0 14.3 Sources: World Bank staff calculations based on the official data from the Karakh authorities. I12005-07 Medium Term Socio-Economic Development Plan and 2005-07 .Medium Term Fiscal Frame,, ork. 21 Oil and gas extraction, extraction related sewices. and oil related construction and transportation. 31Real effective exchange rate (REER) i s a weighted average ofexchange rates oftenge to currencies of 24 countries, 41 January-September 2004 (actual). ANNEXTABLE KAZAKHSTAN: 2: GDPGROWTH, 1999-2005 1999 2000 2001 2002 2003 2004e 2 0 0 5 ~ Real GDP(1990=1) 63.23 69.42 78.80 86.52 94.56 103.45 111.73 Growth in Real GDP, % Total, of which 2.7 9.8 13.5 9.8 9.3 9.4 8.0 Oil GDP 1/ 18.6 26.5 23.2 12.9 10.5 15.1 10.1 Industry(incl. construction) 19.4 27.2 24.0 12.5 10.8 15.6 10.3 Mining 12.7 15.4 17.2 20.6 8.3 15.7 8.7 Oil refinery I:28.8) 3.8 23.7 6.5 12.4 10.0 10.0 Construction 58.4 76.8 50.6 (9.5) 19.4 18.0 17.0 Services 13.1 20.1 15.4 16.8 8.1 10.3 8.2 Non-oil GDP 1.6 7.7 11.9 9.2 9.0 8.4 7.6 Agriculture 21.7 (3.2) 17.1 3.2 2.2 1.o 1.o Industry (incl. construction) (0.4) 10.9 11.0 11.4 8.3 6.0 6.4 Services (0.7) 8.2 11.5 9.1 10.4 10.7 9.0 Source: Statistical Agency of the Republic o f Kazakhstan; WB staff estimates. I/Oilandgasextraction,extractionrelatedservices,andoilrelatedconstructionandtransportation. ANNEXTABLE KAZAKHSTAN: 3: STRUCTURE OF GDP, 2003 NominalGDPby sectors, % 1999 2000 2001 2002 2003 Total 100.0 100.0 100.0 100.0 100.0 Oil and gas 1/ 10.3 15.0 14.1 15.3 15.8 Oil services 10.4 9.2 10.6 11.0 12.0 Nonoilmining 4.4 4.0 3.7 3.3 3.O Metal manufacturing 5.4 8.3 7.4 6.6 7.0 Other 69.5 63.4 64.2 63.7 62.2 Agriculture 10.5 8.7 9.4 8.6 7.8 Manufacturing, excluding metals 8.8 8.3 8.9 7.8 7.0 Power, water 3.9 3.3 3.O 3.1 3.1 Construction 3.1 3.0 3.1 4.2 3.9 Trade, commerce 14.4 13.3 13.0 13.1 13.0 Transport & com 12.1 11.2 11.0 11.3 11.7 Public services 12.2 10.7 10.5 10.5 10.5 Other services 4.5 5.0 5.4 5.1 5.2 Source: Statistical Agency of the Republic o f Kazakhstan; WB staff estimates. 1/ Kational Accounts for the oil and non-oil sectors are not produced officially, but the Agency i s planning to undertake such task. The numbers are, therefore, subject to change. 61 ANNEXTABLE KAZAKHSTAN: VALUE ADDEDINREGIONS, 1996-2003 4: (InUS dollarsper capita, byofficial rate) 1996 1997 1998 1999 2000 2001 2002 2003 prelim. Gross domestic product 1350 1446 1469 1130 1229 1491 1659 1996 Gross Value Added by Regions 1235 1329 1321 1017 1100 1324 1474 1784 Akmola oblast 1051 775 703 742 670 843 875 1053 Aktobe oblast 1109 1434 1541 1040 1104 1321 1549 1912 Almaty oblast 770 794 718 491 499 631 674 807 Atyrau oblast 2927 3282 2752 2418 3762 4413 5390 7349 East-Kazakhstan oblast 1159 1303 1435 1051 993 1120 1133 1315 Zhambyl oblast 660 588 538 367 361 409 465 610 West-Kazakhstan oblast 710 1107 1120 972 1272 1608 1812 2159 Karaganda oblast 1387 1576 1562 1267 1335 1463 1518 1820 Kostanai oblast 2065 2049 1394 1030 1041 1132 1164 1451 Kyzylorda oblast 427 593 750 494 610 742 983 1267 Mangistauoblast 3579 2824 2229 2087 2715 2992 3696 3787 Pavlodar oblast 1946 1469 1961 1144 1355 1631 1647 1938 Korth-Kazakhstan oblast 1689 1346 986 766 637 898 877 988 South-Kazakhstan oblast 608 630 578 460 542 665 662 737 Astana city na 1160 1873 1842 1999 2287 2765 3414 Almaty city 2471 2965 3154 2377 2237 2991 3485 4183 Source: Statistical Agency of the Republic of Kazakhstan. ANNEXTABLE KAZAKHSTAN:EXCHANGE 5: REAL RATE, 2000-2004 Dec 2000 = 100, down = appreciation Der-00 Dec-01 Dec-02 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 .