Archived - Report on Operations Under the European Bank for Reconstruction and Development Agreement Act - 2004 : 1

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Introduction

The European Bank for Reconstruction and Development (referred to in this document as the EBRD or the Bank) was established in 1991. Its aims are to foster the transition towards open, market-oriented economies in Central and Southeastern Europe, as well as in the successor states of the former Soviet Union,^[1] and to promote private and entrepreneurial initiative in those countries that are committed to the fundamental principles of multi-party democracy, pluralism and a market economy (see Annex 3 for a list of the EBRD's 27 countries of operations).

The EBRD differs from other multilateral development banks in four ways. First, its overriding focus is the private sector and support for the transition from central planning to stable market economies. Its charter stipulates that not less than 60 per cent of its financing commitments should be directed either to private sector enterprises or to state-owned enterprises implementing a program to achieve private ownership and control. Second, it has a particular focus on the promotion of democratic institutions and human rights in its countries of operations. Third, while all multilateral development banks are committed to ensuring the environmental sustainability of their projects, the EBRD is the only such institution where this commitment is explicitly written into its Articles of Agreement. Fourth, the EBRD does not provide concessional financing.

The Bank seeks to help its 27 countries of operations to implement structural and sectoral economic reforms, taking into account the particular needs of countries at different stages in the transition process. In particular, its private sector activities focus mainly on enterprise restructuring, including the strengthening of financial institutions, and the development of infrastructure needed to support the private sector. The EBRD has 62 members: 60 countries, the European Union (EU) and the European Investment Bank (see Annex 3 for a list of members).

Canada is the eighth largest shareholder (tied with Spain), following the other Group of Eight (G-8) countries. Canada's formal participation is authorized under the European Bank for Reconstruction and Development Agreement Act, which was promulgated in February 1991. Article 7 of the Act states that:

This report responds to this requirement and reviews the activities and operations of the Bank for the year 2004.

Benefits of Membership

As a major trading nation, Canada has a stake in global peace and stability, which the successful integration of Central and Southeastern Europe and the former Soviet Union into the world economy and global institutions helps to promote. By fostering continued political and economic reform in the region, the EBRD is contributing to its integration into the world economy and to its stability.

The Minister of Finance is a Governor of the Bank and nominates a Director to its 23-member Board. This representation allows Canada to have high-level influence on decisions taken by the EBRD on investments in the region and on policies to move countries through the transition process. The EBRD also provides trade opportunities for the Canadian private sector, supporting a diversification of international markets for Canadian businesses.

Details on Canada's financial contributions to the EBRD are provided in Annex 1.

The EBRD fosters the transition of former centrally planned economies of Central and Southeastern Europe and the successor states of the former Soviet Union towards market-oriented economies; promotes private entrepreneurial initiative by targeting at least 60 per cent of its resources to private sector projects, with the balance in support of commercially viable state sector projects that promote private sector development; operates only in countries committed to applying the principles of multi-party democracy, pluralism and market economics; promotes environmentally sound and sustainable development; and operates on a self-financing basis.

Role and Mandate of the EBRD

The EBRD's operations to advance the transition to a market economy are guided by three principles: maximizing transition impact, additionality, and sound banking. Financing is provided for projects that expand and improve markets, help to build the institutions necessary for underpinning a market economy, and demonstrate and promote market-oriented skills and sound business practices. EBRD financing must also be additional to other sources of financing and not displace them, further ensuring that the Bank contributes to the transition process. Finally, Bank projects must be sound from a banking perspective, thus demonstrating to private investors that the region offers attractive returns. Adherence to sound banking principles also helps to ensure the financial viability of the EBRD and hence its attractiveness as a co-investment partner for the private sector.

In promoting economic transition in its countries of operations, the Bank acts as a catalyst for increased flows of financing to the private sector. The capital requirements of these countries cannot be fully met by official multilateral or bilateral sources of financing, and many foreign private investors remain hesitant to invest in the region, particularly the central Asian republics. By providing an umbrella under which wider funding for private sector investment can be assembled, the EBRD plays a catalytic role in mobilizing capital. In 2004, for every euro the EBRD invested, it mobilized an additional 2.1 euros from the private sector and other multilateral and bilateral agencies.^[2] Commercial co-financing mobilized by the EBRD reached a record volume of 3.5 billion euros in 2004, up 34 per cent from the previous high in 2003.

