Chasing after the Structural Reforms. Fostering Competitiveness
The need for structural reforms is regularly mentioned in the context of development of both Latvia and the entire European Union (EU). Their significance is particularly emphasized by international institutions like the Organisation for Economic Co-operation and Development and the European Commission (EC). Both organisations point to the importance of structural reforms in overcoming the current crisis of weak demand, ensuring sustainable growth as well as improving the ability of countries to adjust to economic shocks. Moreover, the theoretical basis is supplemented with the results of empirical research. For instance, EC (2014) concludes that the combination of different structural reforms in the longer term could raise the Latvian gross domestic product (GDP) by 10% and employment by 9%.
The notion of structural reforms
Even though structural reforms are often mentioned in public, the understanding of their nature tends to differ widely. Thus, in order to create an idea of what the structural reforms mean, I suggest reading the article "Scalpel needed for structural reforms in Latvia" by my colleague Agnese Rutkovska published last May. Furthermore, I would like to draw the reader's attention to the different kinds of structural reforms.
The notion of structural reforms is very broad, therefore they are usually divided into several groups, for instance:
- The product market reforms – measures oriented toward promoting competition in the product market;
- Labour market reforms – measures that promote employment and flexibility of the labour force;
- Human capital reforms – measures in other sectors, e.g., education or health care that promote growth of human capital.
Since the structural reforms in the product market are different from the human capital or labour market reforms, each type of reforms will be reviewed separately. In this article, I will concentrate specifically on the product market reforms, and in the subsequent series of articles will take a look at the other groups of reforms.
What are product market reforms?
According to the EC definition, product market reforms are a set of measures for fostering economic activity and competition. They could imply changes related to market liberalization, lifting the obstacles to entrepreneurship, reducing the impact of state-owned companies as well as developing a business-friendly environment. One could get the impression that this notion is almost as broad as structural reforms, yet all product market reforms are instituted with a single goal – encouraging competition.
There is wide range of reforms and, in the shorter term, some may be painful and unpopular, i.e. provoke public dissatisfaction. For this reason, it is of essence to find out about the potential gains before the reforms are instituted. Hence a valid question arises: how to determine the potential for the product market reforms?
The world is not static and thus we can evaluate what we have accomplished (reformed) with the help of various international ratings. To evaluate the countries' potential to institute structural reforms in the product market, the OECD product market regulation (PMR) index is often used. The PMR includes a set of internationally comparable factors, which serves as an indication as to what extent legislation fosters or, on the contrary, interferes with the development of competition in the product market.
In developing the PMR index, several indicators are aggregated to reflect the following (The PMR structure available here):
- how business-friendly is the country's legislation;
- what are the obstacles to trade and investment;
- how significant is the role of state-owned companies.
PMR is measured on a six-point scale where 0 characterizes a system has no barriers to the competition and 6 reflects the system with the strictest regulation.
Over time, most of the OECD countries have shown remarkable progress in the area of product market reforms. If in 1998, the average PMR indicator among the OECD countries was about 2.21, in 2003, it was 1.78, in 2008, 1.59 and in 2013, already 1.47 (Fig. 1).
Figure 1. PMR value in OECD countries and partner countries
Source: OECD
It may seem that the enthusiasm of countries to introduce reforms is waning because the improvement in indicator is becoming somewhat smaller. Similar point is stressed by OECD, which indicates that the determination of countries to implement structural reforms has diminished along with the easing of the pressure created by the economic crisis. Yet such interpretation should be accepted with caution. Most of the developed countries have already implemented significant reforms which have resulted in PMR indicators close to the world's best examples. Therefore, subsequent improvements become increasingly complicated and their contribution ever smaller. The fruit from the lower branches have already been taken and the rest are at the top of the tree.
In Latvia, the regulation of the product market is only slightly stricter than in the OECD countries on average but lags substantially behind the three countries with the lowest PMR indicator (hereinafter, frontier).
