This is about the difficulties to establish the Rule of Law in Soth-Est Europe, about the economic costs of a lack it and about thrust and confidence building in networks.

1. Final 25/11/2008
Are the Western Balkan Economies trapped by the weak Rule of Law?
Economic aspects of enforcing the rule of law
Background paper of a presentation
to the International conference
Perspectives of sustainable economic growth
in the countries of SEE
Organised by ECOSTAT
Government Institute for Strategic Research of Economy and Society
Budapest, November 6-8, 2008
O. Bodin1
1
The author is an official of the European Commission. The view expressed in this document does not
necessarily reflect the opinion of the European Commission.

3. i
“… mature markets rely on deep institutional underpinnings, institutions that define property
rights, enforce contracts, convey prices, and bridge informational gaps between buyers and
sellers. Developing countries often lack these markets and regulatory institution… However,
we do not know in detail how these institutions can be engineered, and policy makers cannot
always know how a market will function without them..”
The Growth Commission, 2007
“Despite the wealth of material, neither empirical nor theoretical research has yet advanced
to the point of offering clear and confident policy recommendations for the process of
institution-building or reform.”
Avisnash K. Dixit,2004

4. ii

5. iii
Are the Western Balkan Economies trapped by the weak Rule of Law?
Economic aspects of enforcing the rule of law
Table of contents
0. Introduction ........................................................................................................................ 1
1. The weak rule of law in SEE countries and microeconomic implications......................... 3
1.1. Insufficient progress................................................................................................... 3
1.2. Two models for regulating economic transactions .................................................... 5
A highly efficient, but fragile, rule of law…...................................................................... 6
…versus robust, but inefficient, network regulation.......................................................... 8
…resulting in a major market failure ............................................................................... 10
2. Macroeconomic implication of a weak rule of law.......................................................... 11
2.1. Investment, growth and weakeness in the rule of law: a regulatory trap? ............... 11
2.2. Alleviating obstacles to growth in an environment of weak rule of law................. 14
3. Transition to the rule of law and the EU accession process............................................. 18
4. Conclusions ...................................................................................................................... 21
Annex 1: Problems in doing business 2005 ............................................................... 23
Annex 2: EBRD transition indicators methodology .................................................. 25
Bibliography..................................................................................................................... 31

6. iv

7. 1
0. Introduction
The purpose of this paper is to reflect on the economic consequences of a weak rule of law,
and on how economic forces can create obstacles or increase opportunities for establishing the
rule of law as the supreme regulatory principle in the economy.
In line with the Copenhagen accession criteria, the European Union has put the rule of law on
top of the agenda of the accession countries. High standards in this respect need to be met to
ensure an adequate protection of human and civil rights, a cornerstone of the European values.
Respecting these standards is also a prerequisite for being able to implement effectively EU
and EU related legislation, and therefore to join the Union. It is also needed for establishing a
functioning market economy able to integrate the EU internal market.
Against this background, the European Commission has confirmed in its Enlargement
Strategy 20082 that the rule of law should remain a top priority for accession countries as only
few progress have been made since the preoccupating diagnostic established in 2007:
“The enforcement of the rule of law, notably through judicial reform, and the fight against
corruption and organised crime are top priorities. Most countries have taken steps to improve
the organisation and performance of their justice systems…However, justice systems still
require considerable improvement across the region. Wide-ranging reforms need to be
conducted in a sustained manner to ensure the independence, efficiency and accountability of
the justice system…Criminal networks extend to various socio-economic sectors and into
politics. They often benefit from insufficient transparency in public procurement, investment
planning and privatisations… Considerable and sustained efforts are needed in this area.”3
In this paper, the rule of law is looked from economic point of view. It is defined as the
existence of a public, independent and impartial institution4 or institutional system
guaranteeing that:
• Given the legislation in force, property rights are respected and contracts will be
enforced with a high degree of certainty;
• The regulatory and legal framework ensure that transactions take place in a
competitive, transparent, fair and open environment; the purpose is that transactions
are decided only on the basis of an assessment of their intrinsic value, disregarding
any consideration linked to the identity of the contractors. In other words, the market
has to be free for entry and exit and impersonal; implementation of economic
regulation and policies by public agents should be impartial, predictable and fair
(guaranteeing equal access and conditions).
If theses conditions are filled, economic theory predicts that a market economy will produce
best results in allocating private goods and services and in engineering the private
investment level needed for sustained growth.
2
(Commission of the European Communities, 2008)
3
(Commission of the European Communities, 2007), p. 6
4
Institutions are conceived here in a very broad sense and refer to any legal rule, effective norm and beliefs,
public organisation or private arrangement constraining choices of individual agents at a given moment.

8. 2
Section 1 provides an overview of indicators on the degree of enforcement of the rule of law
within the SEE countries, which illustrates the insufficiency of progress made for its
economically relevant part. After having briefly recalled the way an impartial and trustworthy
judicial system can boost economic activities, the starting point of the reflection is that
economic activities do not stop with a weak rule of law. To undertake activities, economic
agents still need to be reasonably confident that contracts will be respected and that expected
earnings will not be stolen. Some regulation therefore is needed which will have to be
“invented” by the economic agents as it supposed not to be satisfactorily offered by the
collective good “rule of law”. It is shown that, in case of a weak rule of law, the emerging
regulation is robust but inefficient and results in major market failures.
Building on the previous microeconomic analysis, Section 2 address some expected
consequences of a weak rule of law on macroeconomic aggregates, and investigates possible
implications on effectiveness and prioritization of policy recommendations. It is shown that
without a substantial effort to enforce the rule of law, countries will be bogged down in a “
regulatory trap”, characterized by low judicial credibility and poor public administration,
great reliance on informal regulation, low productivity and international integration, and in
turn few resources to improve the badly needed provision of public goods. It is also argued
that economic agents will not respond to incentives as expected by traditional economic
models, which are in general based on the hypothesis that the markets function effectively.
While there are obvious and well documented substantial economic (and political) benefits to
be gleaned from introducing the rule of law, the intriguing question is why only a minority of
countries in the world apply these principles in satisfactory way. Section 3 provides a brief
analysis of the obstacles for the adoption of the rule of law as regulatory principle and of the
opportunities offered to surmount them in the context of the EU accession.
The paper is not a complete literature review5. The material has been rather selected to shed
light on questions which are crucial for the SEE countries if they want to succeed in their
objective to join the European Union and enjoy a sustainable, high growth. It includes recent
theoretical research and empirical evidence on economic development and transition, as well
as on the economy of institutions and networks. The paper can also be read as an
encouragement to economists engaged in the practice to internalize more systematically
institutional building and the rule of law as an issue in their day to day work. It can also be
considered as starting point further theoretical and empirical research.
5
This can be found in (Dixit,2007) or (Rodrik, 2006)