The Bank's projects serve a dual purpose. They are intended not only to directly support the transition from a command to a market economy in countries of operations, but also to create a demonstration effect to attract foreign and domestic investors. Like the World Bank Group's International Finance Corporation, the Bank is required to operate on a strictly commercial basis and to attract companies through financially viable projects, not through subsidies.

Key Economic Developments in 2004

Most of the transition economies experienced economic growth in 2004, accompanied by a rapid rise in domestic bank lending that has boosted investment and consumption. Most countries in the region continued to perform well in comparison with other emerging markets. The exception continues to be the poorer countries in the Commonwealth of Independent States (CIS),^[3] where the reform process continues to lag and uncertain climates continue to discourage domestic and foreign investment.

The process of transition to market-based economies continued to advance in most of the EBRD's countries of operations. Belarus, Turkmenistan and Uzbekistan are the exception, with reform largely stalled at a very early level of transition. The results of the Bank's annual assessment of key transition indicators are summarized in the following table.

Progress in Transition in EBRD Countries of Operations 

			Enterprises
Countries	Population (millions, mid-2004)	Private sector share of GDP in %, mid-2004 (EBRD estimate)	Large-scale privatization	Small-scale privatization	Governance and enterprise restructuring
Albania	3.2	75	2+	4	2
Armenia	3.1	75*	3+	4*	2+
Azerbaijan	8.3	60	2	4-	2+
Belarus	9.9	25	1	2+	1
Bosnia and Herzegovina	3.8	50	2+	3	2
Bulgaria	7.8	75	4*	4-	3-
Croatia	4.4	60	3+	4+	3*
Czech Republic	10.3	80	4	4+	3+
Estonia	1.4	80	4	4+	3+
FYR Macedonia	2.0	65*	3+*	4	2+
Georgia	4.6	65	3+	4	2
Hungary	10.0	80	4	4+	3+
Kazakhstan	14.4	65	3	4	2
Kyrgyz Republic	4.8	75*	4-**	4	2
Latvia	2.3	70	4-	4+	3
Lithuania	3.5	75	4-	4+	3
Moldova	4.3	50	3	3+	2-
Poland	38.3	75	3+	4+	3+
Romania	21.7	70*	4-*	4-	2
Russia	144.9	70	3+	4	2+
Serbia and Montenegro	8.3	50	2+	3+*	2
Slovak Republic	5.4	80	4	4+	3
Slovenia	2.0	65	3	4+	3
Tajikistan	6.5	50*	2+	4-	2-
Turkmenistan	6.0	25	1	2	1
Ukraine	48.4	65	3	4	2
Uzbekistan	26.0	45	3-	3	2-
Note: The classification of transition indicators uses a scale from 1 to 4, where 1 implies little or no progress with reform and 4 implies a market economy. A rating of 4+ indicates the country has achieved standards and performance typical of advanced industrial economies. * arrow indicates change from the previous year. One arrow indicates a movement of one point (from 4 to 4+, for example) and two arrows a movement of two points. Source: EBRD, 2004 Transition Report.

 

Progress in Transition in EBRD Countries of Operations (cont'd)

