What the private sector needs from the State

Speech delivered by: President Suma Chakrabarti
Event: Carnegie Endowment for International Peace
Date: 15 April 2015

EBRD President Sir Suma Chakrabarti has delivered a speech at the Carnegie Endowment for International Peace in Washington, DC.
 
I. INTRODUCTION: THE STATE VS. MARKET AND THE ORIGIN OF THE EBRD
 
Good evening ladies and gentlemen. Many thanks to the Carnegie Endowment and to Andrew Weiss for hosting me here tonight. I am very pleased to see so many of you here, especially during a busy week!
 
The topic of my address this evening is what the private sector needs from the State.
 
Of course, it is interesting to be making these remarks in an institution created by the late great industrialist Andrew Carnegie. Carnegie, if my understanding of the history of the period is correct, made his fortune in the steel business during a period of fierce private sector competition and almost no government intervention in the economy. During the late nineteenth century in this country, there was of course minimal government oversight on standards, on anti-trust, on financial, labour and product market regulation and there were no income taxes to allow the state to serve the cause of social justice or redistribute wealth.
 
If you had asked what the private sector needs or expects from the State back then, the answer would be: not much! Not even the role of a nightwatchman!
 
Since that time, the debate on the role of the state versus the market in spurring economic growth and development, and in improving the well-being of citizens, is one that has animated economic policy and development economics for decades, and one that has captured my thinking as a development economist.
 
Today, however, I speak on this issue as the President of the European Bank for Reconstruction and Development, an institution that was created at a special point in history, and – indeed – a critical point in the debate of the state versus the market.
 
To recall, the EBRD was created after the fall of the Berlin wall and its charter was written at the very beginning of the 1990s. As such, it was ‘designed’ at the height of market triumphalism and the domination – not just in this city – of the “Washington consensus”.
 
This thinking is also embedded, to a certain extent, in the charter of the EBRD. The EBRD was specifically created to be unlike the other Multilateral or Regional Development Banks. It was created with a mandate to support the transition to a market economy, to support the private sector in particular, and to promote private entrepreneurial activity. As such, it was not given a traditional “development” mandate, where more emphasis was usually placed on state-led development. At the same time, EBRD was given another unique feature for a development bank: a political mandate to operate in countries committed to and applying the principles of multi-party democracy and pluralism. In this way, the Bank’s founders acknowledged the importance of inclusive political institutions for long-term economic success.
 
Of course, as you will recall, this was at the time when prominent political theorists like Francis Fukuyama spoke of the ‘End of History’. When the triumph of market economics and democracy as systems of economic and political governance was axiomatic. And when the transition in former communist economies, particularly those that emerged from communism with comparatively better human and physical capital, was expected to be reasonably short. The need for sustained international support in the form of finance for investment as well as policy dialogue and capacity building was expected to be fairly modest given the strong political commitment to reform and reintegration with the rest of Europe for many of these countries. The invisible hand of the market, along with a small state, was expected to take care of the rest.
 
 
II. THE IMPORTANCE OF STRONG STATE INSTITUTIONS
 
However, the transition process was not as short or as smooth as some had expected.
 
Some of the first generation reforms were carried out quickly – and there were seemingly good political economy reasons for this. This was broadly successful in countries such as Poland, the Czech Republic and the Baltics. But often they were carried out with little attention to regulation and the creation of market-supporting institutions. A good example of this was the early privatisations in some transition countries, where the rush to privatise outpaced the creation of important legal and regulatory institutions needed to promote good corporate governance and prevent asset stripping. The cause of market transition was set back by the very speed with which it was done in some cases, by the mis-governance and state capture it set in train and by the backlash it triggered from those who lost (or failed to gain) in a game of ‘winner take all’.
 
Nevertheless, even in countries that were doing well after the first rounds of reforms and sharp output contractions, tensions started to build. By the second half of the 1990s we started to see periodic economic crises – balance of payments/exchange rate crisis, banking sector fragility and macroeconomic mismanagement. This culminated memorably in the 1998 Russian financial crisis.
 
Underneath the region’s catch-up growth, which began to bring countries back to the level of output achieved prior to the onset of the transition recession, inequalities started to grow. There were clear winners and losers in the transition process; important regional disparities; and increasingly divergent paths across countries. These imbalances and growing tensions were also reflected in politics: political crises and new sets of powerful vested interests partially reversed or hindered reforms.
 