\Ia)-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nou-04 Dee-04 I.TmdeableE~ontradeablcE (Dec 2000 = 100) 1000 957 943 915 909 903 898 897 896 901 9 1 1 915 913 905 901 893 Inflation ('%,changeoverpre, month) I 3 0 100 I 4 0 090 070 0 50 040 040 020 030 020 0 4 0 0 80 IIO 090 0 90 Tradeables 065 022 078 053 025 (001) 004 023 012 060 097 067 068 056 060 027 Non-tradeables I 5 2 132 173 117 093 070 055 042 019 007 (011) 023 090 135 108 1 1 8 Consumerprice Index (Dec 7000 = 100) Tradeables 100 104 IO9 115 I15 115 115 115 116 116 I17 118 119 120 120 121 Non-tradeables 100 108 116 125 127 127 128 129 129 129 129 129 130 132 134 135 2. Kamk Tenge \is a vis US Dollar 100 99 98 88 85 81 84 83 83 83 82 82 81 79 77 76 Memo Xomnal exchangerate 144 I50 155 145 141 139 139 138 137 136 136 136 135 133 131 130 3.RealEflectiveExchangeRatelndex1/ 100 101 109 Ill Ill 110 108 107 106 106 108 106 105 104 104 106 Source Statistical Agency of the Republicof Kazakhstan.National Bank of Kazakhstan. WB staff eslimates I/Xational BankoftheRepublicofKazakhstan 62 ANNEXTABLE KAZAKHSTAN:SAVINGS AND INVESTMENTRATES, 1999-2004 6: (%OF GDP) 1999 2000 2001 2002 2003 2004 prelim. proj. Total savings 17.8 23.0 26.9 27.3 26.6 27.3 External -2.3 -8.6 0.9 -0.9 -6.2 -6.1 Domestic 20.1 31.6 26.0 28.2 32.8 33.4 Government 11 -2.5 1.4 5.1 5.2 7.9 8.9 Rest of the economy 22.6 30.1 20.9 23.0 24.9 24.5 Total investment (National Accounts) 17.8 23.0 26.9 27.3 26.6 21.3 Government 1.5 1.3 1.8 3.3 4.4 5.0 Rest of the economy 16.2 21.7 25.1 24.0 22.2 22.3 Yon-extractive sectors 5.0 5.7 5.5 5.2 4.5 4.6 Yon-extractive sectors 5.1 5.7 7.0 7.0 6.2 6.3 Statistical discrepancy -0.1 -1.5 -1.8 -1.7 -1.7 Mining and infrastructure 10.7 15.3 19.4 18.9 17.4 Oil and gas sector 21 9.1 13.6 16.9 16.3 14.8 Memo: non-oil and gas, % non-oil GDP 9.8 11.2 12.3 13.5 14.1 of which nongovernment 8.1 9.6 10.3 9.1 9.0 Memorandum ifems: actual 6 months Total Investments 18.3 22.9 29.0 29.1 28.8 16.6 Oil. gas and mining 21 9.1 13.6 16.9 16.3 14.8 10.0 Government services 2.0 1.3 2.5 3.3 3.6 2.7 Infrastructure 31 1.6 1.7 2.5 2.6 2.7 2.0 Others, of rvhich 5.6 6.4 7.2 6.9 7.7 6.6 Tradeables(agriculture, manufacturing) 2.3 2.9 3.3 2.9 3.0 2.3 Rest (construction, trade, hotels, commerce and services) 3.3 3.5 3.9 3.9 4.7 4.3 Gross FDI inflow 11.0 15.2 20.6 16.7 14.9 13.9 Sources. Statistical Agency of the Republic of Kazakhstan.National Bank of Kazakhstan, Ministry of Finance of Kazakhstan, WB staff estimates I / Current consolidated budget revenue minus current consolidated budget expenditure. 21 Includes oil & gas extraction, services incidental to oil & gas extraction, mining. geological exploration & engineering related to oil&gas and transportation via pipelines. The latter includes fixed capital for the CPC construction. 31 Includes power, non-oil transport. communications, and other infrastructure. 63 ANNEXTABLE KAZAKHSTAN:EXPORTSKEY COMMODITIES, 1999-2004 7: OF (inmillions o fU S dollars) 1999 2000 2001 2002 2003 2003 2004 9 months 9 months Exports of goo& (BOP) 5989 9288 8928, 10027 13233 9622 14483 Exports of goo& (customs declarations) 5872 8812 8639 9670 12927 9455 14093 Total primary commodities 4722 7971 7635 8686 Major primary commodities 4060 7239 6829 7841 11282 8411 12503 Fuel and oil products 2288 4827 4760 5641 7907 5929 895 1 O.W. Oil and gas 2392 4387 4464 5363 __ __ -_ Ferrousmetals 886 1I 7 8 1008 . 