	Market and trade			Financial institutions		Infrastructure
Countries	Price liberalization	Trade and foreign exchange system	Competition policy	Banking reform and interest rate liberalization	Securities markets and non-bank financial institutions	Infrastructure reform
Albania	4+	4+	2*	3-*	2-	2
Armenia	4+	4+	2	2+	2	2+
Azerbaijan	4	4-	2	2+	2-	2
Belarus	3-	2+	2	2-	2	1+
Bosnia and Herzegovina	4	4-	1	3-*	2-	2+
Bulgaria	4+	4+	2+	4-*	2+	3*
Croatia	4	4+	2+	4*	3-	3*
Czech Republic	4+	4+	3	4-	3+*	3+
Estonia	4+	4+	3-	4*	3+	3+
FYR Macedonia	4	4+	2	3-	2*	2
Georgia	4+	4+	2	3-*	2-	2+
Hungary	4+	4+	3	4	4-	4-
Kazakhstan	4	3+	2	3	2+	2+
Kyrgyz Republic	4+	4+	2	2+	2	2-*
Latvia	4+	4+	3-	4-	3	3
Lithuania	4+	4+	3	3	3	3-
Moldova	4-	4+	2	3-*	2	2
Poland	4+	4+	3	3+	4-	3+
Romania	4+	4+	2+	3*	2	3+*
Russia	4	3+	2+	2	3-	3-*
Serbia and Montenegro	4	3+	1	2+	2	2
Slovak Republic	4+	4+	3	4-*	3-	3-
Slovenia	4	4+	3-	3+	3-	3
Tajikistan	4-	3+	2-	2*	1	1+
Turkmenistan	3-	1	1	1	1	1
Ukraine	4	3	2+	2+	2+*	2
Uzbekistan	3-	2-	2-	2-	2	2-
Note: The classification of transition indicators uses a scale from 1 to 4, where 1 implies little or no progress with reform and 4 implies a market economy. A rating of 4+ indicates the country has achieved standards and performance typical of advanced industrial economies. * arrow indicates change from the previous year. One arrow indicates a movement of one point (from 4 to 4+, for example) and two arrows a movement of two points. Source: EBRD, 2004 Transition Report.

Russia

Russia's economic growth is estimated to have slowed to 7.1 per cent in 2004, down from 7.3 per cent in 2003. Economic growth continued to be driven by high oil prices, increasing oil export volumes and stronger investment, which was mainly directed to the energy sector. High taxation revenues from the oil and gas sectors led to a fifth straight budgetary surplus in 2004 and allowed the Oil Stabilization Fund to reach the equivalent of US$19 billion by year-end.

Monetary policy continued to be guided by the dual objective of reducing inflation and limiting real appreciation of the ruble. The central bank continued to intervene heavily in the foreign exchange market in 2004, allowing Russian authorities to increase their foreign exchange reserves to a record-high US$125 billion by the end of 2004. Difficulties in sterilizing this rapid reserve accumulation have, however, resulted in a surge in money growth, which in turn has contributed to higher-than-expected inflation. Year-end consumer price inflation in 2004 was 11.7 per cent, well above the initial official target of 8-10 per cent.

There are growing concerns that Russia's oil-driven boom may be losing steam. These concerns have led Russian authorities to decrease their 2005 growth forecast to 5.8 per cent. In order to promote more sustainable growth, Russia needs to diversify its economy by implementing structural reforms aimed at increasing economic activity in the non-energy sector and at improving the overall investment climate. Russia's investment climate was clouded in 2004 by concerns of growing government interference in the economy, triggered by the Yukos affair. Concerns about the business climate contributed to net capital outflows of US$7.8 billion in 2004, quadruple 2003's outflow. Unless structural reforms enable other sectors of the economy to develop, Russia's dependence on natural resource exports will increase, and economic growth will continue to fluctuate in tandem with oil and other raw material prices.

Other CIS Countries

Other oil-exporting CIS countries continued their rapid economic growth in 2004. This strong growth largely reflected revenue from sustained high oil prices and rising fixed investment in resource-based sectors. Kazakhstan recorded the strongest economic growth among oil-exporting CIS countries in 2004, with estimated real gross domestic product (GDP) growth of 9.4 per cent, mainly due to a continuing investment boom in the oil and gas-related sectors. Azerbaijan also maintained strong growth momentum at 7.8 per cent in 2004, fuelled by the construction of the Baku-Tbilisi-Ceyhan pipeline, which will begin operations in mid-2005.

Many of the remaining CIS countries have also benefited from high non-oil commodity prices. These include Ukraine (steel), Tajikistan (aluminum), the Kyrgyz Republic (gold) and Uzbekistan (gold). High commodity prices have also had positive indirect effects on other economic sectors, such as services and construction. Despite its year-end political crisis, Ukraine is estimated to have recorded real GDP growth of 12.0 per cent in 2004, up from 9.4 per cent in 2003. Decisive action to address double-digit inflation and large increases in government spending will be crucial, however, to deal with the mounting pressures on the economy. Growth rates in Tajikistan, the Kyrgyz Republic and Uzbekistan all increased in 2004 compared to the previous year, although per capita incomes in these countries still remain very low relative to other CIS countries.