9. 3
1. The weak rule of law in SEE countries and
microeconomic implications
1.1. Insufficient progress
Several indicators confirm the diagnostic by the European Commission on the weaknesses of
the rule of law in the Western Balkan countries, and on the resulting damages for economic
development. Some interesting points are worth to be noted:
According to the EBRD transition indicators:
• The countries made substantial progress in liberalizing internal and external trade and
in privatizing, but
• countries made less progress in areas requiring judicial strength such as enforcement
of bankruptcy or competition legislation (Corporate governance, competition)
EBRD TRANSITIONS INDICATORS
Figure 1
Average SEE6
2000 2007
4,50
4,00
3,50
3,00
2,50
2,00
1,50
1,00
0,50
0,00
gov ernanc e
priv atiz ations
priv atiz ations
liberalis ation
C om petition
liberalis ation
s ec tor and
F oreign trade
interes t rate
S m all s c ale
N on-bank
Large s c ale
C orporate
reform and
financ ial
ex c hanges
B ank ing
P ric e
and
Best performance is noted with 4,33. Source EBRD SEE6: Albania, BiH, Croatia, Macedonia, Serbia, Montenegro
Source: EBRD;own calculation for average. Methodology see annex 2

10. 4
Entrepreneurs consider as most problematic weaknesses of the “institutional” frame, such as
anti-competitive practices, bad functioning of the judicial system, contract violation,
uncertainties about regulations, tax administration; these issues are more often cited as being
problematic than criminal activities and than weaknesses in physical infrastructure and labour
regulation (Business Environment and Enterprise Performance Survey-EBRD and World
Bank-2005)
Figure 2

11. 5
According to the governance indicators calculated by the World Bank, most SEE countries
significantly lag behind new EU member states and comparable emerging economies.
Figure 3
1.2. Two models for regulating economic transactions
This section presents two models for the regulation of economic activities: the rule of law and
a network regulation6. It asks for the stability and the efficiency of these both modes of
regulation. Indication about empirical evidence underpinning the hypothesis made under both
models are provided, as well as about associated theoretical research.
The conclusion of this approach is not encouraging. The main characteristic of a regulation by
law, its universal or impersonal nature, which makes it highly efficient, makes it at the same
time extremely instable. By contrast, regulation by network can in general be expected to be
stable, but socially inefficient.7 The rule of law is not an automatic by-product of economic
development. It requires a strong collective effort to be established.
In the reality, there exist limits both to the expansion of informal network regulation and the
contraction of the rule of law (at least, in countries adhering to basic democratic principles).
This opens a wide field for theoretical and empirical research for improving and validating the
underlying models, in particular to understand better the factors affecting the balance between
varying modes of regulation which co-exist in reality. This would help to identify policy
actions which could improve the stability of law regulation, and weaken network regulation.
6
A network can be defined as constituted by a group of persons which discriminate between “us” and
“them”, when ever they decide about conducting a transaction.
7
Stability (Instability) means, here as usual in the economic theory, that deviations of the effective
situation from its equilibrium will engender forces bringing it back to this equilibrium (farer away from it).

12. 6
A highly efficient, but fragile, rule of law…
To establish a favourable business environment, advanced Western economies have, decade
after decade, developed sophisticated, public institutions, including rules, norms,
implementation agencies and administrations and judicial systems. These institutions include
cadastre, legislation on property rights (including intellectual property), competition and
bankruptcy laws, accounting norms, administrative and commercial courts, debt collection
rules and debt collector offices, and more.
All these institutions are only efficient if they can be trusted to deliver what they promise on
an accountable, transparent, fair and predictable manner8.The key here is that their only
existence produces potential benefits for all. Trusting that an independent and impartial
institution has the power to enforce rights and/or punish non-conform behaviors, can largely
substitute to trust in the fairness of potential business partner9 or competitors. Furthermore, it
increases substantially the incentive to strictly conform to commitments or rules, civilizing
even more economic and social life. This, in turn, increases further the potential for inter-
personal or inter-agent trust. This contributes to improve the competitiveness of an economy,
by enlarging the circle of potential transaction partners for each and everyone and in inducing
a high degree of internal competition. And, as far it guarantees an equal and transparent
treatment of all participants, it substantially reduces the risk that the return on an investment is
lowered by unfair competitor’s practices10. There are also good reasons to believe that under
the umbrella of the law, non-market forms of coordination and cooperation among economic
agents can better develop and contribute to overall productivity gains (see Box 1). There is
some empirical evidence for the link between a strong judicial system and inter-agent trust.
For example, using results from the EBRD/World Bank survey of firms across 26 transition
economies11, a study12 analyzed the factors influencing trust in business relationships. The
level of prepayment demanded by suppliers was used as a proxi for trust. It is reasonably
postulated that prepayment is a substitute for information on the willingness or ability to pay13
of the potential customer. However, requesting prepayment is costly: customers can be lost
which could be trusted, but are unable or unwilling (following a lack of reciprocal trust?) to
prepay. The study shows that the level of prepayment tends to be lower (trust to be higher)
where courts are perceived by business as fair and honest. This positive association of court
quality with trust does not extend, however, to other dimensions of the legal system, such as
8
(Root, 1996) p. 180ss
9
For example: A bank will be prepared to give a credit against collateral if it trusts the cadastre and
commercial courts: uncertainties about the efficiency and fairness of the judicial system will increase the risk
premium. Savers hold nominal deposits in a bank and contribute to better financial intermediation if they trust
that the supervising institution will be uncorrupt and will control efficiently the bank rulers and if they trust the
monetary authority not to engage in an inflationary spiral. Traders can order goods and make some prepayment
with a producer if he get trustworthy information on the financial soundness of his potential partner (publication
of certified accounts) and if the risk taken is limited through bankruptcy laws and procedures (and, reciprocally,
for the trust needed by the producer to the trader). Investors will invest more if they feel protected by a strong
and uncorrupt judicial system from predators or from hazardous and corrupt implementation of tax laws.
10
See, (Rothstein, 2005)
11
(EBRD & World Bank, 2002 & 2005)
12
(Raiser, et al.)
13
Idem, p. 61

13. 7
speed or affordability14. According to this study therefore, the belief that using the judicial
system will ultimately lead to an impartial enforcement of rights is more important that the
effectiveness of the system itself. This confirms that a trustworthy judicial system produces
benefits well beyond its only activities and has major external positive effects.
Box 1
Rule of law and non market transactions
While a trustworthy judicial system increases significantly the potential for privately and
socially valuable market transactions, residual risks of non enforcement still exist. And, in
case of failures, getting contracts enforced is costly. Economic agents can develop further
strategies to reduce such risks. Some of them are market solutions and will in general take
the form of financial instruments (in particular, insurance). Business partners can also
develop non-public institutions: they can agree on an arbitrage by a private third party in
commercial cases, avoiding public courts; or, enterprises may reduce uncertainties on the
transaction outcome in establishing a stable network of partners with a good track record;
they can also improve reciprocal knowledge in participating in formal, socio-economic
networks, such as Chambers of Commerce or producer/trader/consumer associations and
cooperatives. “Ethical” or other norms may also emerge with the time, making even more
predictable on a reciprocal basis the behavior of potential partners belonging to the group.
Obviously, such formal or informal arrangements, which lead to a certain personalization
of transactions, can further reduce transactions costs and risks on a efficient way. They
can also serve as a vehicle for cooperation and production of collective goods that single
firms cannot access or afford on their own, as for example, vocational training centers,
diffusion of know how about the introduction of new technologies, information on
procurement rules, etc.. The importance of non market cooperation between firms as a
complement to market transactions has, for example, been recently underlined in
“Changing governance of local economies, eds: C. Crouch, P. Le Galès, C. Triglia and H.
Voelzkow, Oxford University Press, 2004” (see in particular, p.335). Such cooperation
can result in a significant increase of the overall productivity of the economy. But, as
public institutions, privately induced arrangements can be easily perverted to support
collusive behaviors, to simply restrict competition or abuse good faith or inequalities.
Their activities need to be regulated by the rule of law, exactly as market transactions and
public institutions.
This has, however, potentially a negative consequence. If, at some stage, trust in the
impartiality of the institution is lost, agents will significantly reduce the number of the
partners they trust; even worse, this will augment the incentive for opportunistic behavior,
multiplying occasions for disappointment and reinforcing general distrust. Therefore, good
theoretical reasons and a sufficient number of historical experiences support the idea that
regulation by law is very efficient, but also potentially very instable15, in absence of an
exogenous control mechanism.
14
Idem, p. 68
15
On the structural weakness of universal institutions see (Rothstein, 2005) p. 143 ss. One of the main
theoretical argument is that universal institutions are weak exactly because of their universality: no group has an
interest to defend this universality, each group has an interest to pervert it to the benefit of its own particular
interest.