Transition – and transition of such fundamental proportion – was never going to be smooth. But the importance of having an effective state and of sound political and economic governance institutions to guide the process became increasingly apparent over time.
 
Not surprisingly, in the face of such experience, the consensus shifted, not least here in Washington DC, in the World Bank and the IMF. A more balanced model emerged, recognising the role of the state in putting in place the framework conditions for sustainable, inclusive, private-sector led growth. At the same time, a growing literature emerged on the importance of institutions in the development process. The importance of protecting private property and contract rights, promoting competition and upholding the rule of law became part of the development discourse. Economists like Dani Rodrik, Arvind Subramanian, Tim Besley and Daron Acemoglu, drawing on insights of intellectual giants like Douglas North, began to steer the development agenda more towards strengthening both political and economic institutions to support markets and ensure social cohesion.
 
In short, we learned that the preconditions for an effective market economy have to be delivered by the state. The EBRD has been learning these lessons on the ground in our recipient countries.
 
For example, our early efforts to support privatisation in eastern Europe were stymied by the absence of acceptable participants in deeply flawed privatisation processes. Our attempts to inject private sector and commercial discipline into infrastructure projects was hindered by both the public’s lack of readiness (for example in the case of toll roads in Hungary) and the weakness or complete absence of effective regulatory authorities. Moving too quickly to privatise municipal services in non-competitive markets, when the state was still weak, delivered sub-optimal results, such as with water utilities in Bulgaria. There is no point replacing a state monopoly with a private one if you don’t have a strong and effective state to regulate service provision and quality. In such contexts, strengthening the public provider might have been a more appropriate intermediate step than pushing prematurely for private sector solutions. Ownership, public or private, matters less than the environment within which firms operate.
 
These lessons influenced the way the EBRD thought about transition and the way it did business. We refined our concept of transition along the way, balancing the role of the state and the market, which in turn affected how we select and structure investments to fulfil our mandate.
 
The lessons we were learning were also influencing our approach to investments. We have become much more aware of the need to package investments together with policy advice and technical assistance in a more ‘integrated approach’ to promoting transition. A good example is our programme of investments in the water sector in Romania, where we helped to build state capacity at the municipal level for public sector contracting and gradual commercialisation of local utilities, and improved consistency and quality of supply for cities across the country. Another is our work in creating a legal framework for pre-harvest and post-harvest financing for agricultural producers in countries like Serbia and Ukraine.
 
Through the establishment of crop receipts and warehouse receipts, farmers have access to credit when they need it most, which sustains jobs and promotes food security. Transition success is ultimately about improving the well-being of citizens, not just putting the right institutions in place.
 
 
III. THE BALANCED MODEL – THE FOUR PILLARS
 
The consensus that emerged, at least at EBRD, is not one that will surprise you today. It is not, as some have suggested, a ‘Beijing Consensus’ that places primacy on the state. We do not conclude from our experience of the past 25 years of transition that state capitalism is a preferred model of development.
 
Rather, I like to think of the following four main broad pillars of our thinking about transition in the 21st century:
 
