COMPETITIVE ADVANTAGE OF REGIONS - …ime.bg/pdf_docs/papers/C-A-R.doc · Web viewThe economic recession will not stop soon; there is no growth in the real sector despite the financial

COMPETITIVE ADVANTAGE OF REGIONS

CREATING COMPETITIVE CLUSTERS IN BULGARIA:

FACTORS, VISION AND STRATEGIES

A Joint Report of the Institute for Market Economics and the World Bank Institute

November 1998 - September 1999

Svetlana AlexandrovaZora Blagoeva

Latchezar BogdanovValentin ChavdarovLuibomir Dimitrov

Tzveta Dimitrova Georgy GanevAtanas GochevDiana Kopeva

Magdalena KotupovaRossen Rozenov

Alexander PopovKrassen Stanchev

1

INTRODUCTION

This report appears thanks to the efforts and support of many prominent and committed individuals from the Institute for Market Economics, the Center for Liberal Strategies, the International Relations Department, Capital Consult Ltd. and The Agency for Economic Analyses and Forecast. Djordjija Petkoski of EDI has been leading Competitive Advantages of Regions project, and suggested to use children’s paintings for promoting the debate on the future. This idea was a response to 1997 survey on Vision of the Future: Bulgarian Reflect on Their Competitive Future which demonstrated a random desire of the adult Bulgarians to overcome then existing political and economic stalemate. The president of Political Academy for Central Europe, Evgenii Dainov, invited IME to represent the result of our work at the Third PACE Session with the majority faction of the Bulgarian Parliament and all the members of the cabinet, this year dedicated exclusively to Economic Reform Challenges (the session was held on June 19-21, 1998, in Borovetz). Many individuals were supportive for the dissemination of the findings but we would like to acknowledge the role of Peter Andonov, currently Ambassador of Bulgaria to Japan, who during the work on the project was Economic Observer for Radio Free Europe Bulgaria and a Secretary of the President’s Economic Policy Council. Prof. Evdokia Slavcheva organized on her own children painting on the future, and with her students from the Sofia University Department of Psychology organized an exhibit which was widely covered by the media.

This report examines the competitive position of the Bulgarian economy on the basis of the methodology proposed by M.Porter in his book “The Competitive Advantage of Nations”. An important objective of the work on the text was and remains to provoke and maintain alive a broad public debate on how to improve existing competitive advantages of Bulgarian industries and/or achieve better relative position in the future.

There is no doubt that it is applicable to the conditions in Bulgaria, a country in transition from planned to market economy; with persistent macroeconomic and political instability, and underdeveloped private sector. The IME, in a co-operation with the Economic Development Institute of the World Bank, conducted a review of firms’ competitive strategies and emerging clusters in perfumery and canning industries in the first half of 19971. Under the same EDI project, the Center for Liberal Strategies and Gallup International surveyed the impact of the public’s and businessmen vision of the future on prevailing notion of competitiveness.2 And most importantly, the same year, Dr. Atanas Gochev initiated a survey which was entirely based on M.Porter’s book.3

Today's Bulgarian economy is still to identify its specific competitive advantages: 1992-1997 key exporting industries (petrochemicals, ferrous and non-ferrous metallurgy) were subsidized through energy prices. Economic conditions in 1996 and early 1997 were an extreme case of instability: economy was dollarized, saving, investment and taxes went sharply down, one third of the banks were closed, private sector went into informality, etc.4 July 1996 to April 1997 is the only period 1 Copyrights belong to EDI.2 See: Djordjija Petkoski, Vision of the Future: Bulgarians Reflect On Their Competitive Future, EDI of the World Bank, 1998.3 Atanas Gochev (editor), Competitiveness of Bulgarian Export Industries, Sofia, Albatros, 1997.4In 1996, accumulated year inflation was 310%. (First quarter 1997 inflation was 438%.). CPI deflated interest rate on bank deposits (even after the increase of the basic interest rate in late September up to 300%) was negative - minus 43%. (In February 1997, basic interest rate was 18% a month while inflation reached 242%. Business corporations were forced to convert their accounts into hard currency and keep as much cash as possible.It was a period of economic instability reflected in the exchange rate: between January 2, 1996 - January 3, 1997 depreciation of the Bulgarian lev (BGL) marked 601%. For the same period rate on one month time deposits was 104%. By mid-January 1997 the rate was at the level of 1,000 BGL for USD, and by the first week of February it reached BGL 3,000. (In March 1997, local currency appreciated by 50%, up to 1,500 and stabilized at this level.) GDP shrunk in 1996 by 11%, and in 1997 by 7%. The level of aggregate indebtedness (including foreign debt of 9.665 billion USD) in the economy was about 180% of 1996 GDP. In 1997 it fell down to about 130%. Political instability went hadn in hand: Scialist cabinet in 1996 had three options: to default on the country’s external debt (with a Brady plan adopted in mid-1994), to restrict money supply and ensure new borrowing, or to continue to continue issuing money, and it chose the latter, but resigned in December 1996. The economic crisis necessitated a change in the government and fresh elections. The new majority is dedicated to reforms, and the new cabinet managed to secure IFIs support to Bulgaria’s balance of payments for 1997 and 1998, and introduced a currency board regime as

2

since 1992 when private sector restricted its output. In "normal" years it was compensating for the declining output of state-owned enterprise. Industries that survived 1996-1997 crisis are export oriented and competitive. Although financial adjustment in 1997 and 1998 did not allow any specific pro-competitive policy, an overview, attempted by this report, of what worked and what did not is an useful basis to derive lessons for the future.

In terms of macroecponomic stability, 1998 has confirmed the gains of the second half of the previous year. As Michael Fairbanks and Stace Lindsey have pointed out studying a similar situation in Latin America, "macroeconomic stability is necessary but insufficient for creating sustainable growth".5 As in many Latin American countries Bulgarian macroeconomy is not changing at the same pace. The government is still following a paternalistic approach towards human capital and private sector. Besides the fact that the latter contributed to 57% of the GDP, the government is still concerned with natural resource driven state-owned companies, sets incentives for natural resource dependent industries and establishes artificial licensing and permit requirement on the private sector.

Prof. Gochev and his colleagues found that Bulgaria’s 1992-1996 “model of national advantage is factor-driven”, that “competitive advantages are demonstrated mainly in industries with existing basic factors…”.6 At the same time they have proved that subsidized Bulgarian export leaders have few time smaller share in total world export than those which did not "enjoy" such favoritism. Prof. Gochev's group have determined that: · “top positions of the [exporters’] list are occupied by natural resource industries (non-ferrous

and ferrous metals, chemical industry);· a large number of export industries are related to agriculture production (vegetables and fruits,

tobacco, live animals, animal products); wine and spirits fall in this category;· a group of products strongly related to light industries such as different type of clothing.”7

The Graph below demonstrates this distribution.8

Percentage of Bulgarian Exports by Clusters of Competitive Industries in Total World Exports

00,10,20,30,40,50,60,70,80,9

11,11,21,31,4

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

19921995.

Legend: 1. Metals and Materials; 2. Wood Products; 3. Petrochemicals/Chemicals; 4. Total upstream exporters; 5. Multiple businesses use devices (electrical motors, generators); 6. Transportation equipment; 7. Electrical distribution equipment; 8. total supporting industries; 9. Foods; 10. Wines; 11. Tobacco; 12. Textile Products and Clothing; 13. Footwear; 14. Pharmaceutical products and cosmetics; 15. Total final consumption goods and services.