14. 8
…versus robust, but inefficient, network regulation
Economic activities do not stop with the failure of a judicial system. Economic agents develop
alternative mode of regulations. One possibility is the emergence of networks or groups of
agents which restrict their transactions to partners belonging to their own network16. The
theoretical approach is based on the hypothesis that the interest of (selfish) economic agents
to be honest is to preserve their own reputation with the ultimate goal to find business partners
in the future. Basically, agents will tend to be more honest to those which are geographically
or socially proximate. One of the principal reasons may be that proximate agents have more
deterring power to punish the defector by spreading the information on bad behaviour to
neighbours; this leads in turn to a high probability for the defector to be excluded from future
business, and possibly to other more aggravated forms of social banishment.
The size of reputation based networks is limited by the need to preserve the quality of
available information on potential business partners. The hypothesis that entrepreneurs
consider existing business relations as most important source of information on new
customers or suppliers is in particular validated by the above mentioned BEEP Survey.17
Repeating transactions with a few same partners becomes a size restricting, but stabilising
factor for the network18, making it more and more robust, and transforming it into an effective
insurance for contracts being enforced.
Stability linked to a restricted size goes, however, hand in hand with economic inefficiency.
There is some common sense here: as noted by J. McMillan and C. Woodruff, “the self-help
substitutes for market-supporting institutions work well only for firms that are small. Larger
firms, dealing with many suppliers and customers and trading at a distance, cannot rely solely
on personalized relationships to undergird their transactions. Formal institutions are needed,
therefore, both by privatized firms, and after a while, by startup firms if they are to grow to an
efficient scale”19.
A way to expand the potential size of the network is the use of pre-existing criteria allowing
the possibility to distinguish with a high degree of confidence “us” (people which can be
trusted) from “them” (people which cannot). Such criteria can be of religious or ethnical
nature,20. “Ethical” norms may also emerge improving the predictability of behaviour and
being used as instrument of demarcation21. However, while “endogenous” norms may
16
While the weakness of the rule of law explains both, network regulation and informal economy, they
are conceptually distinct. The first relates to the relation between business partners, the other to the relation
between enterprises and the State. Institutional weaknesses deteriorates significantly the balance between the
advantages (being protected by the Rule of Law and having access to formal financial and public services) and
the costs (paying taxes and publicizing accounts, in particular) to act as registered enterprise.
（Raiser et al.）Table 3.3, p. 66-67
17
18
See (Dixit, 2004), P. 78
（McMillan et al.，2002）
19
20
For example, cross border networks (diaspora) can positively contribute to external trade integration.
While this way to integrate world markets is far to be optimal, it mitigates nevertheless the costs of the weakness
of the Rule of Law on the potential for international integration. A study of the impact of ethnic Chinese
networks on international trade suggest that such networks substantially increase trade in improving information
on trade opportunities and alleviating the consequences of weak legal institutions; (Rauch et al.2002)
21
For a description of how business networks can emerge in case of failures of the Rule of Law see:
(Radaev, 2004)

15. 9
Box 2
The difficult transition to the rule of law:
An application of the prisoner’s dilemma theorem
At the theoretical level, the key question is under which condition an agent being part of a
network (and acting accordingly) will be prepared to defect and act in conformity with the
rule of law, meaning expand honestly his activities beyond the network. Let us start from a
very favorable “supply” shock on the judicial, e.g. following a change of government,
leading to a stronger confidence of the agent in the rule of law, in particular in its
impartiality. As recourse to the judicial system remains costly (and to a certain extend
uncertain), the preparedness of the agent to take the risk of a change of regime and expand
activities to people less known does not only depend on his own confidence in judicial
system. It will also depend on his belief how those potential partners will behave, in
particular how these partners will assess the risk to be punished by the rule of law if they
cheat. Even if all agents have the same positive assessment on the “new” judicial system,
the equilibrium may be well that everybody continue to rely on the old, well known, own
network regulation. This is because, in absence of certainty about the intention of “them”
(in contrast to “us”), the subjective risk to be cheat remains too high. Obviously, the
possibility of such an outcome is closely related to the fact that the main effect of the rule
of law is the creation of trust among people, and not the supply of a possible recourse in
case of being cheat. This is typically a situation like the prisoner’s dilemma in the theory of
cooperative games. If both players cooperate, they will both win substantially. But, if one
cooperates and the other cheats, the one which cooperates losses substantially, and the one
which cheats wins something, but less than in the case of full cooperation. As long as
players do not have trustworthy information on the behaviour of the other, the equilibrium
solution will be to do nothing, loosing the potential gain of cooperation. Only trust in the
behavior of the other or in a deterring sanction by an external arbiter ( the “law”) in case of
cheating can lead to the win-win solution.
authorize some expansion of the network beyond most proximate “neighbours”, there is still a
limit. This is set by the fact that expanding the network increases the risk of confrontation
with an opportunistic behaviour of a partner located far away. When religious or ethnical
demarcation criteria begin to substitute personal reputation based on experience, the risk of
abuse increases. A study of the recent development of exchanges among “Islamic”
companies22 in Turkey describes how a functioning network could become victim of its own
expansion, despite the fact it was based on the respect of strong religious norms and beliefs
(see Box 3).
Weaknesses in the rule of law favor not only the emergence of networks among “equal”
partners as described above. It can also favor hierarchical structures able to impose own rules
by dishonest practices up to the use of violence. Private agents may be at the origin of such
structures (mafia), or public agents (cronyism). Such structures will tend to act as monopolists
（Berna et al.，2006)
22

