Interview with Tigran Jrbashyan, the Armenian director of the Armenian-European Policy and Legal Advice Centre (AEPLAC)

- To what extent the economic situation of Armenia meets the demands of a market economy? What are the main obstacles to an effectively functioning market economy in the country?

- There is one very serious problem in the path towards transition to, and development of a market economy, and this problem is characteristic of all transition countries. It is the clash between formal and informal institutions. First, let's define some technical terms. Institutions are the ‘rules of the game' according to which the members of the society establish their relations with each other and the government. Formal institutions are written and binding for its participants and include laws, agreements, contracts, etc. Informal institutions are laws that are not stipulated in writing, i.e. traditions, business culture, and relations between friends, family and relatives. Transition economies can be grouped into three main categories. The first category includes those countries which have managed to preserve, during their transition period, the formal institutions that existed under the totalitarian regimes, and to adapt it to market-based relations. The most striking examples are China, Belarus, and Kazakhstan. The second category includes the Eastern European countries and the Baltic states, which were able, with the support of the European Union, to quickly reform their institutions to meet the requirements of a market economy.

Obviously, they have not yet reached the level of the countries with a developed system of institutions, but the main phase has already been accomplished. Lastly, the third category includes the countries that find themselves in a so-called institutional vacuum: during their transition period, these states destroyed the old institutions but did not succeed in the creation of new ones with the required level of effectiveness. Ukraine, Moldova, Bulgaria, Romania, Armenia, Georgia and Azerbaijan fall under this group. In these countries, the institutional systems were destroyed but the new ones became established in a rather chaotic manner. It brought to a gap which was filled with informal, unwritten laws. When I say “unwritten laws”, I don't mean to say that written laws were absent. Simply, the unwritten laws prevailed over the written ones, and the government could not or did not do anything about it. In the '90s, when during an interview Levon Ter-Petrosyan was asked: “How can we live in such harsh social conditions?”, he answered: “Live by uniting and borrowing money from one another.” And this is how it worked: people started developing informal relations based on mutual assistance and mutual acquaintances.

As a result of these informal relations, certain groups of people were able to form more successful conditions for the development of their businesses. This became the basis upon which those countries saw the growth of businessmen holding monopolistic positions, thanks to obtained competitive advantages. Essentially, during the first phase of establishment of these informal institutions, those who had other options to defend their properties and ensure the fulfillment of contractual obligations were able to ensure also the growth of the economy on the basis of those very informal institutions. It had a positive effect in the beginning, since at that time nobody's property was defended, contractual obligations were not fulfilled and certain groups of people were able to find alternative ways for the establishment and subsequent development of their businesses. However, the problem was that these alternatives acted within the framework of informal interaction and were not equal for all, thus creating unfair conditions for competition.

I will bring an example: any economist will agree that an increase in the taxes on cigarettes causes a rise in price on the market. However, when, in the institutional sense, the country is weak and the primary driving force is the informal system, the result of a raised tariff is that the price on cigarettes may not change or may even decrease. When, for example, the customs tariff is increased, people tend to deal less within the formal field; they will try to cut a deal with the customs official, or bring in cheaper goods resulting in cheaper cigarettes. In another case, the prices stay the same because administrative instruments do not allow increasing the price, and instead, the informal interactions between bureaucrats and businessmen are left unnoticed. Such cases were quite common in the past.

Today, the theory of transitional market economy is in the phase of formulation, however it has already faced another problem – the strengthening of the informal institutions to such a degree that they become a stable and entrenched occurrence. At present, the tendency of this threat in Armenia is evident to me. Small and medium size enterprises see the need to defend fairness, in other words the existence of a formal effective institution. But in many cases entrepreneurs running small or medium sized businesses are forced to refuse making formal agreements since they are deprived of mechanisms by which they can force partners to respect the conditions of such agreements. Thus, they are limiting themselves to the environment in which they have acquaintances, relatives and friends, and where they can have their contracts enforced through informal mechanisms.

My main question is whether we will be able to form formal institutions, set rules of the game, which will be fair and equal for all. In Armenia, there is a significant cash flow thanks to the existence of a large Diaspora, and while the country is on a rise, it is evident that the current conditions cannot persist long; in 3-5 years these opportunities may run out. I hope that in this time we will be wise enough to take advantage of the current opportunities and create equal conditions for all, wishing to invest in the economy. Besides, the Armenian market is small and developed Armenian businesses will be striving to enter the European markets. But since the European market functions under formal conditions, we cannot be interested in it until we develop a compatible culture and predictability to function there. I hope that political-economic groups founded on the basis of informal institutions will prefer to shift to an attitude of formal interactions, at least for the purpose of reaching outside markets. There is no other version of reform that will push them to this change, without ensuring a larger economic benefit.

Now many talk about shadow economy or corruption but they forget that these occurrences are not the reasons preventing the development of the economy, but are merely the consequences of the existence of ineffective formal institutions. The businessman cannot stop his dealings in the informal field; otherwise he will stop being competitive. The human being is rational, especially a businessman, that is why the process of reform must be systemized, agreed upon and accessible for all. Otherwise, we can end up like the countries of Latin America where they are trying to overcome this problem for more than 50 years. Countries like Paraguay, for example, have seen average annual economic growth around negative 2%. This country came to a deep impasse, since its resources were used ineffectively and the rules of business were not equal for all.

