1 Giuseppe Iarossi, World Bank Federica Saliola, World Bank and University of Rome III Giovanni Tanzillo, World Bank Armenia Lake Sevan Business Climate, Productivity, and Competitiveness in Armenia,

2 Investment climate location-specific factors shaping the opportunities and incentives for firms to invest productively, create jobs, and expand World Development Report 2005

3 Business Climate Index (BCI) 1.Combines 93 variables (macro and micro) 2.Geometric Aggregation Method

4 Variables in the BCI 4 categories, 2 dimensions MACRO Cost (6)Quality (17) INPUTS Cost (10)Quality (14) INFRASTRUCTURE Cost (4) Quality (5) INSTITUTIONS Cost (10)Quality (27)

5 First step in the BCI construction Inflation variability Exchange rate variability Real interest rate variability Capital flows Macro instability Corruption index Procedures to start a business Cost to start a business Minimum capital to start a business Credit information index Private bureau coverage Procedures to enforce contracts Time to enforce contracts Cost to enforce contracts Factor1 Factor2 Factor3 Factor4 (Factor1) (Factor2) (Factor3) (Factor4) = MacroQI VARIABLES FACTOR ANALYSIS AGGREGATION INDEX W1W1 W2W2 W3W3 W4W4

6 Second and third steps in the BCI construction MacroCI MacroQI InfraCI InfraQI InputCI InputQI InstitutionsCI InstitutionsQI Factor1 Factor2 VARIABLES FACTOR ANALYSIS AGGREGATION INDEX (Factor1) (Factor2) W1W1 W2W2 W1W1 W2W2 W1W1 W2W2 W1W1 W2W2 Macro Index Infrastructure Index Input Index Institutions Index Factor1 Factor2 Factor3 F1 W F2 W F3 W BCI Business Climate Index FACTOR ANALYSIS AGGREGATIONINDEX

7 Characteristic: Geometric aggregation method Feature: Rewards more countries that improve the dimension where they perform the worst t fp m w ww w xINSTITindeexINFRASTindINPUTindexMACROindexBCI)()()()(

8 Sample composition of micro data Country Albania Armenia Azerbaijan Belarus Bosnia-Herz Bulgaria Croatia Czech Rep Estonia Macedonia Georgia Hungary Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Poland Romania Russia Slovakia Slovenia Turkey Ukraine463594

9 Business Climate Index and GDP growth in ECA, BCI index 2002 Kyrgyzstan Russia Kazakhstan Armenia Georgia Estonia Lithuania Latvia Moldova Bulgaria Romania Slovakia Czech Rep. Hungary Belarus Ukraine Poland Slovenia BiH Turkey Croatia Albania GDP growth (average )

10 Business Climate Index and total factor productivity in Armenia, TFP BCI

11 II IV Better Business Climate BCI 2005 BCI 2002 Change in business climate I Kyrgyzstan Russia Kazakhstan Estonia Lithuania Latvia Moldova Bulgaria Romania Slovakia Czech Rep. Hungary Belarus Ukraine Poland Slovenia BiH Croatia Albania FYROM Azerbaijan Armenia Georgia Turkey Improving Good Bad Deteriorating

12 BCI Index and ranking of ECA countries, CountryRank 2005 Turkey 1 Azerbaijan 2 Poland3 Albania4 Estonia5 Kyrgyzstan6 Croatia7 BiH8 Slovenia9 Lithuania10 Slovakia11 Latvia12 Hungary13 Bulgaria14 Georgia 15 Romania16 FYROM17 Ukraine18 Moldova19 Russia20 Kazakhstan21 Belarus22 Czech Rep.23 Armenia 24 CountryRank 2002 FYROM1 Azerbaijan 2 Albania3 Georgia 4 Poland5 Kyrgyzstan6 Russia7 Kazakhstan8 Armenia 9 Lithuania10 Turkey 11 Slovenia12 Latvia13 Romania14 Estonia15 Belarus16 BiH17 Bulgaria18 Croatia19 Slovakia20 Hungary21 Ukraine22 Moldova23 Czech Rep.24

13 Change in ranking Armenia Georgia Turkey Azerbaijan

14 Components of BCI, Macro index Infrastructure index Inputs index Institutions index

15 Kyrgyzstan Russia Azerbaijan Kazakhstan Armenia Georgia Estonia Lithuania Latvia Moldova Bulgaria Romania Slovakia Czech Rep. Hungary Belarus Ukraine Poland Slovenia BiH Turkey Croatia Albania FYROM Inputs index 2005 Inputs index 2002 Inputs Market Index,

16 Kyrgyzstan Russia Azerbaijan Kazakhstan Armenia Georgia Estonia Lithuania Latvia Moldova Bulgaria Romania Slovakia Czech Hungary Belarus Ukraine Poland Slovenia BiH Turkey Croatia Albania FYROM Institutions Index 2005 Institutions Index 2002 Institutions Index,

17 Dimensions of institutions and inputs indices in Armenia, QualityCostsQualityCosts INSTITUTIONS INDICESINPUTS INDICES

18 First step in the BCI construction Factor1 Factor2 Factor3 Factor4 (Factor1) (Factor2) (Factor3) (Factor4) = InputsQI VARIABLES FACTOR ANALYSIS AGGREGATION INDEX W1W1 W2W2 W3W3 W4W4 Excess labor Cost of finance Proximity to raw materials Access to foreign inputs Access to foreign customers Technology Education of workforce Access to finance Trade credit Availability of skilled workers Availability of managers Informality of supplier network Loan duration

