How Tight Is Too Tight? A Look at Welfare Implications of Distortionary Policies in Uzbekistan

1. Introduction Uzbekistan is strategically located in Central Asia, at the crossroads of the ancient Silk Road between China and Europe. Of the 15 independent states that emerged from the breakup of the Soviet Union in 1991, Uzbekistan is the third largest in population (about 26 million) and the fourth largest in land area (448 thousand square kilometers). During the Soviet period, Uzbekistan was developed as a leading center for cotton production, capitalizing on its vast water resources for irrigation. Since independence, the Uzbek authorities have opted for a gradual approach to reforming their economy. Their strategy aimed at building a socially oriented market economy, and developing industrial and manufacturing capacity in a predominantly agricultural economy using substantial and direct central guidance. To that end, the government has adopted an import-substitution strategy, particularly since 1997, that has relied heavily on administrative intervention and a restrictive foreign exchange and trade regime. Unfortunately, this gradual reform strategy relied heavily on three interventionist pillars, most of which have their roots in Soviet planned-economic practices: exchange and trade controls, directed resource allocation, output targets (especially agricultural) and sizable public investment. Some of these controls and restrictions, discussed in detail in the paper, are quite unique. As a result, while these policies may have prevented output from contracting in the early 1990s, they led to disappointing economic and social conditions later on. (2) Industrial growth was very low and uneven. While some new industries were promoted, many others have ceased operations or are operating below capacity. Production and exports witnessed little diversification. The government's presence remains strong in many areas, with governance and capacity issues providing reasons for concern to the international community. (3) Furthermore, the opacity and unpredictability of government policies continue to hinder domestic economic activity (IFC, 2004) and foreign investment. Uzbekistan lags behind most transition economies in terms of market development, large-scale privatization, and corporate governance. Zettelmeyer (1998) found that Uzbekistan's good output performance during the early 1990s was mainly due to a combination of low initial industrialization, (scale of) cotton production, and self-sufficiency in energy. These three elements more than offset the impact of the government's poor macroeconomic and structural policies. This conclusion that the government's public investment and gradualist reform program were not the driving forces behind the relatively favorable output performance is also repeated in Taube and Zettelmeyer (1998). The government's interventionist and distortionary policies were also reflected in the financial sector--dominated by state-owned banks--and in monetary and exchange rate policies. The legacy of administratively-determined interest and exchange rates and limits to access to cash resulted in deteriorating confidence in the financial system. This is reflected in the low level of monetization and heavy reliance of the banking sector on foreign loans as a liability base. (4) Ranaweeva (2003) shows that the disequilibria in the product and money markets--in an environment of multiple exchange rates, administrative controls, and import restrictions--were the major forces driving inflation dynamics in Uzbekistan. In turn, Rosenberg and de Zeeuw (2000) found that Uzbekistan's multiple exchange rate regime transferred about 16 percent of GDP from exporters to importers and generated identifiable welfare losses in the range of 2-8 percent of GDP on import markets and up to 15 percent on export markets. However, the government has addressed some of these problems since 2000. It has successively reduced exchange market distortions and introduced currency convertibility, tightened fiscal and monetary policies, initiated the restructuring of farms into leaseholds, and followed a more conservative borrowing path. …