1I39 2069 1607 2363 Copper and copper products 576 738 718 715 742 53 1 850 Grain 311 496 344 346 565 345 340 O.W. Wheat 267 450 321 325 Other primary commodities 662 732 806 845 Live stock and live stock products 22 I O 18 19 Crop prodxtion (excl. Grain) 68 63 49 62 Cotton 51 81 86 107 Minerals (excl. Fuel and oil prohcts) 165 219 269 276 Base metals and base metalsproducts(excl 1 356 358 384 380 Manufactures (adjusted to personal shoppers: 1266 1317 1293 1341 O.W. Food(Processedagricultural products) 24 35 48 43 Fats. animal and vegetable oil 1 1 4 4 Food products, alcohol and soft drinks, vineg 23 33 43 39 Memorandum items. Agriculture 476 686 544 517 -- __ _ _ Source: National Bank o f the Republic o f Kazakhstan. Agency o f Statistics of the Republic of Kazakhstan ANNEXTABLE8: KAZAKHSTAN: CONSOLIDATEDGOVERNMENT FISCALACCOUNTS, 1999- 2007 1999 2000 2001 2002 2003 2004 2005 2006 2007 Actual Actual Actual Actual Actual Prelim. W B Est. WB Proj. W B Proj. (In percent o~CDPJ h'on-oil budget revenue 17.2 18.6 19.7 18.8 18.8 19.4 19.0 19.1 19.3 Current programs' expenses. net 20.3 20.3 19.5 17.8 17.2 18.0 18.4 18.8 19.5 Development programs' expenses, net 2.7 2.5 3.5 3.6 5.3 5.4 7.2 5.2 4.5 SON-OIL STATE BUDGET DEFICIT -5.9 -4.2 -3.2 -2.6 -3.7 -4.0 -6.6 -5.0 -4.7 Oil revenue spent through the budget 0.7 3.2 2.3 2.3 2.7 3.6 4.7 4.4 4 1 STATE BUDGET DEFICIT -5.2 -1.0 -0.9 -0.3 -1.0 -0.3 -1.9 -0.6 -0.6 NFRK savings 0.0 0.0 5.8 2.9 5.0 2.5 1 3 0.3 -0.1 Oil revenue sa\ed in NFRK 0.0 0.0 2.3 1.2 2.7 2.3 I.2 0.3 -0.1 Non-oil revenue sabed in NFRK 0 0 0.0 0.2 0.2 0.3 0.0 0.0 0.0 0.0 Net imeshnent income from NFRK management 0.0 0.0 0.3 0.2 0.1 -0.3 0.0 0.0 0.0 Other non-prohibited revenue savedin NFRK (pn\,atization 0.0 0.0 3.0 1.3 1.9 0.4 0.0 0.0 0.0 and sale ofstate oil shares) Sale of land 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Privatization to the budget 1.7 0.8 0.5 0.5 0.1 0.I 0.0 0.0 0.0 CONSOLIDATED BUDGET BALANCE -3.5 -0.1 5.4 3.1 4.0 2.3 -0.6 -0.3 -0.7 Consolidated government revenue 17.9 21.9 24.9 22.7 24.5 25.1 24.9 23.7 23.3 Total oil revenue 0.7 3.2 4.7 3.5 5.3 6.0 5.9 4.7 4.0 Total non-oil revenue 17.2 18.6 20.2 19.1 19.2 19.2 19.0 19.1 19.3 Total state budget expenditure, net 23.1 22.8 23.0 21.4 22.5 23.4 25.6 24.1 24.0 Statebudget expenses, net 22.2 7 7 7 21.5 20.6 20.7 22.5 24.3 23.6 24.0 Current expenses. net 20.3 20.3 19.5 17.2 16.6 17.2 17.5 17.8 18.5 Wages and social contributions 4.9 4.I 3.8 4.0 3.7 4.3 4.6 4.9 5.5 Goods and services 6.2 7.6 8.6 6.7 6.7 7.1 7.1 7.1 7.1 Interest 1.1 1.4 I.2 1.o 0.8 0.6 0.6 0.6 0.6 Subsidies and current transfers 8.1 7.3 6.0 5.5 5.5 5.2 5.3 5.2 5.3 of which: Pensions ... 3.9 3.4 3.2 3.2 3.1 3.2 3.3 3.3 Capital expenses, net I.9 I.8 2.0 3.3 4.1 5.3 6.8 5.8 5.5 State budget expenses, net 22.2 7 7 7 21.5 20.6 20.7 22 5 24.3 23.6 24.0 General public services 1.4 I.4 I.6 I.2 1.4 I.5 1 5 I.5 I.5 Defense 0.9 0.8 I O 1.O I.o 1.o I.2 1.2 15 Public order and safety I.6 I.8 2 0 2.1 2.0 2.1 2.3 2.2 7 7 Education 3.9 3.3 3.3 3.2 3.2 3.4 3.6 3.6 4.0 Healthcare 2.2 2.1 I.9 I.9 I.9 2.4 2.8 2.9 3.0 Social security and welfare 7.9 6.6 5.7 5.3 5.2 4.9 5.3 5.3 5.2 Housing 0.3 0.9 0.9 0.7 0.7 I.2 I.7 I.6 I.6 Culture, sports, tourism and informational space 0.6 0.7 0.6 0.6 0.7 0.8 0.8 0.7 0 7 Fuel, energy and sub-surface use 0.0 0 0 0.2 0.2 0.2 0.5 0.5 0.2 0.1 Agriculture 0.3 0.4 0.7 0.8 I.o I.3 I.6 I.6 I.5 Industry and construction 0.1 0.3 0.I 0.1 0.1 0.0 0.0 0.0 0.0 Transport and communication 0.6 I.5 1.4 I.5 I.8 1.9 I.8 I.9 I.9 Other I.3 