In 1998 we focus on these sectors. They did not benefited from subsidies, or the impact of artificial electricity prices might be considered negligible. The microeconomic change in these sectors is presumed to have been rather "natural"

a key institutional solution to stabilize the economy and foster market reforms. In 1998, the new cabinet signed a three-years program with IMF which objective is establish “a competitive, private sector driven economy” in Bulgaria.5 Michael Fairbanks and Stace Lindsay, Plowing the Sea: Nurturing the Hidden Sources of Growth in the Developing World, Boston, Massachusetts, Harvard Business School Press, 1997, p. 242.6 Gochev, op.cit., p. 29.7 Ibidem.8 Ibidem, p38.

3

We deal with:· wine,· canning,· and wool textile industries.and focused their relevant clusters, e.g. it was difficult to reflect on wine and canning without a brief overview on agriculture.

Below we consider strategies to establish competitive in the category of industries producing products for final consumption. The reasons are:1. these sectors, at least for the last hundred years, did not pass through a significant technological

revolution; the overall dis-investment in the Bulgarian economy since 1990 is not a significant impediment to these industries;

2. the Bulgarian economy in a process of comprehensive change, in terms of both development and institutions; entrepreneurs find a "natural" starting point in the traditional Bulgarian industries;

3. the vision of Bulgarian competitive position is still in a limbo between government macroeconomic commitment to market reforms and firms' endeavors to brake through; physical resources and tradition are presumed as the most immediately available prerequisites for pursuing the advantages believed to be already available.

We surveyed Bulgaria’s competitiveness with a qualitative approach with a focus on current dynamics of diamond’s elements. We made an attempt to follow these elements on both sector and firm level. We begin with a brief comparison between classical trade theories and Porter’s competitive advantage theory. Then, using various statistical data we attempt to find out where Bulgaria stands in terms of factor conditions, demand, firm and country competitiveness strategy, and industrial clusters. Thus, we hope to outline Bulgaria’s competitiveness environment. Adjustment (to macroeconomic shocks) and restructuring requirements (including the issue of subsidies, mentioned above), motivated us to pay attention to the development of small and medium size private sector, which may mediate the change in the competitive strategies. We believe that SME's and Bulgaria's factor conditions, especially lack of the so called humanly designed factors, raises the issue of the general vision and strategy. This two key points are dealt with a special attention devoted to the visioning the future by younger generations (children and student) and specific strategies pursued in different sectors (viewed through sector diamonds) and companies (reflected in the case studies). We believe also that if a critical mass of companies elaborates their own competitive strategy, the economy as whole would take off towards a favorable diamond of national advantage (DNA), and would require that the government designs and pursues policies facilitating competitiveness, growth and prosperity.

BULGARIA’S COMPETITIVE ENVIRONMENT: THE COUNTRY DIAMOND9

FACTOR CONDITIONS

M.Porter, in his book The Competitive Advantage of Nations, maintains the view that factor endowments, although important, do not determine the competitive position of a nation. Moreover, the link between factors of production and trade is not as straight forward as presented by standard economic theory. In Porter’s words, “...the stock of factors at any particular time is less important than the rate at which they are created, upgraded and made more specialized to particular

9 See: ANNEX 1

4

industries.”10 The crucial distinction here is the dynamic aspect of competitive advantage theory. Factors that contribute most to the successful performance of advanced economies are created rather than inherited. These findings have important policy implications. A country which is not well endowed with resources can still build competitive industries and achieve rapid growth provided it adopts appropriate policies that stimulate investments.

Another strong proposition in Porter’s theory is that factors of production are not homogeneous, and in order to understand their role in competitiveness we must distinguish between basic and advanced factors as well as between generalized and specialized factors.

Physical resources

Physical resources constitute a rather broad category including land, timber, mineral resources, geographical location and climate. These are factors inherited by a country and can have little to no influence. Table shows the most recent comparison of Bulgaria’s position regarding availability of arable land, meadows and pastures, and forests.

Use of Land in 1993Thousand hectares Percent of World’s

Arable land 4,310 0.30Meadows and pastures 1,811 0.05Forests 3,877 0.09Source: National Statistics Institute (NSI)

Bulgaria is relatively well endowed with arable land which is a precondition for more intensive plant-growing rather than livestock-raising and forestry. Indeed, in 1994, plant-growing accounted for 52% of total agricultural output in constant prices, but later in 1996 the percentage fell to 39%. To a large extent these variations result from the different climatic conditions of different years, but it is also true that the efficiency of plant-growing has declined substantially in recent years. For example, the average wheat crop per hectare in 1995 was about 2.5 times less than that in Germany and the UK, and about 1.5 times less than Hungary and the Czech Republic. This implies that there is considerable room for improvement in the performance of the agricultural sector by raising productivity of land resources. Clear property rights and less government intervention in pricing are necessary conditions to achieve better results in the agricultural sector.

Bulgaria is not considered to be very rich in mineral resources (see Table below). Over 100 different minerals and ores have been explored, but only a small share of these is economically significant. The deposits of kaolin, silica sand, barite, salt, perlite and clays are substantial for the size of the country, but they have not been intensively exploited. Metal ores are available in relatively small quantities, but the quality in terms of pure metal content is low -- sometimes two to three times below the leading world producers. Although Bulgaria has huge deposits of some ores like manganese and wolfram, it is unable to take advantage of them because of technological and financial problems. Bulgaria is very unfavorably positioned with respect to energy resources. The economy is strongly dependent on imports of oil and natural gas. Domestic production accounts for less than 1% of consumption. Though explorations of the shelf are still going on and there is a possibility of discovering oil , the gap between domestic and imported energy goods is unlikely to disappear in the near future.

Estimated deposits and production of mineral resources as of end 1993Estimated deposits (thousand tons ) Production (thousand tons)

Metal OresIron 204 000 864Manganese 126 000 25Wolfram 22 000 -

10 M. Porter, “Competitive Advantage of Nations”, Macmillan Press, 1990., page 74

5

Lead & Zinc 124 000 2 346Copper 830 000 18 135Energy ResourcesBrown coal 348 000 4 362Lignite coal 4 202 000 26 693Oil 774 53

Gas (mln.m3) 2473 37

Other mineralsKaolin 200 000 694Salt 4 400 000 1000Borite 222 000 761Lime 1 225 000 989Source: USGS International Minerals Information, NSI, CGMR

International trade developments in recent years reveal a tendency towards a diminishing importance of mineral resources. This tendency comes as a result of technological advancement and increased efficiency of use. Contrary to global trends, Bulgaria has been increasing its reliance on resource intensive industries since the beginning of transition. In 1996, exports of chemical and metallurgical industries accounted for 37% of the total, whereas exports of machinery and electrical equipment shrunk to a modest 14.0% (compared to 57.7% in 1990). Given declining world market prices of commodities with a high content of natural resources, Bulgaria will face serious terms of trade deterioration and current account problems. In late 1997 and 1998, former export leaders - Bulgarian fertilizer factories have failed to adjust to decreasing prices, started to accumulate losses and lost their potential buyers.