There are different ways of closing the gap. In countries that find themselves relatively farther from the frontier, reforms are mostly based on using the experience of other countries. Meanwhile in the frontier countries and countries, which lag behind only slightly, it is more complicated to improve the indicator, therefore innovative ways are being sought to accomplish this. This correlation is obvious in Figure 1 where the reduction in the PMR indicator for the frontier countries is smaller than for OECD countries on average, both in relative and absolute terms.
The three countries with the lowest product market regulation level in 2013 were the Netherlands, the United Kingdom and Austria. Our Baltic neighbours had the PMR indicator lower than ours, particularly Estonia, which lags behind the above mentioned countries only slightly. Of the countries surveyed by the OECD the regulation was strictest in China and in India. In Europe, the strictest product market regulation level was in Russia and Croatia.
PMR and frontier are excellent points of reference to evaluate the reform potential. And yet, since the PMR value and position in the rating has no direct impact on the macroeconomic indicators (such as GDP and employment level), it would help to understand how the effect of the reforms can be felt in real life. The question arises: how to evaluate the impact of product reforms?
The goal of the product market reforms is fostering the competition, which, as the EC has pointed out, can impact the economy in several ways:
- first, by reducing the time and costs that are necessary for starting business, thus leading to an increase in the number of new companies and a reduction in administrative costs;
- second, with competition rising, businesses may need to consider ways of raising their competitiveness, for instance, by placing their resources more effectively and/or by reducing the mark-ups and price of products (empirical examples in the EC study);
- third, as a result of competition, businesses can look for new and innovative ways of getting upper hand over their competitors and therefore raising the overall level of investment and innovations
In its study, the EC (2014) indicates that the product market reforms are usually related to the drop in a product mark-ups and price. Depending on the flexibility of demand prices, the drop in product prices may foster an increase in output. This chain reaction can be continued further, as the increase in output, may cause result in a need for new manufacturing equipment and additional labour force. Thus an additional demand for production factors arises, which may mean higher salaries, employment and investments.
Figure 2 suggests that in the OECD countries (and partner countries) the PMR indicator is tightly correlated with the amount of income per resident, thus indicating that a business-friendly product market regulation and reforms could be preconditions for economic growth. [1]
Figure 2. PMR indicators of OECD and partner countries and GDP per capita (PPP) in 2013
Source: OECD
The impact of structural reforms implemented in the product market (expressed in changes in mark-ups) on the macroeconomic indicators has been evaluated in several studies (for a summary, please refer to the EC study). In the case of Latvia, the number of studies is limited, yet the available ones indicate that the reforms in the product market could raise the GDP level in short-term by 1.5%; in ten years by 2.3% and in 20 years, by 3.4% (EC, 2014). One should use caution when assessing the empirical results, however, for the gains from reforms depend also on other factors, for instance, on the political and economic situation in the country as well as on the attitude of the population towards reforms. Thus separating off the direct impact of reforms would be a complicated task.
The initial effect of the reforms in the product market could be completely opposite, however. As competition among businesses increases, so can the number of businesses gone bankrupt, which would mean reduced employment. This effect, however, would be short-lived, for the market share of the failed businesses would be taken over by those who have managed to place their resources more efficiently. Therefore, it is only a question of time when, along with an increase in output, it would be necessary to increase the number of employees.
In what areas can we institute product market reforms in Latvia?
Taking a closer look at the PMR indicator, the categories in which we lag behind substantially not only from the frontier, but also from the OECD average, are obstacles in legislation; indirect obstacles to trade and investments, as well as obstacles to starting a new business. (Figure 3).
Figure 3. The average values of PMR categories in the OECD, TOP 3 and Latvia in 2013
Source: OECD
Obstacles to starting a new business not only impede the access of enterprises to the market, but also contribute to additional costs, which, in turn, may end up reflected in increased prices. Abolishing these barriers reduce the time and costs necessary to start a new business and thus encourage the establishment of new businesses and increased competition. This correlation is shown in a study (EC, 2014/5), which using econometric methods shows that the number of new businesses is substantially affected not only by the number of procedures and costs involved in establishing a new business, but also by the waiting time for other permits. Similar conclusions were obtained by the compilers of the Doing Business index. A good example of reforms that reduce the time and costs involved in starting a business can be found in Spain where, as of 2011, it is possible to register a business electronically. This opportunity has gained wide popularity among the population and year after year, the number of electronically established companies keeps increasing significantly. A world leader in terms of friendliness to new businesses is New Zealand which allows all the procedures of establishing a new company to be done online since 2009. Furthermore it takes less than a day.