16. 10
(or oligopolists), optimizing benefits under two constrains: on the one side the potential
productivity of the network controlled, on the other side the costs linked to the “protection” of
the transactions occurring among his members and between members and non-members. Such
organizations will tend to exacerbate the “us” against the “them” relation, restricting the scope
for transactions to preserve monopolistic positioning and to (brutally) impose prohibitive
costs of defection, in the continuous attempt to increase the chance of survival of the network.
Box 3
Stability and instability of networks: an example
Against the background of relatively high transaction costs for financial intermediation in
Turkey, Islam “provided the necessary ethical and moral ground for wealth creation with
market friendly interpretation”: this favored the development of informal channels of fund
raising by “Islamic” enterprises. In the beginning, “it was in the interest of borrowers and
lenders to remain honest and adhere to the moral codes of Islam as adherence to a moral
code in a small group brings high costs for noncompliance since deviant behaviors are
recorded and punished. But, with the increasing number of investors, geographical
distance and diverse business investments, remembered acts and reciprocal arrangements
lost their strength. While the consequent anonymity led to increased chances of
unmonitored abuses, the moral and economic overload of Islamic institutions failed to
discipline parties. As the moral integrity of the regime weakened, it exposed the
companies to managerial abuses and the uncertainties of the market.”
Gül Berna Özcan and Murat Cokgezen, Trusted market : The exchanges of Islamic companies”, in
Comparative Economic Studies, 2006, 48, (132-155)
The size of such organizations will notably be limited by the increasing marginal costs of
controlling efficiently all members of the network and by competition between networks.
…resulting in a major market failure
A weak rule of law leads to inefficiencies. Valuable economic transactions do not take place
because a lack of trust between potential partners. Investments do not take place or are limited
in scale because general insecurity about property rights and a mobilization of saving often
limited to personal, “trustworthy” relationships. Financial intermediation which could help to
bridge is itself impeded because of unsecured property rights. This results in major market
failures. However, despite this obvious social inefficiency, the network regulation which
substitutes to the rule of law makes it extremely difficult to escape because it provides a
relative security to networks insider and may help them to restrict competition. By contrast, a
regulation by law can be rapidly destabilized whenever trust in the judicial institution is lost.
What happens in case of a weak rule of law on the market for goods is similar to what
happens on financial markets when distrust begins to dominate: the market breaks down and
trust enhancing short term measures and regulation are needed. While such measures are
relatively easy to conceive for the financial markets, even if costly to implement, equivalent,
affordable measures for “rescuing” markets for goods and services are much more difficult to
identify, if any, because of the number of the transaction partners and the nature of the
transactions.

17. 11
2. Macroeconomic implication of a weak rule of law
2.1. Investment, growth and weakeness in the rule of law: a
regulatory trap?
Estimating the costs of the market failure resulting from a weak rule of law and assessing
consequences on economic development and policy effectiveness is still a wide field for
empirical (and theoretical) research. There are, however, some interesting results available.
For example, the expected, strong positive impact on growth of institutional strengthening, in
particular in the area of the rule of law, has been confirmed in recent cross-country studies23.
These studies provide, in particular, evidence for the transition economies that the strength of
institutions had a much more significant impact on growth than the speed or nature of the
privatization. A recent study24 conducted at the level of enterprises in several transition
economies also confirms the importance of good governance25 for the firm productivity,
beside infrastructure quality, financial development, labour market flexibility and labour
quality.
Cumulative FDI 2005
vs. Rule of Law 2004
4500
4000 Sl oveni a
Cumulative FDI per Head 2005
3500
Croa ti a
3000
Sl ova ki a
2500
2000
Tuni s i a
1500 Ma cedoni a
Bul ga ri a
1000
Roma ni a
Turkey
Al b. Bi H
500 Sa M
0
0 10 20 30 40 50 60 70 80 90
Rule of Law indicator 2004
World Percentile Rank
Source: W orld Bank, Governance indicat ors ,and W est ern Balkan Int egrat ion and t he EU: An agenda for
T rade and Growt h. FDI wit hout privat isat ion receipt s
Figure 4
Weaknesses in the rule of law can be expected to have particular detrimental effects on the
integration of small countries into the international division of labour. The rule of law being
weak, foreign partners will find it particularly hard or costly to identify trustworthy partners
and to secure property rights. In a recent study26, the World Bank noted that “most countries
23
For example, (Beck, et al., 2006) (Popov, 2007)
24
(The World Bank, 2008), Annex 3, p205-256
25
as measured by an indicator synthesizing the level of bribes, confidence in the legal system and easiness
to comply with tax regulation. (The World Bank, 2008), p. 224
26
(The World Bank, 2007)

18. 12
of SEE have received lower Foreign Direct Investment (FDI) flows than their potential or
comparators”. According to the same studies, external trade volumes are also under
expectations, in particular exports to developed and emerging economies.
Total trade 2005
vs. Rule of Law 2004
120
Slovenia
100
Exp. & imp. G&S as % GDP 2005
80
Croatia
60
Bulgaria Slovakia
Macedonia
40
BiH
Alb.
Romania
SaM
20
0
0 10 20 30 40 50 60 70 80 90
Rule of Law indicator 2004
World Percentile Rank
Source: W orld Bank, Governance indicat ors ,and W est ern Balkan Int egrat ion and t he EU: An agenda for
T rade and Growt h
Figure 5
Figures 4 to 6 indicate a strong statistical correlation between the world rank of a country as
for an indicator of the rule of law and its capacity to attract FDI and to integrate in the world
trade. However, further empirical research is needed to validate and precise this hypothesis,
taking into account possible more complex causal chains involving some other factors and/or
reverse causality.
According to the European Commission and World Bank studies27 , the SEE countries are at a
crucial point of the transition process. Over the last years, growth was relatively strong,
though not sufficient to reduce huge unemployment rate and to satisfactorily catch up with
other more advanced transition economies.28. According to these studies, growth was mostly
driven by an increase in Total Factor Productivity (TFP). As typical during the first phases of
27
(The World Bank, 2008) (The European Commission, 2008a)
28
(The European Commission, 2008a) p. 17

19. 13
Trade openess
vs. Rule of Law
1600
1400
Trade openess indicator 2003 °/°°°
1200
Croa ti a
1000
Bul ga ri a
Roma ni a
800 Ma cedoni a
600
Bi H
Al b.
400
So urce: W orld Bank, Go vern an ce indicat ors ,and rat io o f effect ive t o p ot ent ial (gravit y m odel) t rade:
W est ern Balk an In t egrat ion an d t he EU: An agenda for T rade and Growt h , p.29
200
Rule of Law indicator 2004
World Percentile Rank
0
0 10 20 30 40 50 60 70 80 90
Figure 6
the transition to a market economy, this increase is mainly induced by a reallocation of
resources from low productivity to high productivity enterprises or by a reduction of
employment. This process is boosted by the external and internal liberalization, privatization
and the hardening of budget constraints imposed to enterprises. At the same time, investment
ratios remained extremely low in the SEE countries, unemployment high, and labour
participation rates low, in comparison to other, more advanced transition economies. The two
studies29 mentioned above suggest that the weakness of the rule of law is a crucial factor for
explaining the relatively poor performance of the SEE countries. In absence of progress, this
will remain so in the next phase of transition. As the factors boosting currently the
productivity growth, labour reallocation and labour shedding as a result of privatisation and
restructuring, will reach limit, growth will depend upon the capacity of the countries to
mobilize more intensively the labour force and to increase the investment ratio, either by
intra-firm expansion or through new entries. On top, improving total factor productivity will
require more than in the past the use of more recent technologies embedded in new
investments. New investments, FDI and the expansion of existing firms and new entries
require, however, an effective regulation by the law to take place at the necessary speed.
As long the rule of law will remain weak, the less advanced SEE countries risk to be bogged
down in what can be called a “regulatory trap”: Low credibility of the judicial system plus a
weak and poor public sector lead to great reliance on informal regulation, which in turn puts
obstacles to productivity increases, employment and investment and international integration.
Furthermore, low income induces low fiscal revenues, maintaining a strong pressure on public
29
(Beck, et al., 2006) (Popov, 2007)