Climate conditions and geographical location can only be assessed qualitatively. The qualities of these factors can be judged by the importance of tourism and transport services to the Bulgarian economy. A typical moderate continental climate with four distinct seasons, combined with mountains and a sea, is a prerequisite for the development of a strong tourist sector. Good examples of this are our neighboring countries Greece and Turkey, which rely heavily on tourism as a source of income. The development of a highly competitive tourist industry would require huge investments not only of physical capital but also of knowledge and human capital. Geographical location offers Bulgaria a good opportunity to gain from transportation, provided the proper infrastructure is in place. In a sense, location is a factor that can be upgraded by building roads and railways to reinforce natural endowments.

Capital resources

Measuring capital has proved to be a difficult issue. The concept of capital in economic theory is related to the idea of income creation. Two approaches to measurement of capital are possible. The first one concentrates on physical equipment, i.e., the asset side of the balance-sheet, while the second one refers to capital as money capital which makes a production process possible to occur, and accordingly appears on the liability side of the balance sheet. For the purposes of this analysis the Fundist view shall be adopted and capital defined as money capital, or, resources available to finance industry. (This is M.Porter’s approach as well.)In the case of Bulgaria, savings to GDP ratio is very low -- 11% on average for the period 1992-1996. In comparison, in fast-growing economies this ratio is 30% or more. The low savings rate for Bulgaria is due mainly to the continuous fall in income combined with high and persistent inflation. The negative real interest rate and the limited choice of financial instruments also discouraged savings.

Capital may take various forms: equity capital, bank loans, bond issue, etc. Since the beginning of transition, the role of equity for Bulgarian non-financial enterprises has decreased to some extent and firms have relied increasingly on debt financing. However, the debt to assets ratio is still much below that of Western countries, which, according to some estimates, is more than 60%. For

6

example, Rajan and Zingales11 report a ratio of 66% for the G7 countries, and for the Bulgarian state-owned enterprises, which still constitute the greater part of the economy, the calculated mean value of this indicator for 1996 is 47%.12 The high share of equity in firms’ total liabilities in the case of Bulgaria has been inherited to a large extent from the pre-transition period when investment was very often financed with equity direct from the budget and did not pass through the banks. However, after 1991 the majority of state-owned enterprises turned primarily to the banking system to obtain financing, and those firms that were not profitable rapidly became over-indebted. The debt to asset ratio for some loss-making firms is greater than 100% (these firms have negative capital). Still, on the average, the present capital structure appears to be sub-optimal, at least if we compare it to that of developed countries. In order to achieve better leverage, firms should diversify between different sources of financing. Those enterprises that earn high profits are in a much better position since they have both internal resources in the form of undistributed profits and relatively easy access to external funds. The less profitable ones have to rely mostly on financing from outside. The important question is whether the capacity and performance of the Bulgarian financial sector are adequate for the needs of the economy. Banks continue to be the main source of money for enterprises, but after the crisis of 1996/1997 they have substantially reduced their lending activity. The stock market has just begun to function and domestic firms as a rule do not have access to international sources of financing.

Considering banks’ reluctance to extend credits and the difficulty of borrowing directly from the domestic and foreign capital market, Bulgarian firms have very limited possibilities of raising funds. Moreover, market inefficiencies result in high transaction costs and increase the price of capital. Interest rates, although now considerably lower compared to previous periods, are not sufficient to induce credit expansion. On the demand side, businesses still seem either not to be finding attractive opportunities in which to invest or are unable to provide enough guarantees for their creditworthiness, and on the supply side, banks are overcautious and prefer to place their money abroad.

Clearly, given the low rate of savings and underdeveloped financial market, Bulgaria cannot be viewed as a capital abundant country. In an increasingly global economy, however, the domestic capital constraint becomes less important provided the country can attract foreign investment. So far, Bulgaria’s performance in this respect has been unsatisfactory compared to the more advanced reformers in central and eastern Europe. It is important to emphasize that unlike natural resources, capital is a factor that is created. In order for this process to be accelerated, appropriate policies encouraging savings and capital formation are essential.

Infrastructure

Infrastructure is closely related to competitiveness and economic growth. A country which wants to engage in international competition should invest heavily in improving local infrastructure so as to reduce the costs of doing business and encourage both domestic and foreign investment.

In this paper when speaking about infrastructure we shall refer only to physical infrastructure (roads, telephone lines, ports, airport, etc.), although in recent economic literature a broader definition is often being used, one that includes legislative and institutional frameworks as well. Since the onset of transition all Bulgarian governments have neglected investing in, and even maintaining, infrastructure facilities. Capital outlays as percent of GDP dropped from 2.5% in 1992 to only 0.8% in 1996. Expenditure on maintenance has also been reduced dramatically. The funds directed to road maintenance in 1996 for example, were 75% less in real terms than those of 1992.

11 Rajan, R. and L. Zingales.1995. “What Do We Know about the capital structure? Some Evidence from International Data” Journal of Finance, vol. 5012 Here and everywhere in the text we have used the book values since market values are not available in the case of Bulgaria

7

Government expenditures on infrastructure(% of GDP)

0.00

0.50

1.00

1.50

2.00

2.50

1992 1993 1994 1995 1996

Maintainance Capital Outlays

Source: Ministry of Finance (MF), NSI, Own calculations

Huge budget deficits in the years prior to 1997 called for a sharp reduction of government expenditure. Since priority was given to the servicing of domestic and foreign debt, non-interest current and capital expenditure were continuously falling in real terms as a result of the efforts of the government to curtail the deficit.

In the second half of 1997, interest rates dropped dramatically. This allowed for a substantial reduction of the deficit, and in the first two months of 1998 the overall budget balance stood at a surplus of about 200 bln. BGL. The favorable current fiscal position allows room for some increase in capital expenditure, but money, although essential, is not the sole answer to the infrastructure problem. Allocation and management of infrastructure projects are key issues that are often neglected. Under a currency board arrangement, budget resources available for investment are quite limited. A higher fiscal deficit could undermine economic stability and therefore, rebuilding the infrastructure would require alternative solutions that would not rely so much on funding from the budget. A good beginning would be to squeeze the maximum of the existing infrastructure by keeping it in good condition and utilizing it more efficiently. In other words, in the beginning, more resources should be devoted to maintenance and management rather than to new investment. The next step could be privatization of some parts of the infrastructure, notably the telecommunications and energy sectors, but there have been instances where commercialization has been extended to roads, bridges, etc.

In many developed countries a significant part of infrastructure is delivered by the private sector. Since these activities are usually associated with low returns and high risks, additional incentives, like tax preferences, are provided in order to make them more attractive to private investors. Another possibility for raising funds for public investment may be to adapt the price of using the existing infrastructure in order to cover the cost of its operation. This solution is unpopular and politically difficult to take, but should be considered as an option in view of the poor condition of public services in Bulgaria. Large project financing can be obtained from international financial institutions such as the World Bank and the EBRD.

In recent years increasing attention has been paid to the information infrastructure, which involves the accumulation, processing and dissemination of data. High performance computing systems, advanced communications networks and software are essential to national competitiveness. Lack of vision and direction in this area could do a lot of harm to the economy. We must rebuild, improve and expand our infrastructure to allow Bulgaria to be an effective competitor in the world marketplace.