There are many ways of reducing obstacles to start a new business; a few of them have been listed by the Doing Business index: transition to an electronic business registration system; linking the registers of different state institutions; easing the standards for stamps and signatures as well as reducing commission charges and the required fixed capital. In Latvia, too, easing the starting a business and alleviating the rest of the administrative burden have not been ignored and both of these topics have been included in the Latvian national reform programme.
Another area in which Latvia has reform potential (also pointed out by Council of the European Union) has to do with the efficiency of the court system and insolvency regulation. According to 2015 EC Report on Latvia, time necessary for successful dealing with court proceedures is too long. Prolonged legal procedures reduce the chances of companies to receive loans (thus impeding their development) and require additional costs, which may be reflected in a price increase. The EC even points out to a direct correlation between GDP growth and the average length of the legal process. In the area of insolvency processes as well we have room to grow. The data of the Doing Business index show that in Latvia, the average amount recovered by the creditors (48%) lags seriously behind the average figure of the developed countries (72%). Moreover, in the frontier countries, for example, in the Netherlands and United Kingdom the indicator is even higher (around 90%). The lack of transparency in the insolvency regulation is in fact an indirect obstacle to attracting investment. Imperfections in the insolvency process may lead to insecurity regarding the repayment of loans, which in turn can find reflection not only in a lower amount of lending (and investment) but also in stricter lending criteria, for instance, in higher interest rates. An excellent example of the impact of insolvency legislation on the lending market was the so-called "keys returned" principle, because of which, commercial banks threatened to substantially raise the requirements for the borrower or even put a halt to lending altogether.
Changes to the insolvency regulation have been an important part of the set of reforms that allowed Spain and Italy to recover after the economic crisis. For example, in Spain the simplified insolvency process was introduced whose administrative part requires fewer costs and less time. As a result, ever since the beginning of the crisis, about 80% of all insolvency cases were resolved through the simplified insolvency process.
Another cause for concern is also the slow development of rules and regulations for the uptake of EU structural funds in the 2014-2020 planning period therefore 2016 promises to be full of challenges. Too complicated regulation can lead not only to a low level of uptake but also raise the administrative costs in the project development and implementation process. Even though the EU funds cannot be the only cornerstone for our long term development, right now it is an important source of financing for the companies. Shortcomings in the regulation can therefore have a direct impact not only on the success on some companies but also on the overall product market.
Moreover, the new planning period for structural funds involves a more purposeful support for research and innovations, separating them off as a priority. A successful uptake of EU funds can result in an increasing number of productive investments and innovations, which in turn would foster an increase in productivity and competitiveness. Right now, Latvia alongside Romania and Bulgaria finds itself at the low end of the EU innovation rating and thus, in the Latvian national reform programme, more attention is paid to those reforms that could encourage investment and innovation.
The small distance from frontier in other indicators is evidence that much has already been done in the area of product market reforms. That has been noticed also on the international level where Latvia's positive attitude towards reforms tends to be praised. Yet, as time passes, the lessons from the recent economic crisis become ever more distant and the desire to implement unpopular reforms may keep diminishing. According to the OECD, this correlation can already be observed in European countries and therefore further reforms may require extra effort. In the case of Latvia, its progress can still be aided by the example of other countries. The evaluations and conclusions of other international institutions may help us to get a clearer idea about our strengths and weaknesses. Membership in the OECD may bring particularly great added value, for it will not only expand the set of evaluations and proposals but also supplement the statistical base for evaluating the progress of reforms.
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[1] Of course, a reverse correlation may exist, i.e. countries with a high level of income have greater capacity for instituting the necessary reforms.
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