I.2 1.o I.o 0.6 0.7 0.6 0.3 0.3 Interest 10 I.4 I.2 I.o 0.8 0.6 0.6 0.6 0.5 Net budget lending 0 9 0.7 0.6 0.5 0.5 0.3 0.2 -0.1 0.1 Financial assets operations 0.0 0.0 0.8 0.3 I.3 0.6 I.3 0.8 0.7 Discrepancy 0.0 0.0 0.0 0.0 0.0 0 0 -0.2 -0.3 -0.8 Total capital revenue I.7 0.8 3.5 I.8 2.0 0.5 0.1 0.0 0.0 NFRK capital rebenue 0.0 0.0 3.0 1.3 I.9 0.4 0. I 0.0 0.0 Budget capital revenue I.7 0.8 0.5 0.5 0.1 0.1 0.0 0.0 0 0 CONSOLIDATED BUDGET BALANCE -3.5 -0.1 5.4 3.1 4.0 2.3 -0.6 -0.3 -0.7 DEFICIT FINASCING (-) 3.5 0.1 -5.4 -3.1 -4.0 -2.3 0.6 0.3 0.7 Toral "VFRK savings (-j 0.0 0.0 -5.8 -2.9 -5.0 -2.5 -1.3 -0.3 0.1 Total net borrowing (-j 3.5 0.1 0.4 -0.2 0.9 0.2 I.9 0.6 0.6 Net extemal borroaing 2.4 I.2 0.3 -1.4 0.2 -0.9 0.0 0.0 -0.5 Net domestic borrouing I.O -1.1 0.I I.2 0.8 1.1 I.9 0.6 1 . 1 VET FINANCIAL GO\'EK\>lENT ASSETS (eop) -31.6 -25.5 -14.5 -9.7 -3.5 0.0 -0.7 -0.9 -1.5 NFRK stock (eop) 0.0 0.0 5.8 7.9 11.5 12.0 11.7 10.5 9.0 Totalgovernment debt (eop) 31.6 25.5 20.4 17.7 15.0 12 I 12.3 1 I.4 10.5 External debt (eop) 24.8 21.8 17.6 14.3 11.3 7.9 6.8 6.0 4.7 Domestic debt (eop) 6.8 3.6 2.8 3.3 3.6 4.2 5.5 5.4 5.8 Lourre World Bank st~ffrrlculaliam bared on the official data from the Kuakh aulhoriliei 65 ANNEXTABLE KAZAKHSTAN: COMMERCIAL BANKLOANSBY SECTOR, 1998-2004 9: (billion current and constanttenge, end o fperiod) 1998 1999 2000 2001 2002 2003 2004 March June Sept Dee March June Sept Dee (Billion currenf tenge) Total, of which: 86 139 216 490 612 697 782 879 978 1037 1184 1329 1484 lndushy 22 32 84 167 23 1 234 246 255 273 275 29 1 286 290 Agriculture 9 12 26 5 1 77 75 93 101 117 I06 99 IO8 125 Construction 7 6 I2 23 43 43 57 72 75 87 118 137 159 Transport 5 5 17 21 20 18 20 23 31 38, 43 47 56 Communication 1 3 6 I2 13 13 13 II 8 I O 13 I 5 20 Trade 22 41 92 151 198 209 225 249 277 296 334 366 399 Other 25 40 40 65 91 I04 129 169 I96 225 286 370 436 (Billion conslanr ZOO2 lenge, end ofperiod) Total, of which: 126 173 313 522 672 685 165 855 916 956 1081 1197 1299 Industry 32 40 96 I78 23 I 230 240 248 256 253 266 258 253 Agriculture 14 15 29 54 77 74 91 99 IIO 97 91 97 110 Construction 3 7 14 25 43 43 56 70 70 80 108 123 139 Transport 7 6 19 22 20 18 19 23 29 35 39 42 49 Conununication 2 4 7 12 13 12 12 I O 7 9 12 14 17 Trade 33 52 I04 161 198 206 220 242 259 273 305 330 349 Other 36 50 45 70 91 102 126 164 I84 207 26 I 333 382 Real Growth (%) Total, of which: 31.3 80.9 66.6 28.8 28.3 34.0 41.1 36.2 39.5 41.4 40.0 41.8 Industry 26 I38 86 30 25 24 24 II 10 11 4 -1 Agriculture 8 IO0 84 42 40 59 61 43 31 I I 0 Construction 147 90 81 74 46 63 74 65 89 93 77 98 Transport -16 22 1 20 -10 -I1 -20 0 45 92 104 86 67 Communication 77 85 85 3 -9 2 -36 -43 -16 -2 36 I38 Trade 58 I02 55 23 24 27 33 31 33 39 36 35 Other 39 -10 54 31 51 64 94 101 103 107 103 108 Composition of loans by sector (%) Total, of Hhich: 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Industry 25.4 23.2 30.5 34.1 34.3 33.6 31.4 29.0 28.0 26.5 24.6 21.5 19.5 AgricuINre 10.8 8.5 9.4 10.3 11.4 10.8 11.9 11.5 12.0 10.2 8.4 8.1 8.4 Construction 2.3 4.1 4.3 4.7 6.4 6.2 7.3 8.1 7.7 8.4 10.0 10.3 10.7 Transport 5.5 3.4 6.0 4.3 3.0 2.7 2 5 2.7 3.2 3 7 3.6 3.5 3.8 Conmiunication I.6 2.1 2.1 2.4 I.9 I.8 1.6 I.1 0.8 I.o 1.1 I 2 1.3 Trade 25.8 29.8 33.2 30.9 29 4 30.0 28.8 28.3 28.3 28.6 18.2 27.5 26.9 Other 28.6 29.0 14.4 13.3 13.6 14.9 16.5 19.2 20.0 21.7 24.I 27.8 29.4 Memo: CPI eop (2002=100) 68.1 80.3 88.2 93.8 100.0 101.7 102.3 102.8 106.8 108.5 109.5 111.0 114.3 Source: National