8

Human resources and knowledge

Human resources and knowledge constitute the most valuable factor that plays a crucial role in the building up and sustaining of a competitive advantage. Standard economic theory focuses primarily on the cost of labor. One of the most frequently used indicators of competitiveness is the exchange rate adjusted for relative unit labor costs. If our analysis were confined only to this indicator, we would infer that Bulgaria, having one of the lowest wage rates in Europe, was a very competitive economy. However, this is not the case. Measuring competitiveness by only using the price of labor is oversimplified at best, and at worst, wrong. In today’s world, what matters more is the quality of labor and its efficient use. Modern technology has created a greater demand for highly educated employees and a general workforce with greater technological knowledge and skills.

Since 1991, the number of undergraduate students has been increasing by approximately 10% per year; however, the number of Ph.D. students fell twice in the period of 1991-1996. The state universities have gained some autonomy and new private universities have emerged, but the quality of education has deteriorated. A great part of the teaching is based on out of date programs, and computers and other technical facilities are either ancient or not available at all. Subscription for periodicals and purchases of new books by libraries has been reduced to a minimum. Although the number of students who pay for their education increased from 30% to 48% of total between 1993 and 1996, Bulgarian universities still rely strongly on financing from the budget, and available funds for education in 1996 were less than 40% of their 1992 level in real terms.

Budget Expenditure on Science and Education(constant prices, 1992=100)

0

10

20

30

40

50

60

70

80

90

100

1992 1993 1994 1995 1996

Education Science

Source: MF, NSI, Own calculations

The differentiation between the different categories of spending is significant. Funds for scholarships, for example, decreased by 78% and expenses on research and books fell by an impressive 86% in real terms.The average wage in education in 1996 was 33% less than the average for the country and 46% less than the average for the industry. The low level of wages demotivates the people involved in teaching and research, and many of them leave the country or move to other sectors where they receive better pay.

The financial situation of the scientific sector is similar or even worse than that of the educational sector. And science is closely related to knowledge resources. In Porter’s definition, knowledge resources are comprised of the “nation’s stock of scientific, technical and market knowledge

9

bearing on goods and services. Knowledge resides in universities, government research institutes, private research facilities...”.13

How can we assess the stock of knowledge in Bulgaria? This question does not have a straight forward answer. Different indicators suggesting an idea of the current situation of R&D activities in the country are presented below.

At the end of 1996, the total number of the people engaged in science was 25,853 -- 11% less than in 1991. The distribution by field of research is shown in the table below.

Distribution of scientists by field of research1991 1992 1993 1994 1995 1996

Natural science 5,272 5,135 5,227 5,151 5,121 5,101Engineering 10,541 9,339 8,583 7,743 7,361 7,421Medical science 4,917 4,914 4,796 4,802 4,729 4,817Agricultural science 1,930 1,662 1,632 1,649 1,626 1,653Social sciences 6,400 5,548 6,046 6,271 6,740 6,861Total 29,060 26,598 26,284 25,616 25,577 25,853 Source: NSI

Financial problems in the science sector hit R&D in engineering most severely. To the extent that engineering is most closely connected with industrial innovation, shrinking activity in this field may have an adverse impact on long-run economic development. Besides the decline in engineering profession, the table above does not reveal a specific structural problem: most of scientist remain employees of in Bulgaria remain employed by government institutions or by the Academy of Sciences, and in general are not involved R&D in the industries. Exceptions are in the sub-fields of agriculture science, metallurgy, nuclear science, microbiology and pharmacy.An international comparison may provide a better idea of Bulgaria’s relative position in R&D. In terms of scientists and engineers per million of the population and expenditure for R&D as % of GDP, although Bulgaria is better positioned than most other central and east European countries, it is still far behind industrial ones.

International comparison of indicators for R&DCountry Year Scientists and

engineers per million population

Technicians per million population

Year Expenditure for R&D as % of GNP

Bulgaria 1995 1,587 873 1995 0.8

Austria 1993 1,631 814 1995 1.5France 1994 2,584 2,874 1994 2.4Germany 1993 2,843 1,472 1993 2.4United Kingdom 1993 2,417 1,019 1993 2.2United States 1993 3 732 0 1995 2.5

Czech Republic 1995 1,159 695 1995 1.2Estonia 1995 2,018 470 1995 0.6Hungary 1995 1,033 512 1995 0.8Poland 1995 1,299 510 1995 0.7Russian Federation 1995 3,520 688 1995 0.7

Japan 1994 6,309 828 1994 2.9Korea, Republic of 1994 2,636 317 1994 2.8Singapore 1995 2,728 353 1995 1.1Source: UNESCO

13 M.Porter, op.cit. page 75

10

There is another important difference between Bulgaria and developed economies. Much of the R&D activity in developed countries is concentrated in the private sector. In the US, for example, about two-thirds of total R&D spending is financed by non-government organizations. Bulgarian firms still haven’t recognized the advantages of investing in research and development. Products of R&D on state-owned enterprises’ balance sheets increased only marginally compared to inflation between 1991 and 1994, and decreased in 1995.

Products of R&D and patents & licenses on SOEs balance-sheets1991 1992 1993 1994 1995

Products of R&D in th. BGL 25,274 127,243 133,530 167,330 160,138 in % of fixed assets 0.03 0.03 0.02 0.03 0.02Patents, licenses in th. BGL 200,697 225,982 415,710 568,159 943,675in % of fixed assets 0.23 0.05 0.07 0.09 0.14 Source: NSI, Own calculations

Patents, licenses, concessions and trade marks grew faster in the period under consideration. This can be attributed to the opening of the economy and obtaining of licenses from western firms as well as to the registering of new trade marks. Unlike developed economies, in Bulgaria, the financial performance of firms is completely independent of their involvement in R&D. A cross section analysis using data from 1995 of about 10,000 enterprises showed that there is no statistically significant correlation between profitability and share of R&D products. This is illustrated in table 2.6 below. Leading export industries like metallurgy, oil processing and chemical production have on the average a lower ratio of R&D to assets and patents & licenses to assets.

R&D and patents & licenses for the leading export industries, 1995R&D Patents&licenses

th. BGL % of fixed assets th. BGL % of fixed assetsFerrous metallurgy 1,213 0.003 5,551 0.02Oil-processing 1,031 0.004 19,046 0.08Tobacco manufacturing 801 0.013 4,243 0.07Machinery production 33,362 0.051 85,034 0.13Non-ferrous metallurgy 74 0.001 1,532 0.02Production of fertilizers 3,163 0.034 30,325 0.33Production of wines 0 0.000 2187 0.06Production of electrical equipment 13,660 0.059 80,955 0.35Production of organic chemicals 95 0.006 217 0.01Production of apparel and clothing 783 0.023 5,341 0.16Source: NSI, Own calculations....

Where Does Bulgaria Stand?

This brief overview of Bulgaria’s factor conditions allows us to formulate some conclusions and recommendations for economic policy. Firstly, the over-reliance on exports based on intensive use of energy and mineral resources is not consistent with the country’s natural endowments. What is perhaps more important, however, is that this is not the appropriate strategy for creating a dynamic competitive economy. At the same time, some basic factors like land, location and general labor force, which are available to the economy and of good quality, are not being deployed efficiently.