19 Principle component factors in the Inputs Quality Index Factor 1 Factor 2 Factor 4 Factor 3 Change Weight

20 Main variables underlying Factors 1 and 3 of the Inputs Quality Index Percentage change in variable, Load Availability of managers Availability of skilled workers Cost of finance Access to finance ptimloa pavapro Suppliers network

21 Principle component factors in the Institutions Quality Index Factor 1 Factor 2 Factor 4 Factor 5 Change Weight

22 Main variables underlying Factors 1 and 2 of the Institutions Quality Index Percentage change in variable, Load Political influence

23 Main variables underlying Factors 1 and 2 of the Institutions Cost Index Percentage change in variable, Load Corruption Mafia Functioning of the judiciary Crime Regulation uncertainty Red tape

24 Principle component factors in the Institutions Cost Index Change Weight Factor 1 Factor 2 Factor 3 Factor 4

25 Main variables underlying Factors 1 and 2 of the Institutions Cost Index Bribes on government contracts Bribes Protection payments Excess labor Percentage change in variable, Load

26 Conclusions Institutions: both perceptions and costs have contributed to the deterioration of the business climate in Armenia in the last three years –More specifically, political influence, corruption, security, red tape, judicial inefficiency –To a lesser extent, also access and cost of credit

27 Armenias perception of investment climate constraints Crime, theft,disorder Electricity Labor regulations Skills of available workers Telecommunications Transport Legal system/conflict resolution Access to land Licensing and operating permits Economic & regulatory policy uncertainty Corruption Customs and trade regulations Anti-competitive/informal practices Access to finance Cost of finance Tax rates Macroeconomic instability Tax administration Percentage of firms rating each constraint a major obstacle Source: BEEPS 2005

28 Tax rates 30% 40% 50% ArmeniaAzerbaijanGeorgiaTurkey Source: Doing Business Percent of tax on gross profit

29 Tax administration: number of tax payments and time to comply with tax requirements ArmeniaAzerbaijanGeorgiaTurkey Payments Time to comply Number Hours Source: Doing Business

30 Tax collection Source: Davoodi and Grigorian (2005) ArmeniaCISLower middle- income countries 10% 18% Tax revenues as a share of GDP 12% 14% 16%

31 Linear model between tax evasion and number of inspections eInspections i Evasion i 10

32 Probability of perceiving corruption as a constraint Number of inspections by tax officials 0 60% 80% 100% Probability 10 20

33 Linear model between tax evasion and number of inspections eInspections i Evasion i 10 InspectionsGifttaxInspectionsEvasion i * / InspectionEvasion uGifttax 101

34 Impact of corruption on tax evasion Inspections Inspections + bribes Rate of tax evasion

35 Cost of finance: Real interest rate in Armenia Source: IMF, International Financial Statistics 0% 10% 20% 30%

36 ArmeniaAzerbaijanGeorgiaTurkey Nominal interest rate on firm loans Source: BEEPS 2005

37 Access to finance: Share of firms with access to bank financing without access with access Short term financing with access without access Long term financing Source: BEEPS 2005

38 Amount of collateral on loans 0% 50% 100% 150% 200% Source: BEEPS 2005 ArmeniaAzerbaijanGeorgiaTurkey

39 Legal Rights Index ArmeniaAzerbaijanGeorgiaTurkey Source: Doing Business

40 Credit provided by the banking sector Armenia ECA countries Low & middle income countries Percent of GDP

41 Conclusions Access to finance, red tape, and corruption are the 3 most important investment climate constraints for firms in Armenia

42 Escribano-augmented Cobb-Douglas production function i n n nnieikili DEscrKLVA ln iiii FCICTFP 210

43 Firm productivity -20% -10% 0 10% Corruption Bank loan Finance index Impact on firm productivity Red tape

44 Priority of reforms Share of TFP Marginal impact on firm productivity Corruption Finance Red tape

45 Armenias productivity gap with selected countries, 2005 Georgia Turkey Kazakhstan Kyrgyzstan Tajikistan Uzbekistan Moldova Estonia Latvia Lithuania -100% -50% 0% 50% 100% 150% 200%

46 Estimating the productivity gap

47 Impact of Investment Climate variables on Armenias competitiveness compared to Turkey TFP (1) (2) (3) Armenia (dummy) (1.70)* (1.09) (2.29)** Red tape (0.06) Armenia*Red tape (0.40) Loan (1.05) Armenia*loan (0.51) Corruption (0.94) Armenia*Corrupt (0.44)

48 Incremental impact on Armenias productivity, over Turkeys 0% 2% 4% 6% Banks, short term Banks, long term Trade credit, short term Trade credit, long term % 5.3% 4.4%

49 Conclusions Political influence in economic activity is the main factor driving the deterioration of the business climate in Armenia in the last 3 years. Red tape, access to finance and corruption are the major business obstacles to private sector development in Armenia. Red tape is the top Investment Climate constraint affecting firm performance in Armenia. Better access to long term finance, both in terms of bank lending and trade credit, would help bridge the 40% productivity gap with Turkey.