20. 14
Figure 7
expenditures and therefore on the provision of public goods. The fiscal effects of low income
are aggravated for the small SEE countries by the high fix costs of maintaining an
administration, by the inherited human and organizational weakness of the judicial system and
public administration and, more recently, a competition between the countries on corporate
tax rates and other taxes as an instrument to attract or retain investments30.
2.2. Alleviating obstacles to growth in an environment of
weak rule of law
A weak rule of law resulting in badly secured property rights, uncertain contract enforcement
and, consequently, a non-functioning market economy, poses major challenges for shaping
and implementing economic policy. The first challenge is that the strength or weakness of the
rule of law have a decisive influence on economic aggregates and behaviors, but depend only
for a non decisive part upon economic policies31 and can be expected to evolve only slowly
(see section 3). The second challenge which is addressed in this section relates to the fact that
the market failure resulting from a weak rule of law substantially affects the expected
effectiveness of policy measures, which, in general, postulate the existence of functioning
30
Corporate tax rate: Albania (23%-2005>>20%-2006), Bulgaria (15%-2005>>10%-2007), B&H (30%),
Czech R. ( 26% -2005>>24%-2006>>2008-21%>>2009-20%), Croatia (20%), FYRM (2006-12%>>2008-10%),
Hungary (16%), Montenegro (9%), Poland (19%), Romania (16%), Serbia (10%), Slovakia (19%) and Slovenia
(25%-2005>>22%)- Source Economic Policy Institute , Sofia
31
Including be research on the link between growth and institutions is far to be to the point to provide
clear guidance to practitioners. (Dixit, 2007)

21. 15
markets and responsiveness of agents to relative prices. In the context of a major market
failure resulting from a weak rule of law, a careful prioritisation of reforms is even more
needed because of limited political capital and scarce administrative and financial resources to
conceive and implement them. These points have been underlined by the “Growth
Commission” in its 2008 “Growth Report: Strategies for Sustained Growth and Inclusive
Development”32,33.
“Economists know how market work and they can say with some confidence how a mature
economy will respond to their policy prescriptions. But mature markets rely on deep
institutional underpinnings, institutions that define property rights, enforce contracts, convey
prices, and bridge informational gaps between buyers and sellers. Developing countries often
lack these markets and regulatory institution. Indeed, an important part of development is
precisely the creation of these institutionalized capabilities. Even without them growth can
occur, and these institutions can co-evolve with the economy as it expands. However, we do
not know in detail how these institutions can be engineered, and policy makers cannot always
know how a market will function without them. The impact of policy shifts and reforms is
therefore harder to predict accurately in a developing economy. At this stage, our models or
predictive devices are, in important respects, incomplete (in bold by the author)…The
number of desirable reforms and outlays a government might consider at any point of time
will vastly exceed its reach and budget. A coherent growth strategy will therefore set
priorities, deciding where to devote a government’s energies and resources. These choices
are extremely important. They should also be country- and context-specific, responding to
widely varying initial conditions.”
As a starting point, it is useful to list the determinants of investment, distinguishing between
social return of an investment and the part of it effectively appropriable by the owner and
underlining the crucial role of the rule of law. However, a list of factors of which
enhancement would positively influence the business environment is not sufficient to shape a
reform program. Identifying bottlenecks is crucial. The responsiveness of investment and
growth to each factor matters, as well as the possibility to substitute one by another. Statistical
analysis, either cross-country studies or at enterprise level, can show by how much on
average lower taxes, lighter labour market regulation, better perception of the judicial are
associated with a better growth performances. They are neither able to predict what happens
incrementally if one parameter is changed, nor are they a decisive help to identify the right
sequencing or priority of policy measures. This is because some of the factors are
complementary and not substitutable input. As a result, they impose a binding constraint on
the outcome. Binding constraints imposed by one factor result in ineffectiveness of other
policy parameters (see Box 5). As noted by A. Dixit, “The question policy prescribers must
address, is not what creates success on average across countries, but what is going wrong in
this country, and how can we put it right?” 34.
32
(The Growth Commission/The World Bank, 2007) p. 4
33
The point has also been put nicely by D. Rodrik in (Rodrik, 2006) “The trick is to find those areas
where reform will yield the greatest return. Otherwise, policymakers are condemned to a spray-gun approach:
they shoot their reform gun on as many potential targets as possible, hoping that some will turn out to be the
ones they are really after. A successful growth strategy, by contrast, begins by identifying the most binding
constraints.” See also on the same line (The World Bank, 2007), p.139, the three first paragraphs of the
conclusions.
34
(Dixit, 2007), p150

22. 16
A strong indication that the rule of law is a bottleneck is provided by the BEEP Survey 200535
(see Table 1). The obstacles related to the rule of law make are the most often cited obstacles
in doing business, together with two other, macroeconomic instability and the level of tax
rates (in all transition economies, and probably everywhere in the world, the level of tax rates
is one of the most cited obstacle in doing business). These three obstacles to do business are
parameters for which a single entrepreneur cannot do much to change them or minimize
consequences (excepted in ceasing their business). By contrast, the quality of infrastructure is
relatively not often cited probably because it is either truly not an issue, or because
established entrepreneurs could adapt to deficiencies, even if at some cost.
Box 5
Effectiveness of policy measures in case of a weak rule of law
Box 4
Changes in the corporate tax rate which are expected to induce new investments can loose
any efficiency if the costs of protecting property rights are prohibitive, as a result of
predation or unfairDeterminants of return onof the corporate tax may
competition. In this case, a reduction investment
principally result in a windfall profit for established firms and entrepreneurs without
“Overall” investment return depends upon:
significant effects on investments, growth and employment.
• Infrastructures and other to a reduction of labour costs or alleviating labour
A similar argument can be appliedpublic goods; Input prices (energy, telecommunication,
regulation. In caseaso.) failure of the market for goods as a result of weak contract
material, of a
• Direct and unsecured property costs availability of does not necessarily
enforcement and of indirect unit labour rights,, unemploymentskilled labour force reflect
• Protection from foreign competitors
labour market distortions; it can be the counterpart of a production and investments being
below the expected level (in view of the prevailing real unit labour cost) because of
prohibitiveowner’sexpand depends upon protect property rights as a result of a weak rule of
Effective cost to return business or to
law. • this case, reducing labour costs will not necessarily result in higher investment and
In Financing cost (for a good part, RoL)
• Direct taxes
employment.
• Fairness of internal competition (RoL)
• Predation empirical (weak of the labour markets in the debt collection,
Based on a in-depthby privateanalysiscontract enforcement, weakWestern Balkans, a
mafia) (RoL)
recent study comes to a very similar conclusion: “The exercise which aimed to determine
• wages are by public officials (corruption) (RoL)
whether Predationmisbehaved with respect to productivity developments does not turn to
strong evidence…The study of the effects of labour market protection legislation does not
indicate that one could expect a strong labour market response to the relaxation of labour
protection…On the side of the demand for labour, the key reforms have to do more with the
product than with the labour markets themselves.” (The European Commission, 2008b).
This is not to suggest that nothing can or should be done to attract investors before the rule of
law has been established. Only, undue expectations should be avoided. Furthermore, policy
measures aiming at improving the profitability of enterprises have in general a cost, either in
term of equity, and/or of use of budgetary resources or international assistance. Policies with a
low return on growth and investment because of the concomitant weakness of the rule of law,
but a negative impact on the fiscal space and/or negatively perceived distributive effects,
undermine the political and social sustainability of reforms and reduce the legitimacy of the
State. This calls for a cautious check of costs and benefits of any economic policy measure
and to privilege policies, such as education, of which own value goes well beyond an
alleviation of investment constraints.
35
Business Environment and Enterprise Performance Survey, (EBRD/The World Bank, 2005)