More efforts should be devoted to the creation of advanced factors -- a modern communications infrastructure and a highly educated labor force. Research and educational institutions must reassess and redefine their roles and objectives in view of the new circumstances. The limited resources imposed by budget constraints provide a strong need for restructuring these sectors. Government expenditure decisions have a significant impact on human resource development. More budget funds should be targeted to fundamental science, and furthermore, incentives should be created for

11

firms to engage in R&D. Given the fact that teaching and research complement and reinforce each other, integration of research and education at all levels of academic activity is essential. The creation of advanced and highly specialized factors of production demands a large and sustained investment. Only through the creation and upgrading of such factors will Bulgaria’s economy be able to achieve a sustainable competitive advantage and prosperity.

See: Annex 2

HOME DEMAND AS A COMPETITIVENESS FACTOR

Home demand may improve the competitiveness of the overall economy by helping local enterprises to anticipate and respond to the needs of the world market. It must be able to identify the changes in consumers’ perceived needs or priorities, which is often a key to success.

Companies achieve competitive advantage through acts of innovation. Innovations that yield competitive advantage anticipate both domestic and foreign needs. The role of home demand in the improvement of a country’s competitive environment is to give clear signs to firms regarding these needs.

1991-1997: Reduction Stage

Innovation usually requires pressure, necessity and even adversity in order to be successful. Therefore, consumers should have enough power to compete with producers by forcing down prices and by bargaining for higher quality or more services. Powerful consumers may ensure a necessary pressure, which would create competitive conditions in the economy.Home demand in Bulgaria has reduced dramatically in the last years. This is due to the decreased purchasing power of the main consumer groups – citizens, government and business consumption (intermediate consumption).

Since 1991, real incomes of citizens have decreased. As result of that, purchasing power of the population almost halved in the period between 1992 and 1996. This reduction is more dramatic if the data on purchasing power of households in 1990 (on the eve of the economic reforms in Bulgaria) and 1996 are compared. Thus, the purchasing power of households has reduced between 2.3 and 4 times, if measured by the purchase of particular goods.

Household Consumption

All of this has caused changes in the structure of household consumption. The change of the structure in household demand is more important than its volume reduction, in spite of the fact that these are closely connected. The character of home demand has a much bigger significance than its size. The share of foodstuffs in the total amount of consumption increased from some 36% in 1990 to about 45% by the end of 1996. Its share achieved an extremely high level of 55% of total household consumption in the first months of 1997, when real incomes were extremely low. At the same time, in the 1993-1996 period, the share of clothes and shoes in the total consumption decreased from some 9% to about 7%, while the consumption of other goods (electricity appliances, etc.) decreased from about 35% to 29% by the end of this period. At the end of 1996, some goods were almost unable to be bought by citizens with an average income. In 1996, a person earning the average annual wage for the country could only have bought 2 refrigerators, or 2 TV sets, or 3 washing machines.

Investment

The change of the structure of home demand concerns not only household demand, but intermediate business demand as well. This is especially true for Bulgaria where 70% of companies

12

registered are sole proprietors. (They report their income once a year and are not required to keep double entry books; so, their financial (tax) report position is similar to that of households.) The demands of investment goods, which are mainly high-end products, reached extremely low levels in 1995 and 1996. The share of expenditures on acquisition of tangible fixed assets to the GDP decreased from 18.3% in 1991 to 10% in 1996. In 1997 it is 11%, and in 1998 (first six months) - 7.4%. Thus, the most science intensive manufacturing branches such as electronics and electric appliances, the machine-building industry, etc. have registered the biggest gap in their output in comparison with the end of 80-ies. On the other hand, reduced investment activity of firms diminishes their ability to be competitive on the world market. In the case of business demand, the huge decrease of demand for high-end products is of crucial importance because it does not contribute to the development of clusters for the production of sophisticated final commodities. Sophisticated business demand allows close contact between firms in the development process, and furthermore creates opportunities for them to engage ina joint development process.

Government Debt

Government demand has also decreased remarkably It has reduced more than two times in only the 1993-1996 period. Government borrowing in the first half of 1998 is zero. This tendency is determined by the huge burden of the government to service debt. It can hardly be expected that the volume and structure of government demand will be able to contribute to the improvement of the whole economy’s competitiveness in the near future.

In Search of Enlightened Demand

The presence of sophisticated and demanding buyers is as, or more, important to sustaining advantage as to creating it. Local firms are prodded to improve and to move into newer and more sophisticated segments over time, and over time, often to upgrade competitive advantage in the process. Buyers’ behavior predetermines market strategy of local firms.Buyers have become price sensitive to a very large extent. The main part of the population is low profitable buyers, and they prefer to purchase goods and services of poor quality but relatively low price. This type of home demand behavior does not contribute to the development of sophisticated, high-end products. Bulgarian producers have followed the same strategy (low quality – low price) implemented on the domestic market, until they considered export. This strategy turned out not to be successful, and as a result Bulgarian exporters lost many of their traditional markets.

A typical instance of this is the reduction of Bulgarian exports to Russia. The common opinion of Bulgarian producers of typical Russian consumers is that they are low-income buyers and price-sensitive like Bulgarian consumers. Thus, the strategy ‘low-quality – low price’ seemed to be good because it had proved its success on the domestic market. However, reality turned out to be quite different:· Russian consumers are separated into different segments and there is not a common (or average)

buyer. Bulgarian exporters did not have a well-developed marketing strategy and in many cases they tried to enter into those segments, where Bulgarian exports had been well accepted in previous years). Now, these buyers earn high incomes and such a strategy would fail. Foreign customers have a much bigger purchasing power than their Bulgarian counterparts, and they prefer to buy products of high quality while placing less importance on their price level.

· Other countries such as China, etc., which have similar export strategies, are nearby residents to Russia and have had easy access to its market since the disruption of CMEA. In many cases the prices of their exports are much lower than the prices of Bulgarian exports, but the quality of the goods is quite similar. Thus, they are more competitive than Bulgarian exporters in the occupation of the low-income segment of Russian consumers.

As a result, other exporters have replaced Bulgarians: Bulgarian firms’ had a srategy copied from the home market.

13

14

Chart 3. Bulgarian export to Russia

0

100

200

300

400

500

600

1994 1995 1996 1997

$ m

ln.

0

2

4

6

8

10

12

14

%

in $ mln. as % of total Bulgarian export

CREATING COMPETITIVE CLUSTERS IN BULGARIA

Available Success Strategies

An example of successful strategy is the development of wine exports. Home demand is traditionally strong and contributes to the competitiveness of the Bulgarian wine industry on the world market. Keeping the high quality of exported products, as well as good production factors and local rivalry have resulted in a good performance of the Bulgarian wine industry and export. At the same time, the strategy of delivering high quality wines at a low price is not always workable: consumers may confuse the low price with a low quality.

Many foreign firms have successfully competed with Bulgarian firms by importing cheap products of poor quality. Bulgarian producers have requested that the government support them against the low-quality imports. Actually, they have demanded protection against their own strategy implemented by foreign companies. All of this has made the foreign trade regime too sophisticated and has reduced the competitiveness of Bulgarian firms because of the government’s umbrella. Deals of non-visible import have grown in number because the importers have tried to get around increased duty and tax payments. The failure of the efforts of the government to protect the local producers is a result of the wrong strategy used by Bulgarian firms to cope with the problem. They requested government protection in order to increase their competitiveness – either by reducing the prices according to the quality of the products, or by increasing of product quality.