  1. First, policies matter. The policies that underpin a modern market economy and that enable private-sector led growth. Which toolkit of policies are we talking about?
  1. We know that a stable and growth-promoting macroeconomic environment is fundamental.
  1. We know that an appropriate regulatory framework for private sector development matters. This includes competition, product, labour and financial market regulations, tax policies, and all of the policies that together form an attractive investment climate and business environment.
  1. We know that tariff, subsidy and other policy reforms to promote sustainable development of infrastructure and a role for the private sector also matter, both in financing and service delivery. This means instilling commercial discipline and cost-recovery models. It means creating a legal framework for the development of public-private partnerships and for transparent and competitive public procurement. It also means creating the policy framework for energy efficiency, a critical factor in our region where we have some of the most energy intensive economies in the world.
  1. And more recently, we know that policies that ensure equality of opportunity, promote social justice and inclusion for women, minorities and other excluded groups and regions also matter. Without these, transition can easily falter or stall, as economies fail to take full advantage of the productive capacity of the workforce and social cohesion around the goals of transition fails to take hold.
  1. Second, institutions matter. Effective institutions are accountable, legitimate, transparent and competent. Which institutions do I have in mind?
  1. The basic institutions of the state such as a modern and effective judiciary that can enforce the rule of law, uphold contract and property rights and enforce commercial legislation.
  1. Effective public administration and a merit-based civil service is key. The best policies in the world will not result in very much if there is not the effective capacity in the civil service to implement the policies. In our region, we have seen that capacity is often very shallow, and can often disappear overnight, leaving massive gaps. Contrast Poland, which gave considerable weight early on to decentralisation and built up administrative capacity steadily through different political cycles, with countries in the Western Balkans, where every political shift led to the wholesale replacement of civil servants. Weak administrative capacity is a concern in even some of our high-income countries, irrespective of the size of the state. Civil service reform is a tricky business. Governments need to think hard about adopting measures that are appropriate for the country’s political culture. Institutions transplanted onto unfertile soil will not take root.
  1. Political institutions are also fundamental to this pillar. Market economies generate powerful interests that can attempt to influence or ‘capture’ the state in ways that do not reflect the public good. The key political governance challenge is to put in place a system that can allow markets to flourish while keeping these powerful interests at bay. Failure to do so tends to undermine public support for further market transition. Democratic systems tend to perform better at this. By replacing failed policies and leaders with new ones. By guaranteeing a level of transparency and accountability. And by dealing more effectively with corruption.
  1. Finally under this pillar, we should not overlook the importance of a free press and active civil society in a well-functioning market system. These institutions foster accountability and transparency, promote a balance of power in society and can act as a referee in upholding the ‘rules of the game’.
  1. Third, leadership matters. Strong political leadership is critical for reform success. Reforms are difficult, obstacles can seem insurmountable and temptations to succumb to corruption or populism can be great. Reform anchors – such as the prospect of joining the European Union, membership in rules-based institutions like the World Trade Organisation, support from standard-setting institutions like the OECD – can certainly help to push things onto the right track. But this cannot substitute for the conviction of strong and committed reform leaders. Reform breakthroughs like in Georgia after the Rose Revolution or in Slovakia after the replacement of the Meciar government were made possible by the energy and drive of the leadership. More recently, the economic reform push in Kazakhstan under Prime Minister Massimov and in Jordan under Prime Minister Ensour is also evidence of the importance of strong leadership for reform success.
  1. Finally, a long-term perspective matters. As we’ve learned after nearly 25 years in the business, transition is a long and winding road. There will be setbacks along the way. We in the development community need to be patient but persistent in promoting reforms. We also need to encourage governments to take the long view. Policies that are failing should be corrected. But policies that are working should not be jettisoned when new governments come to power. We have seen some cases of stop-start transition in parts of our region where government turnover has been high. There is little point in having state of the art policies, if they change at short intervals, or if we see massive reversals. Similarly, many investment decisions are long-term by their very nature. If there is no long-term perspective and no stability, these investments will simply not be made. We can learn from the far-sighted approach of successive administrations in emerging markets such as South Korea, Taiwan, Chile and Botswana, as well as in Estonia in our region of operations, which maintained continuity where it matters in pursuit of long-term reform.
 
IV. KEY LESSONS STILL VALID FOR OUR REGION TODAY
 
These four pillars are not just reflections based on what we see in the rear-view mirror of transition. They are very much at the core of how we see the priorities looking forward, including for some of the most advanced countries in our region.
 
In 2013 we published a landmark issue of our annual Transition Report. We noted that after a fast start in the first decade of transition, countries became ‘stuck’ and reforms began to taper off. This would not have been a concern had transition been close to completion, had countries achieved convergence to western European income levels and had the market institutions in those countries proven resilient to crises. But this was far from the case.
 
Since the onset of the global financial crisis, we have witnessed the fragility of transition in some countries while others have diverted from the reform path. In EBRD we question whether countries can get back on the right path and catch up to the living standards of their more advanced neighbours without fundamental reforms and strengthening of the state and governance in a number of areas.
 
And, they must do this against a backdrop of ongoing sluggish global and regional growth, epochal geo-political and security challenges, and occasionally weak support at home for painful reforms.
 
This reality has informed our own five-year strategy on how we can be of greatest assistance to countries in eastern Europe, south-eastern Europe, the former Soviet Union, and the southern and eastern Mediterranean that make up our region of operations.
 