Bank ofthe Republic of Kazakhstan and WB staff calculations 66 ANNEXTABLE10: SELECTEDINDICATORSFORKAZAKHSTANAND COMPARATORCOUNTRIES, 1990-2003 1990 1991 1992 1993 1994 199.5 1996 1997 1998 1999 2000 2001 2002 2003 GDP Per Capita US$at aver'ageexchangerates ChezhRepublic 3,366 2.181 2.903 3.328 3.975 5.036 5,598 5.141 5,535 5.347 5,007 5,593 6.814 8.375 Estonia 2.831 2,978 2.527 2.461 2,562 2.810 3.077 3,296 3.772 3.775 3.756 1.106 4.792 6,210 H%w 3.189 3.231 3,609 3,749 4,045 4.367 4.43 I 4.503 4.652 4.772 1.657 5,088 6.390 8.182 Latwa 2.573 2.731 1.904 1,708 1.812 1.902 2,045 2,297 2.526 2.782 3.025 3.249 3.595 4.167 Lithuania 2.771 2.712 2.260 1,968 1.857 2.018 2.386 2,750 3.121 3.070 3.247 3.473 4,052 5,273 Poland 1.547 1.998 2.198 2,232 2.556 3.293 3,724 3,976 1.363 4,251 4.309 4,808 5 . w 5.487 Slovakia 2.931 2.053 2.215 2.51 I 2,893 3.617 3,876 3,938 1.111 3.778 3.750 3.883 4.196 5.922 Slovenia 5.781 6.330 6.271 6.443 7.233 9.419 9,481 9. I67 9.876 10.106 9.533 9.877 11.181 13.383 RussianFederation 3,485 3.127 3.095 2.929 2.663 2.670 2.651 2.749 I.su 1,339 1,784 2.118 2.399 3.022 Ukraine 1,570 1.490 I,418 1.258 1.012 936 872 989 833 633 632 771 870 1.024 Kazakhslan 1,647 1,512 1.515 1.429 1.316 1.288 1.350 1.146 1.469 1.130 1,229 1.191 1.659 1.995 EUS (weighted average) 2.370 2.441 2.603 2.701 3.050 3.754 4.105 4 220 4.565 4.487 4.152 1.898 5,484 6.170 Ukraine and Russia (w.a.) 2,989 2.925 2.660 2.495 2.235 2,222 2,194 2 298 1.586 1.159 1.492 1.778 2.012 2.519 Savings ratio, X GDP ChezhRepublic .. 294 248 23 8 26 8 25 I 23 I 220 199 203 Estonia .- 220 176 I 5 9 20 1 I 9 3 197 2 0 1 175 176 H % w 164 189 20 7 189 I 8 8 179 202 185 145 L a h l a - ---- 119 128 12 6 I 6 6 I 5 4 196 174 180 177 Lithuania - -- 136 12 5 I 3 0 12 5 II2 129 I 5 5 1 5 8 163 Poland -- 193 185 I 8 3 I 9 5 1 6 1 176 178 I 5 8 159 SlOvdkia - -- 270 222 219 26 5 23 9 225 24 8 19 8 259 Slovenia -- 21 I 229 212 21 2 24 3 22 8 24 I 24 3 247 RussianFederalion -- 228 228 I8 3 162 26 9 349 299 2 6 1 273 Ukraine -- 209 I 8 I I 7 2 I6 5 24 5 244 234 273 271 Kuakhstan -- 220 137 12 6 102 I 5 2 210 187 212 234 EU8 (weighted average) -- 205 193 I 9 5 20 7 I s 5 1 8 8 193 1 7 1 174 Ukraine and Russia (w.a.) .- 223 21 6 I 8 0 I 6 3 26 3 322 283 266 27 2 Investment Ratio."AilGDP ChezhRepublic -- 266 268 298 340 3 4 2 326 300 28 1 29 5 30 1 28 9 28 7 Estonia -- 26 9 267 274 266 27 8 31 0 293 215 27 8 28 9 31 4 33 3 Hwar, -- 16 I 200 222 224 255 266 289 287 30 9 27 I 211 24 2 Lanid -- 4 1 2 9 2 191 169 186 231 2 7 7 269 27 0 29 2 27 3 26 0 Lithuania -- I 5 7 192 184 233 2 1 1 249 2 5 8 227 I 9 8 20 6 22 I 26 9 Poland -- 1 5 2 I 5 6 177 197 219 230 216 219 24 7 20 7 I S 9 I S 9 Sloiakia -- 28 I 2 1 7 21 0 24 8 347 34 5 310 276 26 I 30 0 29 1 24 7 Sloiema -- 1 - 8 193 206 235 235 246 258 288 27 0 2 1 2 23 5 24 8 Rus~dnFederation -- 34 6 270 25 5 2 5 4 23 7 22 0 I 5 0 148 187 _ _ - 77 7 21 I 196 Lkrame -- 345 363 353 267 227 214 208 175 20 2 21 8 I 8 7 196 Kadhstan .- 315 200 287 233 161 I 5 6 I 5 8 1'8 18 I 26 9 27 3 27 4 EL8 (weighted a\erage) -- 191 1 8 7 206 228 251 260 269 261 26 3 2 1 1 22 6 22 5 Ckraine and Russia(w.a.) -- 346 294 280 2 5 7 234 218 165 I 5 5 19 I 22 1 20 5 196 Government spending, '% GDP ChezhRepublic - 419 418 391 385 384 376 370 392 391 38 0 41 1 Estonia .. 