Sophisticated consumer products are usually imported to the country. Importers bring modern knowledge of the markets and have motivated an emergence of reliable market research and have shown and example of comprehensive understanding of consumer needs. Bulgarian firm which succeeded in sophisticated foreign markets, after the financial stabilization in 1997, have turned to the domestic consumers in 1998. This is especially true for the wine-industry, canning, knit-wear industries.

According to Michael Fairbanks and Stace Lindsay14, in factor-driven economies with legacies of protectionist policies, firms tend to make choices based on comparative advantages. This leads them to compete in areas where cheap raw materials, labor or transportation costs appear to provide an advantage in competition. But to achieve sustainable competitive advantage – which can improve the wealth of the average citizen – firms must compete by constantly striving to innovate in terms of how they deliver value to customers. There, the value is defined in several ways – delivering a low-cost product, a highly differentiated product, or a certain level of service. For the value to be sustainable, the product must continually respond to customers’ evolving needs. Obviously, it has not happened in the case of most Bulgarian producers in recent years.

Buyers, especially business buyers, are demanding where home product needs in an industry are especially stringent or challenging because of local circumstances, selective factor disadvantages, geography, natural resource availability, regulatory standards, taxation, etc.

Comparative Position and the Role of Government

Bulgaria is not a country with considerable stocks of natural resources. Despite this, Bulgarian producers can not develop competitive advantages from the scarcity of domestic energy resources and raw materials. Their prices are very low either because of the existence of international agreements (for instance the Yamburg agreement on gas), low production costs in the country, or government subsidies. Thus, the main part of Bulgarian exports are energy-intensive products, such as products of the metallurgy and chemical industries, but at the same time almost all energy used in the country is imported. Bulgarian firms may lose their competitiveness when these favorable circumstances end (as in the case of Yamburg agreement). At that time, they should rapidly change their demand needs (the technology) or they may go bankrupt.

State control over standards, which should be implemented by the control of individual consumers, is too slack. Firms can easily overturn quality requirements and existing standards. Thus, state

14 Michael Fairbanks and Stace Lindsay, Plowing the Sea, p.12

16


control over standards does not stimulate the development of more sophisticated and qualitative products either. This is the root (as well as the decreasing real incomes in the country) of the success of the‘low price – low quality’ strategy on the home market, and its failure on foreign markets.

Perspectives

A good perspective to adopt regarding larger contribution of home demand to the development of national competitiveness is the expectation for its rapid growth in the near future. The competitiveness of an industry or economy depends crucially on investments undertaken. The rate of investment is as much, if not more, a function of how rapidly the home market is growing in size. It makes the adopting of new technologies progress faster and lessens fear that existing investment will be made redundant. This risk is even smaller in the case of Bulgaria, because the existing tangible assets should be privatised and their worth (usefulness) will be assessed by the prices of the privatisation deals.

Domestic demand may promote the competitive advantage of the Bulgarian economy in branches, where relatively small investments are needed because of low investment capability of entrepreneurs. This is most likely to happen in branches where the requirements of domestic buyers are traditionally strong as in the food industry, agriculture, etc. The availability of other well-developed factors for competitive advantage, especially production factors, also furthers such a possibility. The availability of good skilled experts in the electronics industry has determined the strong demand of local buyers for software, which may explain the success of Bulgarian software producers. However, all parts of the“diamond” must work as a system in order for the potential of the Bulgarian economy to be realised.

Conclusion

Besides the huge reduction in the size of consumer and industrial demand in the period between 1990 and 1997, there is a change in the structure of the domestic demand towards less sophisticated goods and services. But again, most of the residents have weak purchasing power that makes their demand extremely price sensitive thus reducing the pressure on enterprises to follow high standards.

See: Annex 3

FIRM STRATEGY, STRUCTURE AND RIVALRY

The new thinking regarding competitive advantages emphasizes the innovation of technology and the upgrading of capital. Our general impression was that in the period of 1992-1997 there was a poor understanding of the principle that innovation taking lace in an undistorted competitive business environment is an engine for growth and prosperity. In order to evaluate where Bulgaria stays in terms of available strategies and pro-rivalry business thinking, we used, in addition to the analysis of the economic structure, focus-group sessions, and the interviews with managers and owners from wool-textile, canning and wine industries.

Structures

A gap between macroeconomic stabilization and structural reform was typical of Bulgaria’s economic development during the last seven years. The state could not implement an effective restructuring and privatization program (since 1990 there have been eight different governments). The many changes of government and lack of will have predetermined the inconsistent implementation of both the structural reform and the privatization process. The weakness of the

17


State in implementing a radical restructuring policy was a significant obstacle to industrial growth as well. The development of the private sector was hampered by unfavorable and unstable economic conditions. The delay in privatization had a negative effect on the development of state enterprises and increased the budget deficit. The economic crisis at the end of 1996 was a result of enormous internal debt and quasi-fiscal financing. One of the forms of state support for SOEs was the decision to transfer their debt to the budget, via the use of ZUNK bonds. Thus, economic policy was aimed mainly at transferring liabilities from the non-financial sector, rather than at introducing hard budget constraints and reducing the budget deficit. Soft budget constraints were the factor most important to the growing internal debt. The maintenance of unprofitable enterprises increased the economic costs of the transition. Employees were paid salaries regardless of low productivity. The macroeconomic crises and instability had a negative effect on companies' management and their financial results.

Because of the delay in both the structural reform and the privatization process, companies experienced enormous difficulties. Most of the state-owned companies faced insolvency. Their goal was to survive, but not to achieve efficiency and seek ways to maximize profit. The predominant approach of the companies was to rely on state support, borrowing credits from the bank sector and thus becoming big debtors to the state. At the same time companies suffered from the growing competition of foreign goods on the domestic market, due to the liberalization of imports and decreased domestic demand.

Substantial progress in the privatization process in Bulgaria was noticed only during the last year. Since the introduction of the Currency Board in June 1997, most of the of state-owned companies have been put under hard budget constraints. The interest rate is lower in comparison with the previous period, but this still has not stimulated credit expansion. The continuing lack of financial resources and the underdeveloped capital market have kept enterprises from investing in equipment and innovations to their production. The rate of capital investment is still low. Banks continue to be the main source of financing. Enterprises have little interest in borrowing, however, because they are not able to meet the high guarantees required by the banks.

Most SOEs have been transformed into single-proprietor joint-stock companies (wherein the only shareholder is the government) and one-person-owned limited liability companies. The legal framework under which these companies operate are the provisions of the Law on the Transformation of State-Owned Enterprises and Commercial Partnership (1991) and the Commercial Code (1991). The execution of state property rights in the SOE is regulated by several decrees: N 265/1992 (amended in 1993) and N 7/1994 (amended several times; for example, seven times in 1997 alone). Under the provisions of the latter, the Council of Ministers or the respective branch Minister exercises the ownership rights in both types of SOE, appointing the majority of the board members. In this case the managers’ rights are restricted and the rights of the general shareholders’ meetings are increased.State ownership of companies is still predominant. In spite of the substantial progress made during last year, the pace of privatization is unsatisfactory; only 19 percent of state-owned assets have been privatized (12 percent by mass privatization). The privatization process continues to be over-regulated by administration.The wide variety of privatization methods implemented in Bulgaria have resulted in a wide variety of ownership structures, in insider corporate governance or outsider corporate governance, respectively.