23. 17
Table 1
Obstacles in doing business 2005
Albania Bosnia Croatia FYRM Serbia Average
Herzego- and of five
vina Montene countries
-gro
Rule of economically
relevant Law 5,6 5,0 4,4 4,6 6,2 5,2
Criminality 20,5 11,5 13,0 13,5 15,5 14,8
Macroeconomic
instability 5,0 4,0 3,0 11,0 2,0 5,0
Labour market 14,5 18,5 13,5 16,5 13,5 15,3
Economic/Fiscal
Administration 9,3 12,3 12,7 10,3 11,0 11,1
Tax rates* 1,0 7,0 5,0 5,0 4,0 4,4
Land access and titles 17,5 20,5 17,5 20,5 19,5 19,1
Infrastructure 14,0 16,0 20,0 17,3 18,7 17,2
Cost and access to
financing 11,0 2,5 7,5 4,0 4,0 5,8
All numbers are average ranking of most often cited obstacles for doing business:1=most
often cited obstacle out of 21.
Rule of economically relevant Law: Contract violations + Anti-competitive practices of
others + Corruption + Functioning of the Judiciary + Uncertainty about regulatory policies;
Criminality: Organised crimes + Street crime, theft and disorder;
Macroeconomic instability: Macroeconomic instability;
Labour market: Labour regulation + Skill and education of workers;
Economic/fiscal administration: Business licensing and permits + Customs and trade
regulation +Tax administration; Tax rates=Tax rates;
Land access and titles: Access to land +Title or leasing of Land Infrastructure:
Telecommunications +Electricity + Transportation;
Cost and access to financing: Cost of financing + Access to financing
* According to the BEEP survey, there is practically no country where Tax rates would not be
considered as a major obstacle to growth by entrepreneurs.
Detailed ranking by category see annex
Source: EBRD/World Bank, BEEP Survey, 2005, own calculation
This calls also for policies which do not only focus on cost improvements (labour, taxes,
public infrastructure), but are equally, if not primarily, concerned about improving the general
business environment, for example in improving access of enterprises to local public services,
such as information on potential business partners and on technologies, trainings opportunity,
membership in business association and cooperatives, among alia. And, last but not least, this
calls for assigning and preserving an uncontested top priority to the strengthening of the rule
of law.

24. 18
3. Transition to the rule of law and the EU accession
process
While there are obvious and well documented substantial economic (and political) benefits to
be expected from introducing the rule of law, the intriguing question is why only a minority of
countries in the world apply these principles on a satisfactorily manner. For analytical
purposes, it is commode to distinguish obstacles of three different kinds to adopt the rule of
law as dominant regulation. The first arise from the fact that regulatory mechanisms, which
emerge when the rule of law is weak, are robust and stable. The second is linked to the fact
that, without exogenous factor, the immediate interest of the political elite will not necessarily
coincide with the objective of introducing the rule of law. The third is more technical and is
linked to the complexity of the task of building up a judicial system. The prospect of joining
the European Union can fundamentally change the terms of the challenge in bringing a
powerful “exogenous” factor into the game.
Analysis in section 1 and 2 show that success in adopting the rule of law is not granted.
Endogenous forces playing against may well dominate. Adopting the rule of law as regulatory
principle will change the social and economic daily life of people. And, taken individually,
people may have good reasons not to take the risk of a regime change in a lawless
environment, even if substantial collective benefits can be expected out of such a change. Per
se, the progressive integration into the EU internal market as part of the accession process
augments the incentives of entrepreneurs for respecting the rule of law as they may anticipate
increased business opportunities with foreign partners. However, this needs to be
complemented by policy measures enhancing the incentives for enterprises to participate into
the formal economy, a pre-condition for escaping network regulation, and doing business
under the umbrella of the law. Such incentives include the provision of public goods, of which
most of them could be local (for example, vocational training, and access to different
information: legal, technological, trade opportunities). The provision of these public goods
could be best organized through functional organizations, such as business associations or
cooperatives. This would have a twin positive effect, directly in improving the overall
productivity of “legal” enterprises and, indirectly, in building up confidence among business
people. In some cases, it may also be important to reduce socio-economic dependencies of
people from informal networks. Appropriate and sustainable social safety nets and social
services may help in this respect. Finally, improving the skills of the labour force will help to
rebalance business opportunities in favor of the legality.
Institutional changes are shaped by the interest of those groups with political power (in a
broader sense, including groups inside the public administration and around). Strengthening
the rule of law is a complex task. It needs to be a top priority on the political agenda for a long
time and needs to distract public resources from other tasks. Because strengthening the rule of
law will go hand in hand with redistribution, potential loser can be expected to actively
oppose. While circumstances will differ from one country to the other, there is no doubt that
self-interest of the political elite can negatively influence the process of adopting the rule of
law if political parties, civil society or any other factors do not massively press in the right
direction. In making further progress towards the goal of accession conditional upon
significant advances in the judicial area, the Union sets strong signals. It can influence a
political elite which earns part of its legitimacy from progress made on the accession path and
may reassess the value of short term benefits against the prospect to be able to declare victory

25. 19
and to “sit” at the table of the European council36. Another way the Union can influence the
process is in insisting on reforms reducing the opportunities for extracting rents from the
public sector. Improved public finance management is key in this respect, as any other anti-
corruption measure. Adopting policies requiring a low level of discretionary power at the
stage of implementation will also help.
Third, the complexity of the task should not be underestimated. Establishing the rule of law is
particularly challenging because it cumulates two handicaps. The first handicap is that the
ability of a (public) monitoring of the output is weak because it relates to numerous decisions
affecting primarily individual interest. The second is that producing these decisions involve
several activities, to be undertaken according to several complex rules (commercial law,
enforcement rules) by several actors (lawyers, accountants and auditors for commercial cases,
prosecutors and judges, debt collectors,…).37,38 This complexity increases the opportunity for
agents inside the system to resist to changes. A technical assistance in support of a
comprehensive and well sequenced program addressing the parts of the judiciary relevant for
guaranteeing contract enforcement, security of property rights and fair competition can
become decisive. However, it will only succeed if it is driven by committed authorities and
pushed by private agents and the civil society.
36
For an extensive discussion of the way the EU accession process can influence political decisions in accession
countries, see (Grabbe H., 2001)
37
See on this point, F. Fukuyama, State Building, Cornell University Press, New York, 2004, p. 55 et 59
38
This contrasts for example with the circumstances prevailing for running a central bank. Even if this task
requires high skills, the intensity of required input is low, limited to transactions on few markets which can be
undertaken by a limited number of actors, and the output easy to be publicly monitored (few macroeconomic
indicators). According to this approach, it is not surprising that central banks are most often one of the few
institutions well run in most developing or transition countries, and the judicial system one of the most difficult
to establish.