333 330 349 329 315 320 363 334 318 32 0 32 4 Hunguy - 568 57 8 19 1 4 1 5 45 5 49 I 46 I 307 303 34 9 31 0 Latvia - 359 409 415 395 3 8 1 1 3 4 419 401 3 7 1 38 6 37 8 Lithuania -- 33 8 364 310 342 33 5 369 396 33 0 31 I 30 8 31 I Poland - 578 1 6 3 418 414 410 393 395 3 7 1 1 1 9 42 7 16 1 Sloiakia -- 4 4 1 1 2 4 1 3 3 4 1 2 44 I +I5 1 2 8 100 380 25 6 39 9 Slo\enia - 467 1 6 1 429 4 2 1 431 432 439 419 1 2 8 43 0 13 0 RussianFederation - 4 7 1 48 1 4 3 1 453 1 7 8 425 367 33 8 347 38 2 36 3 Lkraine -- 709 506 42 7 399 13 6 38 0 31 I 345 3 1 1 35 2 35 I Kazakhsian -- 254 2% 1 25 7 25 9 28 I 26 I 23 1 22 8 23 0 21 4 23 3 EU8 (weighted average) -- 51 8 460 43 6 427 409 405 405 368 388 38 8 42 4 Ukraine and Russia (n.a.1 -. 535 488 13 2 13 9 46 7 41 1 360 339 346 3 7 1 360 Source World Bank. LVorld DevelopmentIndicators.IMF InternationalStatistics, and\Voild Bank stafTestimdies ANNEXTABLE10 ---CONTINUED 1990 1991 1992 1993 1991 1995 1996 1997 1998 1999 2000 2001 2002 2003 Rlanufacturinglabor productivit), USS per worker ChezhRepublic -. 7.179 8,621 10.418 13.216 14.659 13.640 11.974 14.979 14,692 16.013 18.967 22.961 Estonia -- 6.287 5,576 5.842 5,814 6.101 6,500 8.093 7.985 8.405 9.331 10,922 14.376 Hunzav -- 11.569 11.997 12.708 13.971 14.035 14,777 14.267 13.723 13.661 14.105 17,564 22.514 LatLia -. 6.576 5,141 5.284 6.723 7.053 7,941 7.039 6.805 7.061 7.763 8.586 10.085 Lithuania -. 11.116 9.096 7.779 7,056 7,076 8.194 9.224 9.178 10.949 11.719 12,429 16.869 Poland -- 6.401 7.175 8.126 10.865 11.600 11,308 11.782 11.688 12,345 12,963 13.271 14,936 Slovakia -- 5.044 5,783 7.331 11.197 10.944 9.821 10.105 10.295 10.486 I1.494 11,931 15.250 Slo\enia -. 21.293 18.572 21.986 25.731 25.943 26.069 28.696 29.882 28,355 28.518 32.000 38,370 RussianFederation ,-. -- 6.074 5.673 5.687 5.123 5,515 6.095 4.132 2.921 3.799 4.216 4,529 5.669 Lkraine -- 9.031 5.341 4.796 4.524 3,910 4.226 3.815 2.703 1.628 2.151 2.745 3.415 Kazakhstan -- 1.136 4.120 4.392 3,121 3,126 3.623 4.213 3.787 5.181 7,064 7.090 8,695 EU8 (weighted ayerage) -- 7.771 8.251 9.231 11.620 12.221 12.015 12.553 12.166 12838 13.562 11.835 17.689 Ukraine and Russia (w.a.) -- 6.812 5,587 5.456 1.968 5.102 5.616 4.051 2.866 3.218 3.693 4.078 5,100 Agricultural labor productii worker ChezhRepublic 3.147 4.085 5,194 6.384 7.668 6.956 8,402 7.670 7.639 9.036 9,333 11.119 Estonia 3,229 3,079 3,352 1.395 4,816 5,023 5,496 5,808 5,913 6.171 6.757 8.682 Hungary 6.43 I 6.131 6,707 7.677 7,335 6.873 6.7 I 6 6.096 5.758 6.729 8.379 10.711 Latvia 2.946 1,829 1.550 2.132 1.837 1.174 1.090 1.471 2 058 1.935 2.082 2.41 I Lithuania 2,824 2,620 2.102 2,125 2.828 3,049 2.869 2.531 2.629 3,096 3.407 4.378 Poland 1.354 1.344 1.491 2.029 2.138 1.953 1.962 1.716 I 6 3 5 1.943 1.712 1.880 Slovakia 2.544 3.118 3.864 4.669 1.662 4.689 5,124 1.716 5 323 6.399 6.710 7.931 Slo\enia 6,324 5.998 5.482 7.690 7.792 6.080 6.340 6.300 6.491 5,969 6.147 7,731 RussianFederalion 2.960 2.918 2.115 2.418 2.637 2.853 I 7 8 7 1.608 1806 2.160 2.163 2.401 Ukraine 2,850 2.579 1.360 1.126 944 1.078 861 823 997 1.256 1.275 1.352 Kazakhstan 3.395 2.097 2.063 1.678 1.819 1.61 I 1,309 1.178 738 833 838 891 EL8 (neighted auerage) 2.697 2.759 3.076 3,828 4.035 3.722 3.942 3.596 3.578 4.157 1.383 5,265 Ukraine and Russia (w.a.) 2.931 2.830 1.919 2.085 2.202 2.398 1.551 1.409 1.600 1.931 1.939 2.137 Infant Rlortalitg ratio. per 1000persons ChezhRepublic 10 7 5 4 Estonia 15 -- I 4 -- i1 -- I O Hungary I 5 -- II 8 8 Latiia 16 -- 19 -- I? -- I 7 Lithuania I 7 -- 22 -- I 7 8 Poland 16 -- I1 9 8 Sloiakia 14 -- II 8 8 Slovenia 8 6 5 4 RussianFederation 21 -- I S -- I 8 -- I 8 Ukraine I 8 .. 20 -- I 7 -- 16 Kazakhstan 41 .- 52 .. 7 I .