Reforms must urgently address the chronically poor investment climates and weak institutions if these countries are to enjoy stronger growth over the medium and longer term.

Central Europe^[4]

In 2004, the economies of Central Europe grew by an average of 4.9 per cent, up from 3.8 per cent in 2003, driven primarily by domestic demand and increasingly by an expansion of exports.

The Baltic States continued to register strong growth in 2004, led by Latvia, which grew by 8.5 per cent for the second consecutive year. All Central Eastern European countries recorded significant real GDP growth in 2004. In particular, growth in Poland increased strongly to 5.4 per cent, up from 3.8 per cent in 2003, buoyed by exports and investment. Growth in Hungary also picked up, rising from 2.9 per cent in 2003 to 4.0 per cent in 2004.

Economic conditions across the region contributed to the improvement in government deficits from an average of 3.6 per cent of GDP in 2003 to 3.2 per cent of GDP in 2004. However, several large Central Eastern European countries have failed to bring their fiscal positions under control. Fiscal deficits as a per cent of GDP in Hungary (5.6), Poland (5.4) and the Czech Republic (3.4) have remained substantial, and further fiscal consolidation will be required. In order to meet the Maastricht criteria for monetary union (to join the euro), among other things these countries must reduce their public deficits to 3 per cent of GDP or less.

The average current account deficit in Central Europe remained at 5.8 per cent of GDP in 2004. High investment and consumption levels, fuelled by a booming credit market (particularly for consumer finance), have led to sustained demand for imports.

Following a sharp drop from 6.6 per cent of GDP in 2002 to 2.4 per cent of GDP in 2003, foreign direct investment (FDI) is estimated to have increased marginally in 2004. In Hungary and Poland, FDI inflows were replaced by less stable portfolio inflows, which have increased their vulnerability to sudden reversals in capital flows. The decline in net inflows of FDI reflects the tapering off of major privatization deals as a source of FDI, and the increasing difficulty in attracting greenfield investments.

Accession to the European Union 2004 marked a milestone in the EBRD's short history, with 8 of its 27 countries of operations joining the EU on May 1 (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia). As the transition process advanced in Central Europe, the Bank began to slowly shift its operations to the less advanced transition countries, particularly as it begins to implement the newly approved Early Transition Countries Initiative.[5] In line with its principles of transition impact, sound banking, and additionality, the EBRD also sharpened the focus of its operations in the advanced transition countries. The beneficiaries of EBRD operations in these countries are now largely small and medium-sized municipalities that cannot obtain funds elsewhere without a sovereign guarantee and small and medium-sized enterprises that require equity or longer-term commercial financing on reasonable terms. Co-financing with EU structural funds also figures in the Bank's activities in the new EU countries.

Southeastern Europe^[6]

Increased political stability, although still fragile in some cases, and the prospects of EU membership for Bulgaria (for entry in 2007), Romania (for entry in 2007), and Croatia (accession negotiations to begin in April 2005) are motivating structural reform and economic growth in Southeastern Europe.

Average real GDP growth increased from 4.4 per cent in 2003 to 5 per cent in 2004. Growth in Albania and Romania has been particularly strong (6.2 and 8.0 per cent, respectively). Only FYR Macedonia (2.5 per cent) is lagging behind the region, which is partly due to persistently low per capita net FDI inflows.

Throughout the region, rapid real GDP growth has been associated with the expansion in bank lending (domestic bank lending grew by 23 per cent in 2003), leading to higher consumption levels. Credit has expanded particularly quickly in Bulgaria and Romania. Excessive credit growth, however, can lead to vulnerabilities in the financial sector, with possible repercussions for public and corporate sector creditworthiness and exchange rate stability. This has prompted the introduction of tighter regulations on bank lending in many countries.

General government deficits averaged less than 3 per cent of GDP in 2004. Albania and Croatia were the only countries with fiscal deficits above this level. In contrast, FYR Macedonia reduced its deficit to around 1 per cent of GDP, reflecting significant fiscal consolidation.