26. 20

27. 21
4. Conclusions
The conclusions can be summarized in five points:
• In the SEE countries, the weakness of the judicial system in guaranteeing contract
enforcement, security of property rights and fair competition results in a major failure
and dysfunction of the market for goods and services and in low investments. The
economic and social costs of a weak rule of the commercially and economically
relevant law are huge.
• In the absence of significant progress in this area, countries can get bogged down in “a
regulatory trap” characterized by: a low credibility of the judicial; great reliance on
informal network regulation; weak integration in international trade; low productivity
and, in turn, few resources to enhance the services to be provided by the public sector
to sustain growth.
• Relying on internal forces only will make it difficult to escape the “regulatory trap”,
because existing, informal regulation mechanisms are robust and stable, even if
socially inefficient. Progress will depend upon a combination of strong conditionality
imposed by the European Union in the context of accession, public policies to improve
the business environment and to provide public goods supportive of entrepreneurial
activities, as well as upon specific assistance program focusing on economically and
commercially most relevant part of the judiciary system.
• The market failure resulting from a weak rule of law affects negatively the
effectiveness of economic policy measures, reforms and programs aimed at improving
the growth prospects through higher investment profitability and cost reduction
(labour cost, taxes, energy prices, aso) because a strong responsiveness of aggregate
demand and supply to changes in relative prices can no longer be supposed. This poses
particular challenges to the design of economic policy packages and sequencing.
• Unfortunately, neither academic literature, nor accumulated practical experiences
allow us to draw a single, universal recipe for successful institutional building.
Progress will move forward step by step, involve trial and error, and the path of
reforms will need to be adapted to each country.

28. 22

29. 23
Annex 1: Problems in doing business 2005
Ranking of most often cited obstacles
Bosnia Serbia and Average
Albania Herzegovina croatia FYRM Montenegro ranking
Contract violations 6 5 8 3 9 6,2
Anti competitive practices of other 2 6 2 2 7 3,8
Corruption 3 5 7 4 8 5,4
Functioning of the judiciary 8 8 1 6 6 5,8
Uncertainty about regulatory policies 9 1 4 8 1 4,6
Organised criminality 20 11 12 14 16 14,6
Street crime, theft, and disorder 21 12 14 13 15 15
Macro instability 5 4 3 11 2 5
Skills and education of workers 14 19 11 18 14 15,2
Labour regulations 15 18 16 15 13 15,4
Business licensing and permits 13 14 10 10 12 11,8
Customs and trade regulation 11 13 13 12 11 12
Tax administration 4 10 15 9 10 9,6
Tax rates 1 7 5 5 4 4,4
Title or leasing of land 18 20 17 21 19 19
Access to land 17 21 18 20 20 19,2
Transport 16 15 19 19 21 18
Electricity 7 16 20 16 17 15,2
Telecom 19 17 21 17 18 18,4
Cost of financing 10 2 6 1 3 4,4
Access to financing 12 3 9 7 5 7,2
Source: EBRD & World Bank Business Environment and Enterprise Performance Survey (BEEP Survey)2005.

30. 24

31. 25
Annex 2: EBRD transition indicators methodology
The transition indicator scores reflect the judgment of the EBRD’s Office of the Chief Economist
about country-specific progress in transition. The scores are based on the following classification
system, which was originally developed in the 1994 Transition Report, but has been refined and
amended in subsequent reports.
“+” and “-” ratings are treated by adding 0.33 and subtracting 0.33 from the full value. Averages
are obtained by rounding down, for example. a score of 2.6 is treated as 2+, but a score of 2.8 is
treated as 3-.
Overall transition indicators
Large-scale privatisation
1 Little private ownership.
2 Comprehensive scheme almost ready for implementation; some sales completed.
3 More than 25 per cent of large-scale enterprise assets in private hands or in the process of
being privatised (with the process having reached a stage at which the state has effectively
ceded its ownership rights), but possibly with major unresolved issues regarding corporate
governance.
4 More than 50 per cent of state-owned enterprise and farm assets in private ownership and
significant progress with corporate governance of these enterprises.
4+ Standards and performance typical of advanced industrial economies: more than 75 per cent
of enterprise assets in private ownership with effective corporate governance.
Small-scale privatisation
1Little progress.
2 Substantial share privatised.
3 Comprehensive programme almost ready for implementation.
4 Complete privatisation of small companies with tradable ownership rights.
4+ Standards and performance typical of advanced industrial economies: no state ownership of
small enterprises; effective tradability of land.
Governance and enterprise restructuring
1 Soft budget constraints (lax credit and subsidy policies weakening financial discipline at the
enterprise level); few other reforms to promote corporate governance.
2 Moderately tight credit and subsidy policy, but weak enforcement of bankruptcy legislation and
little action taken to strengthen competition and corporate governance.
3 Significant and sustained actions to harden budget constraints and to promote corporate
governance effectively (for example, privatisation combined with tight credit and subsidy policies
and/or enforcement of bankruptcy legislation).
4 Substantial improvement in corporate governance and significant new investment at the
enterprise level, including minority holdings by financial investors.
4+ Standards and performance typical of advanced industrial economies: effective corporate
control exercised through domestic financial institutions and markets, fostering market-driven
restructuring.

32. 26
Price liberalisation
1 Most prices formally controlled by the government.
2 Some lifting of price administration; state procurement at non-market prices for the majority of
product categories.
3 Significant progress on price liberalisation, but state procurement at non-market prices remains
substantial.
4 Comprehensive price liberalisation; state procurement at non-market prices largely phased out;
only a small number of administered prices remain.
4+ Standards and performance typical of advanced industrial economies: complete price
liberalisation with no price control outside housing, transport and natural monopolies.
Trade and foreign exchange system
1 Widespread import and/or export controls or very limited legitimate access to foreign exchange.
2 Some liberalisation of import and/or export controls; almost full current account convertibility in
principle, but with a foreign exchange regime that is not fully transparent (possibly with multiple
exchange rates).
3 Removal of almost all quantitative and administrative import and export restrictions; almost full
current account convertibility.
4 Removal of all quantitative and administrative import and export restrictions (apart from
agriculture) and all significant export tariffs; insignificant direct involvement in exports and imports
by ministries and state-owned trading companies; no major non-uniformity of customs duties for
non-agricultural goods and services; full and current account convertibility.
4+ Standards and performance norms of advanced industrial economies: removal of most tariff
barriers; membership in WTO.
Competition policy
1 No competition legislation and institutions.
2 Competition policy legislation and institutions set up; some reduction of entry restrictions or
enforcement action on dominant firms.
3 Some enforcement actions to reduce abuse of market power and to promote a competitive
environment, including break-ups of dominant conglomerates; substantial reduction of entry
restrictions.
4 Significant enforcement actions to reduce abuse of market power and to promote a competitive
environment.
4+ Standards and performance typical of advanced industrial economies: effective enforcement
of competition policy; unrestricted entry to most markets.
Banking reform and interest rate liberalisation
1 Little progress beyond establishment of a two-tier system.
2 Significant liberalisation of interest rates and credit allocation; limited use of directed credit or
interest rate ceilings.
3 Substantial progress in establishment of bank solvency and of a framework for prudential
supervision and regulation; full interest rate liberalisation with little preferential access to cheap
refinancing; significant lending to private enterprises and significant presence of private banks.