As a consequence of the mass privatization and cash privatization completed up to now, the privatized shares of the enterprises in question are distributed among privatization funds, the State, and individuals (citizens, managers and employees). The Law on the Transformation and Privatization of State and Municipal Enterprises (LTPSME), adopted in 1994 and amended several times afterwards, limits the share of ownership of the privatization funds to a maximum of 34% and of the State to 33%. At present the large block shares belong to the privatization funds.

18


Bulgarian politicians still believe that their country and people constitute a unique, “peculiar” case, especially in terms of privatization. Referring to this “peculiarity,” they advocate non-traditional privatization methods. Our surveys prove that here, as well as in other countries, the approaches of mass privatization and management-employee buy-outs lead to a predominantly insider corporate governance of the privatized enterprises. Financing the restructuring of enterprises of which the shares have been distributed to a block of shareholders is painful in the short term. On the other hand, the insiders cannot effectively exercise control over the enterprise’s development. The problem of financing disappears when the insiders sell their shares to outsiders.If we rank the different type of ownership structures in terms of their pro-competitiveness value, as it is revealed in the focus groups, sector analysis and case studies, the picture is the following:1. private sector “green field”;2. privatized through market privatization (clear property rights);3. privatized through voucher schemes (dispersed property rights);4. state-owned enterprise.We do not have reasons to maintain that all companies that fall to one category or another are not competitive or do not have a proper vision or strategy. This is a general picture and it demonstrate the dominant roles of different players.

Firm strategy

The efficiency of corporate governance depends not only on the character of the shareholders, but on the managers’ and employees’ skills, as well as their incentive to turn a profit. Managers can exercise effective control and be highly motivated when privatization gives them ownership stakes in the firm where they work. The positive effect of the latest amendment to the LTPSME (1997) is that managers can buy shares under preferential conditions, and their salaries are linked to the enterprise’s financial results. It is to be expected that under these conditions the level of insider control will increase and enterprises’ performance will improve.

The concentration of ownership helps to improve corporate governance, while the dispersion of ownership rights among many small holders makes it ineffective. An enterprise’s performance is improved when its ownership is held by strategic investors. The new privatization strategy in Bulgaria, oriented mainly towards pool privatization and selling shares on the stock market, is a step toward establishing outsider corporate governance.Management in the privatized companies have shown better results than in the enterprises which are still state-owned.15 Research carried out by IME at the beginning of 1997 reveals that managers' decision-making in the state-owned companies is subject to supervision by the board of directors, and because of this managers waste a lot of time in consulting with them on corporate and operational management issues. The research was repeated at the end of 1997, in enterprises the majority of the shares of which are owned by one of the largest privatization funds in Bulgaria. The managers are more independent in these enterprises; they waste less time in consulting with the board of directors, and when they do so it is mainly with regard to strategic financial issues and less on operational management ones.

Most of the firms in Bulgaria at present are run by managers who are not neither real owners nor real managers. The attitude of the managers of the privatized enterprises, however, shows a growing responsibility for the financial results of the enterprises and more interest in improving their performance. At the same time, they still avoid taking risks and are not in a hurry to make innovations. A focus-group which involved managers of privatized enterprises and private firms which started green-field have demonstrated a full consensus when determined the strategy majority of Bulgarian firms in 1995-1997. It was rather simple: Survive! However, most of the group members were positive that a critical mass of business leaders is emerging; that they have derived

15 This conclusion is based on IME studies on the role of the bureaucracy in business.

19


lessons form operating in difficult conditions, and that they have gained experience mostly on international markets.

The Survivalist strategy can be explained as a private sector response to political and economic instability. But there were background attitudes of the business community that required time for incremental change. These basic attitudes were summarized by an American manager of a klocal investment fund by the following formula: “ [When the fund stated to operate], I witnessed that, first, that Bulgarian entrepreneurs were “production oriented”: they used not to take into account that products and services should have a market; and, second, they still had to comprehend that capital has a price.”

Rivalry

Economic conditions up to now have not been favorable for the creation of competitive advantages for Bulgaria’s enterprises.As explained above, Bulgaria is a country with limited resources, and companies in the industrial sector rely on foreign suppliers for their inputs. These companies can upgrade and sustain their competitive advantages through investment in new technology and products, or upgrading their labor capital. An extremely important manner of helping them do so is through attracting foreign strategic investors. A thriving industry could be formed this way; product innovative models could be implemented and Bulgarian companies could better their positions on both the national and international markets. Foreign investment could also help the growth of the national companies — at present they are managed only with a view to achieving financial stabilization and eventually profit, while their growth is not a topical problem.

Companies in Bulgaria do not have enough resources to promote the education of their personnel or to provide financial support, equipment or other facilities to the universities. A relationship between the enterprises and the universities is not cultivated. Companies don’t play a significant role in the creation of research departments in the universities or in improving the quality of education through involving students in research and practical work.A factor which is delaying the development of competitiveness in Bulgaria is the inherited infrastructure. There are a few large enterprises which are the sole suppliers of electricity, gasoline, telecommunication services, etc. They have monopoly positions and have not been privatized or scheduled for privatization. Households consumption of electricity and water is subsidized via extra-charges of businesses. 1998 Agreement with IMF have plan to skip these subsidies by the spring of 1999 while deregulation of monopolistic utilities is scheduled for 2000.

Summarizing from the point of view of the diamond analysis of Michael Porter, Bulgarian companies perceive their advantages in the terms of classical theory as low labor costs. However, export oriented private sector is relying more and more on well-qualified employees and studying the needs of the “enlightened” foreign consumer . The lack of either a government strategy or a clear model for economic growth, however, have been an obstacle to the formation of an export-oriented sectors and dynamic rivalry on domestic and foreign markets. Another hindrance is the fact that Bulgarian companies do not have strategic ideas and programs for stimulating innovation processes.

The new Bulgarian government has shown a tendency to force the regulation of the national market and of business relations. This can limit entrepreneurs’ initiative, and as a whole has a negative effect on the creation of sustainable competitive advantages. At the same time, the current implementation of policy changes is supporting new strategies on both policy and firm level.

See: Annex 4

20


COMPETITIVE CLUSTERS

There is much empirical evidence, from both developed and developing countries, that clustering in certain areas and industries brings about external economies of scale and increases the efficiency of small and medium-sized enterprises (SME). The impressive economic growth of “Third Italy” and other regions in Europe have inspired a lot of research on the SME and competitive clusters.

Third Italy includes the northeastern and central parts of Italy. The region registered high real growth in the 1970s and per capita consumption moved above that in the wealthier north in 1981. 16

This impressive economic performance was associated with the concentration of small and medium-sized firms in particular sectors and localities in the region. The impressive economic growth of the Third Italy was presented to the English-language audience as of a model of industrial development economics, in which linkages between SMEs induced high real growth.

The natural units of a competitive cluster are small and medium-sized enterprises (SMEs). The prospect of competitive clusters emerging in the Bulgarian economy is closely related to the establishment of SMEs.

SMEs in Bulgaria: the missing link in the chain of clusters

Typology of SMEs

According to regulation No. 314 of the Council of Ministers, on the Setting Up of an Agency for SMEs within the Ministry of Industry (Regulation of the Council of Ministers No. 314/1997, on the Setting Up of an Agency for SMEs, State Gazette, issue 63/1997), small enterprises are defined as those with up to 50 employees, and medium-sized ones are those with 51 to 100 employees. The Law on Setting Up the State Investment and Development Bank defines as “small” enterprises which have up to 50 employees and a balance-sheet value of fixed tangible assets up to an amount equivalent to 5,000 minimum monthly salaries. The enterprises defined as “medium-sized” are those with 51 to 100 employees and a balance-sheet value of fixed tangible assets of up to 10,000 times the minimum monthly salary.