Current account deficits remained large throughout the region, averaging 8.8 per cent of GDP. In Bulgaria, the current account deficit remained above 8 per cent due to the credit-fuelled consumption boom.

In contrast to Central Europe, net FDI into Southeastern European countries has remained at historically high levels for the second year in a row. This has mainly been generated by large privatization contracts. The increase in net FDI inflows-and the simultaneous decrease of flows into Central Europe-also partly result from European investors relocating business activities to Southeastern European countries, with the aim of taking advantage of lower unit labour costs and taxation levels than those in some Central European countries.

Canada's Cooperation With the EBRD in Southeastern Europe

In response to the Kosovo crisis in 1999, the EBRD developed the South Eastern Europe Action Plan (SEEAP), which seeks to promote investment and to assist in the economic recovery of the region. Eligible countries are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Romania, and Serbia and Montenegro.

Under the SEEAP, EBRD investments focus on developing commercial approaches to infrastructure (such as telecommunications, airports, and municipal and environmental infrastructure), micro, small and medium-sized enterprises, and the financial sector. These investments address the transition challenges facing the region: crumbling infrastructure; a weak industrial asset base; mostly small, fragile banks; and pervasive problems of poor governance.

To date, Canada, through the Canadian International Development Agency (CIDA), has committed $18 million in support of the EBRD's SEEAP activities. The total Canadian contribution is being used for technical assistance and co-financing related to project preparation and implementation, advisory services, and capacity building. Canada's assistance is contributing to the efforts of both the EBRD and the international community in supporting the transition process and in promoting stability in the region.

In 2000, CIDA committed a total of $12 million to Phase I of the CIDA-EBRD Cooperation Fund for Southeastern Europe (CFSEE), of which $2 million was designated for the Balkan Region Special Fund (BRSF) to support post-conflict reconstruction efforts in the Balkan region. The total amount ($12 million) has been earmarked against 36 projects approved by CIDA-26 against the BRSF and 10 against the CIDA-EBRD CFSEE Program.

In March 2003, CFSEE Phase II, valued at $6 million, was launched. Phase II builds upon the results of Phase I and adheres to a more focused programming approach in line with CIDA's Strategy for the Balkans Region. In Phase II, Canadian funding is targeted to countries that CIDA identified as priority countries-Bosnia and Herzegovina, and Serbia and Montenegro. Projects with a regional focus are also supported under Phase II and these may include other countries in the Balkans.

2004 Transition Report

The Transition Report is an annual publication of the EBRD that charts the progress of transition from a centrally planned to a market economy in each of the Bank's 27 countries of operations. The Transition Report is recognized as the leading publication analyzing the progress of transition in the former Soviet bloc. Infrastructure, and the private sector's role in its provision, was chosen as the special theme of the 2004 report in recognition of the shift in thinking about infrastructure. Apart from the EBRD, international financial institutions (IFIs) had reduced their involvement in core infrastructure services on the assumption that, with proper regulation, the private sector could finance and operate these services. However, the expected private financing did not materialize. Contributing factors were the global economic slowdown (2000-2003) and the coinciding crises in the international telecommunications and electricity markets that led to a scaling back of private sector investment in emerging markets. Thus, realizing that good infrastructure is essential for economic development and poverty alleviation and that the private sector will not do it alone, infrastructure is back on the IFIs' agendas.

In the transition economies, the infrastructure challenges are maintaining and upgrading service networks and developing rules and regulations that encourage efficient, cost-effective, environmentally sustainable and affordable services. The 2004 Transition Report assesses the potential contribution the private sector can make to infrastructure, and suggests past expectations were too high. The changing nature of private sector participation, with the private sector increasingly providing management skills rather than capital investment, will make the arrangements less risky for both the government and private sector partners. It suggests that strengthening regulatory institutions and removing political constraints can improve the success of private sector participation. Tariff reform is a particularly challenging area, and the report suggests that innovations, including "lifeline" tariffs that allow a certain level of services to be provided free of charge, offer a way to address equity concerns while improving the overall efficiency of services.

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