33. 27
4 Significant movement of banking laws and regulations towards BIS standards; well-functioning
banking competition and effective prudential supervision; significant term lending to private
enterprises; substantial financial deepening.
4+ Standards and performance norms of advanced industrial economies: full convergence of
banking laws and regulations with BIS standards; provision of full set of competitive banking
services.
Securities markets and non-bank financial institutions
1 Little progress.
2 Formation of securities exchanges, market-makers and brokers; some trading in government
paper and/or securities; rudimentary legal and regulatory framework for the issuance and trading
of securities.
3 Substantial issuance of securities by private enterprises; establishment of independent share
registries, secure clearance and settlement procedures, and some protection of minority
shareholders; emergence of non-bank financial institutions (for example, investment funds,
private insurance and pension funds, leasing companies) and associated regulatory framework.
4 Securities laws and regulations approaching IOSCO standards; substantial market liquidity and
capitalisation; well-functioning non-bank financial institutions and effective regulation.
4+ Standards and performance norms of advanced industrial economies: full convergence of
securities laws and regulations with IOSCO standards; fully developed non-bank intermediation.
Infrastructure reform
The ratings are calculated as the average of five infrastructure reform indicators covering electric
power, railways, roads, telecommunications, water and waste water. The classification system
used for these five indicators is detailed below.
Electric power
1 Power sector operates as government department with few commercial freedoms or pressures.
Average prices well below costs, with extensive cross-subsidies. Monolithic structure, with no
separation of different parts of the business.
2 Power company distanced from government, but there is still political interference. Some
attempt to harden budget constraints, but effective tariffs are low. Weak management incentives
for efficient performance. Little institutional reform and minimal, if any, private sector involvement.
3 Law passed providing for full-scale restructuring of industry, including vertical unbundling
through account separation and set-up of regulator. Some tariff reform and improvements in
revenue collection. Some private sector involvement.
4 Separation of generation, transmission and distribution. Independent regulator set up. Rules for
cost-reflective tariff-setting formulated and implemented. Substantial private sector involvement
in distribution and/or generation. Some degree of liberalisation.
4+ Tariffs cost-reflective and provide adequate incentives for efficiency improvements. Large-
scale private sector involvement in the unbundled and well-regulated sector. Fully liberalised
sector with well-functioning arrangements for network access and full competition in generation.
Railways
1 Monolithic structure operated as government department, with few commercial freedoms. No
private sector involvement and extensive cross-subsidisation.
2 Rail operations distanced from state, but weak commercial objectives. Some business
planning, but targets are general and tentative. No budgetary funding of public service

34. 28
obligations. Ancillary businesses separated, but little divestment. Minimal private sector
involvement.
3 Commercial orientation in rail operations. Freight and passenger services separated and some
ancillary businesses divested. Some budgetary compensation available for passenger services.
Improved business planning with clear investment and rehabilitation targets, but funding
unsecured. Some private sector involvement in rehabilitation and/or maintenance.
4 Railways fully commercialised, with separate internal profit centres for freight and passenger
services. Extensive market freedoms to set tariffs and investments. Implementation of medium-
term business plans. Ancillary industries divested. Private sector participation in freight operation,
ancillary services and track maintenance.
4+ Separation of infrastructure freight and passenger operations. Full divestment and transfer of
asset ownership implemented or planned, including infrastructure and rolling stock. Rail regulator
established and access pricing implemented.
Roads
1 Minimal degree of decentralisation and no commercialisation. All regulatory, road management
and resource allocation functions centralised at ministerial level. New investments and road
maintenance financing dependent on central budget allocations. Road user charges not based
on the cost of road use. Road construction and maintenance undertaken by public construction
units. No public consultation in the preparation of road projects.
2 Moderate degree of decentralisation and initial steps in commercialisation. Road/highway
agency created. Improvements in resource allocation and public procurement. Road user
charges based on vehicle and fuel taxes, but not linked to road use. Road fund established, but
dependent on central budget. Road construction and maintenance undertaken primarily by
corporatised public entities, with some private sector participation. Minimal public
consultation/participation on road projects.
3 Fair degree of decentralisation and commercialisation. Regulation and resource allocation
functions separated from road maintenance and operations. Level of vehicle and fuel taxes
related to road use. Private companies able to provide and operate roads under negotiated
commercial contracts. Private sector participation in road maintenance and/or through
concessions to finance, operate and maintain parts of highway network. Limited public
consultation/participation and accountability on road projects.
4 Large degree of decentralisation. Transparent methodology used to allocate road expenditures.
Track record in competitive procurement of road design, construction, maintenance and
operations. Large-scale private sector participation in construction, operations and maintenance
directly and through public-private partnerships. Substantial public consultation/participation and
accountability on road projects.
4+ Fully decentralised road administration. Commercialised road maintenance operations
competitively awarded to private companies. Road user charges reflect the full costs of road use
and associated factors, such as congestion, accidents and pollution. Widespread private sector
participation in all aspects of road provision. Full public consultation on new road projects.
Telecommunications
1 Little progress in commercialisation and regulation. Minimal private sector involvement and
strong political interference in management decisions. Low tariffs, with extensive cross-
subsidisation. Liberalisation not envisaged, even for mobile telephony and value-added services.
2 Modest progress in commercialisation. Corporatisation of dominant operator and some
separation from public sector governance, but tariffs are still politically set.
3 Substantial progress in commercialisation and regulation. Telecommunications and postal
services fully separated; cross-subsidies reduced. Considerable liberalisation in the mobile
segment and in value-added services.

35. 29
4 Complete commercialisation, including privatisation of the dominant operator; comprehensive
regulatory and institutional reforms. Extensive liberalisation of entry.
4+ Effective regulation through an independent entity. Coherent regulatory and institutional
framework to deal with tariffs, interconnection rules, licensing, concession fees and spectrum
allocation. Consumer ombudsman function.
Water and waste water
1 Minimal degree of decentralisation; no commercialisation. Services operated as vertically
integrated natural monopolies by government ministry or municipal departments. No financial
autonomy and/or management capacity at municipal level. Low tariffs, low cash collection rates
and high cross-subsidies.
2 Moderate degree of decentralisation; initial steps towards commercialisation. Services provided
by municipally owned companies. Partial cost recovery through tariffs; initial steps to reduce
cross-subsidies. General public guidelines exist regarding tariff-setting and service quality, but
both under ministerial control. Some private sector participation through service or management
contacts, or competition to provide ancillary services.
3 Fair degree of decentralisation and commercialisation. Water utilities operate with managerial
and accounting independence from municipalities, using international accounting standards and
management information systems. Operating costs recovered through tariffs, with a minimum
level of cross-subsidies. More detailed rules drawn up in contract documents, specifying tariff
review formulae and performance standards. Private sector participation through the full
concession of a major service in at least one city.
4 Large degree of decentralisation and commercialisation. Water utilities managerially
independent, with cash flows – net of municipal budget transfers – that ensure financial viability.
No cross-subsidies. Semi-autonomous regulatory agency able to advise and enforce tariffs and
service quality. Substantial private sector participation through build-operator-transfer
concessions, management contacts or asset sales in several cities.
4+ Water utilities fully decentralised and commercialised. Fully autonomous regulator exists with
complete authority to review and enforce tariff levels and quality standards. Widespread private
sector participation via service/ management/lease contracts. High-powered incentives, full
concessions and/or divestiture of water and waste-water services in major urban areas.

36. 30

37. 31
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