- 76 EU8 (weighted aberage) 14 -- 13 I O 8 Ukraineand Russia (!\.a,) 20 -- 19 18 -. I7 Spending in education & health.'% GDP ChezhRepublic -- 103 102 101 9 7 9 9 9 7 102 Estonia -- 8 1 9 1 8 3 8 2 9 2 8 4 7 0 Hungary -- 7 9 7 8 8 1 8 5 8 0 8 0 8 1 Latiia -. 5 7 5 7 5 3 5 7 5 6 5 1 5 0 Lithuania -. 2 7 3 1 5 1 6 3 6 2 5 9 6 1 Poiand .. 9 5 9 8 9 5 9 6 9 9 101 1 0 6 Slovakia .- I 3 0 I 2 1 1 1 6 107 1 0 6 I o 5 105 SloLenia -- 9 4 9 8 101 100 9 9 9 5 9 8 RussianFederdtlon -- 6 4 6 7 8 0 6 2 6 7 5 2 5 3 Ukraine .. 101 8 7 9 5 7 9 6 7 7 2 7 2 Kazakhstan .. 7 5 7 2 7 1 6 2 6 1 5 3 5 2 EU8 (neighted aterage) -- 9 1 9 3 9 2 9 2 9 4 9 1 9 7 Ukraineand Russia (w.a.1 -. 4 8 5 0 6 0 4 6 5 0 3 9 1 0 Source World Bank. h'orld Deielopment Indicators.IAIF International Statistics.and U'orld Bank staffestimates 68 ANNEX2: LISTOF BACKGROUND PAPERS AND ACTIVITIES Background Papers: 1. The Role o f a Public Investment FundinPromoting Diversification inKazakhstan, Gregory T. Jedrzejczak and Pedro L.Rodriguez, January 2003. 2. Economic Diversification inKazakhstan, with Special Emphasis on the Oil and Gas Value Chain, Gary Gereffi (Duke University, Durham, North Carolina, USA), Pedro L. Rodriguez, and Zhanar Abdildina, September 2003. 3. Selected Issues on the Management o f Oil Windfalls, Samuel Otoo, Nina Budina, and Pedro L.Rodriguez, December 2003. 4. Elements o f a Competitive Environment inKazakhstan, Samuel Otoo, Nina Budina, and Pedro L.Rodriguez, December 2003. 5. Supplier Development inthe Kazakh Oil and Gas Sector, Paul Domjan and Alfred Waltkins, April 2004. 6. Note on Macroeconomic Management and National Fund Concept, Ricardo Hausmann, Sweder Van Wijnbergen, Pedro L.Rodriguez, MadiUmbetaliev, and Ilyas Sarsenov, August 2004. 7. Investment Strategy for Kazakhstan's Oil Stabilization and Savings Fund, Roberto Rigobon, October 2004. 8. Priorities for Financial Sector Reform: Selected Issues and Options, Thomas Glaessner, Joaquin Gutierrez, Pedro L Rodriguez, Aslan Sarinzhipov, and Ilyas Sarsenov, October 2004. 9. Enteringthe Information and Communication Technology, Gareth Locksley and Howard Williams, April 2004. 10. Fiscal Policy and the Oil Windfall Management, Nina Budina and Arthur Radzvill, January 2001 11. The Bottleneck to Sustainable Development: Telecommunications inKazakhstan. Summary comments and suggestions based on a brainstorming Seminar on Electronic Communication and Sustainable Development (Astana, February 17-18, 2005) 69 Other Activities: 1. Comments onthe Government's Innovation Industrial Development Policy andAction Plan (June 2003). 2. Note on Technoparks (June 2003). 3. Comments on the draft 2004-2006 Medium-Term Expenditure Framework (June 2003). 4. Seminar on ways to foster Innovation (East Asia Experience); Sponsored by Japanese Government andWBI (April 2004). 5. Video conferenceson promoting innovation (WB innovation grant) (April 2004- June 2004). 6. Comments on 2005-2007 Medium-TermExpenditure Framework (August 2004). 7. Video Conference series on Economic Management (February 3 and March 11,2005) 70 ANNEX3: REFERENCES Auty, R. (2001), "Resource Abundance and Economic Development", WIDER Studies in Development Economics, Oxford UniversityPress. Bamett, S., Ossowski, R. (2002), Operational Aspects of Fiscal Policy in Oil-Producing Countries, IMFWorking Paper 021177. Berengaut, J., Keller, P., Elborgh-Woytek, K. (2004), IMF, Republic o f Kazakhstan, SelectedIssues and Statistical Appendix, SM/04/223. Davoodi, H. (2002), IMF, Republic of Kazakhstan, Selected Issues and Statistical Appendix, CWO2164. J. Carmichael, A. Fleming, D. Llewellyn (2004); It i s Aligning Financial Supervisory Structureswit Country Needs; World Bank Institute, WBI Learning Resources. D e Gregorio, J., Giovannini, A., Wolf, H. (1994), "International Evidence on Tradables and Non- tradables Inflation", European Economic Review, No. 38. EifertB., Gelb A., Bode, TallrothN.