Azerbaijan, in my opinion, is in practically the same situation. For Armenia, the compatriots working out of the country represent what oil represents for Azerbaijan, with one difference – the remittances coming into Armenia are distributed much more evenly among the population than the oil money, which accumulates in the hands of a certain group of people. That happens to be an additional factor for the strengthening of the informal system and the difficulties of its reformation. It's therefore no surprise that the relative effectiveness of formal institutions in countries with mineral resources is of a lower level than in those lacking such resources.

- What position do small and medium sized businesses have in the economy of the country and what are the main obstacles to their development?

- There are estimates suggesting that 40% of Armenia's GDP is supplied by small and medium sized businesses. But I have to note that small and medium sized businesses are developing well in those areas where the government intervenes the least. For example, the government decided to issue licenses to dental centers and step aside. Surprisingly a competitive market for dental clinics was quickly formed; and today these clinics are famous even outside the country. I know for a fact that many of our compatriots prefer to treat their teeth here, where the correlation between quality and price is quite competitive. But, for example, the government decided that ambulatory services should be free. Of course, from the social point of view, it is a very appropriate decision, but in reality such services are not offered for free: people give money to doctors and the funding budgeted by the government is used inefficiently since there is no competition neither in quality nor in price.

Now let's imagine that the government offers tax preferences to the IT sphere. I am sure that other businesses will present themselves as IT organizations, receiving tax preferences not intended for them. Today many say that the government should support small and medium businesses, but I am confident that under no conditions should the government, in its current state, be allowed to interfere in the development processes of businesses. Governmental support can lead only to additional distortions, therefore it is better, at the current stage, to avoid the involvement of the government. The government can pursue a supporting policy only in case it is a stable and effective system, from an institutional point of view. Today the business environment is primarily directed at the informal institutions. At the very minimum, the government must fulfill its main function of being the guarantor of fair rules of the game for all the participants of the market.

- What is the role of the banking system of the country in the development of the private entrepreneurship, and in particular, of small and medium sized businesses?

- The banking system in Armenia possesses a surplus of liquid financial resources, whereas small and medium sized businesses need investments. However, the demands of the businesses and the offers of the banks do not yet meet. The reason is obvious: the banking system is a formal institution with formal rules, by which it offers credits; while the businesses function in a completely different, informal environment. Therefore, the banking system and the small and medium-sides businesses do not go on the same path. In my opinion, from the perspective of formal institutionalisation, the banking system is one of the most successful structures here. However being formal, it cannot come into interaction with those structures which do not function in that same formal field. The banking system is developing due to other spheres, for example thanks to consumer credits and mortgages. Today only 7-8% of company owners apply to banks.

A businessman acting in the formal field has a variety of advantages. For example, several types of businesses cooperate with international organizations and the gap in the competitiveness in the area of pricing is compensated by other advantages. For instance, they can carry the brand name and logo of the company they cooperate with, offer guarantees to clients, offer services, etc. These advantages fill gaps and thus enterprises working in formal fields can to some degree compete in the market. However, this is more of an exception than a rule.

- To what extent do the legislation of the country and its tax policies comply with the needs of developing small and medium sized businesses?

- The legislation meets the needs of development of small and medium sized businesses, and so what? I can say that the legislation of Armenia is close enough to the legislation of the European countries but this does not mean anything yet. This is a formal institution that does not guide small and medium sized businesses. The level of our laws is very high, but the secondary legislation and the systems that are responsible for the enforcement of these laws mess up the laws. The main purpose of having secondary legislative acts is not to ensure the implementation of laws, but to ensure that a group of people has the ability to make money. Let me try to explain with an example.

Legislation in Armenia suggests that imported goods used for funeral ceremonies are not subject to VAT. The European Union also has such a law but unlike us, the EU specifies in a separate list the items that can be used during a funeral and are exempt from tax. We do not have such a list so it becomes at the customs official's discretion whether or not a particular good can be used for funerals. Thus, one can import flowers registering them as an item for a funeral ceremony thus making them exempt from VAT, while another will not do this.

The laws are written well, but the secondary legislation significantly decreases their effectiveness. That is why I believe that the secondary legislation must be presented together with the relevant law, so that the decision-makers understand how the particular law works. A law itself cannot describe everything.

- What is the portion of foreign investment in small and medium sized businesses?

- Again, since we are dealing in the informal field, what opportunities can a foreign investor have given the ineffective system of defending property and ensuring contract enforcement? Small investments cannot justify themselves since the expenses for their defense exceed their profit. We are thus left with large investments, of around 1.5 million USD, under which the expenses could potentially be guaranteed. Small businesses immediately fall out of competition, which leaves us with medium sized ones. If we take a closer look, such investments only accumulate where the interference of the government is minimal. There have not been very large investments yet.