 
V. RE-ENERGISING TRANSITION
 
The challenges facing our region have forced us to think long and hard about the obstacles and blockages to more successful transition, and how – in turn – we can re-double our efforts to support more fundamental changes in our region. Of course, the EBRD is a project-focused Multilateral Development Bank working primarily in the private sector, not an institution focused on fast disbursing policy-based lending. And we are not changing that. But there are still things we can do, in particular to help the state become a more effective enabler of strong, sustainable, inclusive private-sector-led growth. We are strengthening our policy dialogue and capacity building efforts, in areas closely linked to the EBRD’s project investments. Indeed, that is our strength, we know the obstacles facing the private sector from working with the private sector and private finance on a daily basis.
 
We will be working to re-energise transition over the coming five years, focused on three headline objectives:
  1. supporting economic resilience and sustainable, inclusive growth, precisely by putting more emphasis on shoring up reforms and institutions;
  1. promoting regional integration, within countries and across borders;  and  
  1. focusing on the supply of global public goods – especially in the areas of sustainable energy, mitigating climate change and food security – where reinforced state action and private initiative need to walk hand in hand to address persistent market failures.
 
We are doing this in a number of ways throughout the EBRD, but one initiative stands out as particularly relevant to the subject of today’s event.
 
Last year we launched the Investment Climate and Governance initiative. The initiative focuses EBRD resources and expertise on creating a level playing field for business, reducing investment obstacles, strengthening the legal framework and tackling corruption in countries where there is a strong reform commitment.
 
The initiative grew out of our first-hand experience of unfair practices against out-of-favour businesses in the case of Ukraine under the previous government. Such practices were hurting Ukraine, stunting its development potential. So, one of the first things we did with the new Government after the Maidan uprising was to sign an Anti-Corruption Memorandum of Understanding on ways to work together to improve things for the private sector.
 
We are starting in Ukraine with the establishment of a Business Ombudsperson Institution, which will help to create a level playing field for business and a recourse mechanism for businesses with legitimate claims against state or sub-state entities that infringe on their rights. Hopefully, the corporate raidering we have seen in recent years will become a thing of the past with the new Government, but it is a long road ahead and the reforms will be challenging.
 
Since the Ukraine Memorandum of Understanding was signed, we have signed broader-based investment climate and governance MoUs with governments in Albania and Moldova, and we hope to sign one with the government of Serbia later this year.
 
As other countries step up to meet the challenge of fighting corruption, strengthening state institutions and implementing reforms to attract investment, EBRD will be there to help them.
 
 
VI. EBRD AND THE EVOLVING GLOBAL DEVELOPMENT AGENDA
 
Ladies and gentlemen, transition is not over. We all know that tackling the transition challenges our countries face will take concerted effort by the leaders, businesses and citizens of those countries.
 
EBRD has been part of the process from the beginning and will be there supporting transition countries for the duration. This applies equally to our existing countries and to new ones, whether they are in the southern and eastern Mediterranean region or in the crises-affected south-eastern European region.
 
EBRD is changing, adapting and expanding to help meet these challenges. Although we are the largest financial investor in many of these countries, we cannot go it alone. Other institutions and actors must also play a role.
 
Interestingly, as the Bank moves to broaden its private sector perspective to embrace some of the issues that are the bread-and-butter of other development organisations, such as gender and inclusion as aspects of transition, so the global development agenda has moved gradually in the direction of EBRD’s market-based approach.
 
We only need to look at this year, and the discussion on the Sustainable Development Goals to be launched in September at the UN General Assembly meeting, and on Climate Change and the upcoming COP21 meeting in Paris, and on the financing arrangements for these two integrated agendas.
 
For both the new Sustainable Development Goals and the climate change agenda, the dialogue is all about the importance of sustainable inclusive private-sector led economic growth, backed by strong infrastructure, and shored up by strong institutions and an effective state. Climate resilience is widely seen to be key to the sustainability of any development efforts going forward. Finally, the financing agenda is dominated by discussions about how to leverage the private sector.
 
So, the core mandate of the EBRD, even though developed at a very special moment in time, has proved the test of time, with some modernisation along the way in the light of experience and better understanding of the challenges. Indeed, as we start to talk more about the enabling role of the state, I strongly believe that we have a set of tools and expertise that is highly complementary to those of other Multilateral Development Banks. Leveraging our respective skills will be critical as we embark upon the efforts to implement the substantial and ambitious sustainable development agenda going forward.
 
Thank you very much for listening.