(2002), "The Political Economy ofFiscal Policy and Economic ManagementinOil-Exporting Countries", World Bank Policy ResearchPaper, No. 2899. Engel, E., Valdes, R. (2000), "Optimal Fiscal Strategy for Oil Exporting Countries", IMF Working Paper 00/118. Fasano, U. (2000), "Review of the Experience with Oil Stabilization and Savings Funds in Selected Countries", IMF Working Paper 001112. Frankel, J. (1999, "Have Latin American and Asian Countries So Liberalized Portfolio Capital Inflows That Sterilization i s Now Possible?", Paper presented at the 1995 Annual American Economist Association Meetings, Washington DC. Gelb, A. (1988) "Oil Windfall: Blessing or Curse?", Oxford University Press. Goldstein, M. (1995), "Coping With Too Much O f a Good Thing: Policy Responses For Large Capital Inflows to Developing Countries", World Bank Policy ResearchPaper, No. 1507. Grennes, T., Ghura, D. (1993), "The Real Exchange Rate and Macroeconomic Performance in Sub- SaharanAfrica, Journal of Development Economics", No. 42. Gylfason (ZOOO), "Natural Resources, Education, and Economic Development", 15th Annual Congress of EEA, Bolzano. 71 Hausmann R., Rigobon R. (2002), "An Altemative Interpretation o f the `Resource Curse"' Theory and Policy Implications", National Bureau o f Economic Research, Working Paper No. 9424. Hausmann, R. (2003), "Venezuela's Growth Implosion: A Neoclassical Story?" InRodrik, Dani (ed) "In Search of Prosperity: Analytic Narratives on Economic Growth", Princeton University Press. IMF (2003), Republic o f Kazakhstan - Staff Report for the 2003 Article IV Consultation., SM/03/168. IMF(2004), Republic of Kazakhstan -Selected Issues, Country ReportNo. 04/362. Medas, P. (2003), "The Non-Oil Sector in Kazakhstan: Links with the Oil Industryand Contribution to Growth", Republic of Kazakhstan-Selected Issues and Statistical Appendix, SM/03/174. Mclean, I.,Taylor, A. (2003), "Australian Growth: A Califomian Perspective", InRodrik, Dani (ed) "In Search of Prosperity: Analytic Narratives on Economic Growth". Mussa, M. (1990), "Exchange Rates in Theory and Reality", Essays in International Finance, No. 179, PrincetonNJ: InternationalFinance Section, Princeton University. Pack, H. and Noland, M. (2003), Industrial polices and growth: Lessons from intemational experience. Sachs, J. D. and M. Warner, A. (1995), "Natural Resource Abundance and Economic Growth", National Bureau o f Economic Research, Working Paper No. 5398. World Bank (2004a), "Kazakhstan - Dimensions o f poverty in Kazakhstan Vol. 1 o f 2 / Policy briefing", ReportNo. 30294. World Bank (2004b) "Kazakhstan's Livestock Sector - Supporting Its Revival", Europe and Central Asia Region, Working Paper Number 31382. World Bank (2004~)"Innovation in Fisheries Management for Kazakhstan", Europe and Central Asia Region, Working Paper No. 31383. The World Bank (2002) "From Natural Resources to the Knowledge Economy: Trade and Job Quality, Latin America and the Caribbean Studies-Viewpoints", Working Paper No. 23440. World Bank Country Economic Memorandum (1999, "Living with Oil", Chapter 3, Figure 3.7, WBDNo. 12849.