World Bank’s New Approach Helps Business in Transition Economies Lessons Learned from the Latest Adjustment Loan to Latvia
by Lars Jeurling

The World Bank’s thinking about how to encourage the development of the private sector in the former Soviet Union has evolved considerably as it has learned more about the transition process. We started with the notion that macroeconomic reform, liberalization, and mass privatization would be sufficient to set economic incentives right and get the market and private sector going. We soon realized that this was not enough and began to focus on broad-based institutional and legal reform, such as civil service reform, budget management, and the enactment of laws governing the rules of the market. The institutional focus greatly improved our ability to promote successful reform. However, it is becoming increasingly clear that without bottom-up action to implement institutional reforms, disseminate knowledge, and change attitudes, the impact is limited. In many cases, such action has to precede broad-based top-down macroeconomic, institutional, and legal reform, because without successful cases showing that reform works it is hard to build a constituency for such reform.

The need to shift from a top-down to a bottom-up approach should not come as a surprise. For decades the Bank has been in the business of promoting micro-level reform through investment lending of various kinds. A number of private sector development operations in the CIS and the Baltic countries were successful, including rural credit operations in Latvia and Kyrgyzstan, enterprise restructuring and management training operations in Moldova, and the enterprise and finance operation in Lithuania.

These operations target public institutions (increasing their efficiency and responsiveness and improving their ability to implement laws and regulations) and enterprises and banks (supporting their privatization and restructuring). Training and technical assistance are the most widely used interventions, but other tools—such as twinning arrangements, capacity building of local consultants and professional and private enterprise organizations, and study trips and exchanges—have also been undertaken.

These experiences have not easily found their way into adjustment lending, perhaps because micro-level interventions seemed fraught with difficulties in the often distorted and corrupt environment of several transition economies. The Structural Adjustment Loan (SAL) instrument, with its short time frame and broad agenda, has not been well suited for pursuing long-term, bottom-up, micro-level reforms. Investment lending has not been well integrated into SAL programs either. It could not address the broad-based, top-down policy and institutional reform that is necessary to make bottom-up programs sustainable and reproducible.

A key challenge for the Bank has been to find effective lending instruments and tools for micro-level actions to promote private sector development. To address the issue, the Bank has developed new lending instruments, the Programmatic Structural Adjustment Loan (PSAL) and the Adaptable Program Loan (see box). These new products, which involve a series of shorter loans that build on one another, promise better results because they follow a balanced top-down and bottom-up agenda under the umbrella of a longer-term program.

The new model is based on several key premises:

• Reforming public institutions is at least as important to private sector development as reforming private institutions.

• Private sector governance and business ethics are central to private sector development. Trust and a constituency for good governance are needed for reforms to work.

• Institutional and governance reform takes time to implement. Reform cannot be legislated; institutions must be built over time.

• Reform needs to come both from the top down at the macro level and from the bottom up at the micro level.

The New Thinking in Practice

The Latvia PSAL, approved in March, 2000, is a good example of how this thinking can be applied to the new-style adjustment lending. The PSAL is based on a three-year program of public sector and governance reform.

The program was supported by an earlier SAL. Good progress has been made to date on macroeconomic and structural reform, including institutional reform and creation of a legal framework. Latvia has also implemented a number of successful micro-level programs, such as the Rural Development Program, also financed by the World Bank. The success of that program helped build a constituency for reform. However, Latvia still has some way to go in making institutions work and implementing laws on the book. The PSAL program focuses on improving governance, providing training, reforming the civil service, and improving the management of public expenditures—in other words, on creating an appropriate macroeconomic and institutional framework for development of the private sector.

An important part of the program is promoting selected bottom-up reforms, introducing more transparent and efficient processes for case-by-case privatization, and establishing independent professional regulatory and inspecting bodies. These agencies must operate with clear and transparent procedures, keeping regulations and inspections as simple and as minimal as possible in order to protect the public interest.

Because these reforms will take years to implement, they require the longer-term PSAL program. To be effective, they will require a significant amount of technical assistance and hands-on supervision by the Bank. (Supervision could be provided through complementary investment lending. The recent Romania SAL is accompanied by a $25 million Technical Assistance Loan, which finances the retainer fees of investment banks that manage privatization.) We were initially worried that this would be a stumbling block, as Latvia seemed unwilling to borrow for technical assistance. After some initial reluctance, however, the Latvians warmed to the idea. The government agreed to set aside a significant amount of its privatization revenues to pay for such advisors, on the assumption that these expenses will pay off in the form of higher privatization revenues. The government has also committed significant resources to improving regulatory and inspection bodies and processes, which will be complemented with grant funding from bilateral donors and the Bank’s Public-Private Infrastructure Advisory Facility.

In designing the PSAL, we had to resist the temptation to focus on top-down, broad-brush reform—that is, to include too much—at the expense of implementing reform from the bottom up. Our initial program included issues such as licensing, customs, and tax administration, but we soon realized that to carry out an effective reform with a good chance of being implemented, we needed to be much more selective.

Links between Corporate and Public Governance

The PSAL has demonstrated that key elements of the private sector development agenda, such as privatization, regulation, and inspection, in fact concern about governance. Clear and transparent processes and institutions should be established, shielded from undue political and financial pressures.

An intriguing question that we were not able to pursue adequately in the PSAL is the extent to which corporate governance problems feed on and reinforce governance problems in the public sector. Do poor business ethics and nontransparent business dealings and accounting encourage and sustain public corruption? To what extent do problems of poor governance in the public and private sectors feed on and reinforce each other? Can the problem of governance be tackled effectively only by addressing public and private governance simultaneously?

So far the Bank has focused mainly on public governance; private sector governance issues have been addressed largely in the narrow sense of protecting the interest of investors and minority shareholders. There is a movement to broaden the perspective, to see corporate governance more as a question of how corporations should best be governed to serve the public interest. This seems to be a particularly urgent issue for the Europe and Central Asia region; work in this area could contribute significantly to dealing with the public governance problem. (Editor’s note: The following article tries to answer some of these questions.)

Lars Jeurling is senior advisor to the Private Sector Development Unit, Europe and Central Asia Region, the World Bank.