The distinctions outlined above clearly show that the problems facing each of those categories of enterprises require different policies. The development of small businesses is closely connected to the development of the private sector, and has an important role to play in the transition from the model of a centralized planned economy to a market economy. Since 1990 the number of companies registered in Bulgaria has been rising rapidly. The boom was seen during the first two years after the disintegration of the centralized planned economy: in 1990 and 1991 the number of firms doubled each year, due to the rapid growth in the number of private registered firms immediately after the start of economic reforms in the country.Nearly 95 percent of those entities were small firms. Over 80 percent of the subsequent decrease in the total number of registered firms was due to the decreasing number of sole proprietors. These were primarily small and even micro-firms, mainly active in the sector of retail trade. After 1992, the increase in the number of registered firms gradually slowed down.

The de-monopolization of state-owned enterprises and the fast growth of the private sector gave rise to substantial changes in the size structure of the Bulgarian economy. According to the National Statistical Institute (NSI), the total number of economically active private companies in 1995 and 1996 was between 190,000 and 200,000. Moreover, the number of economically dormant companies (companies which have not officially declared any activity) at that time was around 65,000. Although more than half of the private companies currently in operation are trading companies, a trend can be observed of a greater number of private companies entering the manufacturing and service sectors. As of the end of 1996, around 16.8 percent of all economically 16 John Humphrey & Hubert Schmitz, Principles for Promoting Clusters and Networks of SMEs, Number 1, Paper Commissioned by the Small and Medium Enterprises Branch, October 1995.

21


active private companies were producing industrial goods (compared to 15.5 percent in 1995 and 14.7 percent in 1994. According to another NSI survey, in 90 percent of private companies the number of employees does not exceed three persons. It can be assumed that most of these companies are actually family-run businesses (according to IME representative survey from 1996, 70-80 percent of all companies registered were family businesses). The share of the private sector in the country’s Gross Value Added increased considerably from 1991 to 1996, when it reached a level of 47.4 percent. In 1997 the private sector already contributed 58.79% of Gross Value Added. Preliminary data on the first half of 1998 show that private sector’s share in the GVA has reached about 62%. The majority of private companies were registered in sectors with a low level of capital consumption. Thus, in industry and construction the number of newly-registered private companies is still lower than the corresponding figures in other CEE countries. Likewise, there are huge discrepancies between the firms registered in different regions of the country.

Notwithstanding the rapid development of the sector, the legal and economic framework is still far from promoting the establishing and growth of SMEs. Complicated legal procedures, problems in the economic environment, and high level of crime often force existing SMEs to operate on the “shady” side of the economy. Access to premises and buildings is difficult, the banking system is completely unfit to service SMEs, there is no infrastructure, and the costs of servicing their transactions are rather high.

The size of the sector and its performance

The available statistics still cannot provide the total number of enterprises registered and active in Bulgaria, although there exists a centralized register which should provide such data. By mid-1998, the overall number of companies registered is about 560,000, and about 200,000 out of them submitted reports to the NSI. The explanation for this (to a certain extent reasonable) is that the data from the register would be irrelevant, since an unknown number of registered enterprises do not function but simply have not undergone the necessary court procedure to close the business officially. The table below displays the 1997 structure of the enterprise sector.

Enterprises according to size and sectorCompany size Industry Agriculture&Fore

stryConstruction

Trade Transport

Services

Finances

Other Total

PublicSelf employed 10 2 2 5 2 4 309 4 291-9 employees 194 84 51 304 23 170 63 1043 193210-19 employees 156 97 50 206 22 133 120 725 150920-49 employees 320 233 154 304 66 155 134 1655 302150-99 employees 350 235 144 171 69 94 52 1398 2513100-249 employees

381 103 132 96 102 83 42 888 1827

>249 employees 382 7 50 28 132 27 16 430 1072total employees 1793 761 583 1114 416 666 427 6143 11903

Private, single-entry accountingSelf employed 10063 2505 3227 71654 8767 10519 309 3006 1100501-9 employees 5383 699 1410 22343 2249 2062 151 658 3495510-19 employees 274 28 130 322 23 61 2 21 86120-49 employees 96 23 42 79 6 33 0 7 28650-99 employees 18 7 1 6 1 8 0 1 42100-249 employees

7 2 2 6 1 0 0 0 18

>249 employees 0 0 0 0 0 1 0 0 1total employees 15841 3264 4812 94410 11047 12684 462 3693 146213Private, double-entry accounting

22


Self employed 1345 266 663 7146 561 1870 125 279 122551-9 employees 2597 1009 1291 9882 955 1760 285 2298 2007710-19 employees 1048 780 386 1397 166 188 79 204 424820-49 employees 945 879 278 790 102 132 89 137 335250-99 employees 537 307 96 217 31 52 16 38 1294100-249 employees

509 103 74 97 29 26 19 24 881

>249 employees 288 12 17 17 8 9 7 3 361total employees 7269 3356 2805 19546 1852 4037 620 2983 42468

The statistical institute is monitoring the sector according to a strange "up-down" methodology. The different sectoral departments each prepare their own samples according to their own methodology (which means that each department proposes which enterprises should be part of the monitoring sample). There is no direct correspondence with the general register, which has both positives and negatives. The negatives: the sample does not reflect the general register, and thus it is an open question as to what the percentage of the sample is. The positives: the sample does not reflect the general register, which seems to be rather irrelevant — hence the chance that such an "intuitive" sample better reflects the situation "on the ground" seems to be higher.The sample size: 11,740 enterprises, 8,500 of them private and 3,240 of them public sector non-financial. Of them, 5,805 private and 3,031 public have stated their final results from the first quarter of 1998 (total: 8,836). A total of 5,788 of them qualify as small and medium-sized enterprises employing less than 50 persons (4,152 private and 1,636 public).

Assuming that the sample is somehow representative, some general tendencies can be outlined.First, we count 2,695 private and 209 state-owned enterprises which have not submitted their reports to the NSI. Since reporting to the statistics office usually goes hand-in-hand with submitting tax declarations, we can assume that 2,695 of the private firms (or 32 percent of the private sector) prefer to stay in the “shadow economy.”

SME performance (sample data) - Private sectorType Numbe

r Sales

(1,000)Profits(1,000)

Losses(1,000)

Number of

employed

Net profit (loss)

(1,000)

Average sales per enterpris

e

Average sales per employee

per enterprise

Private non-financial sectorSMEs with 1-5 employees

1 307 116 474 724

7 642 480

3 247 214

3 108 4 395 266 89 116 37 476

SMEs with 6-10 employees

736 104 013 497

4 243 069

3 569 213

5 848 673 856 141 323 17 786


550 76 143 403

3 907 723

3 668 634

7 105 239 089 138 443 10 717


456 70 056 124

9 671 105

11 556 237

8 153 -1 885 132

153 632 8 593


1 103 209 796 928

12 527 869

9 203 011

36 238 3 324 858 190 206 5 789

Total SMEs from private sector

4 152 576 484 676

37 992 246

31 244 309

60 452 6 747 937 138 845 9 536

Public sectorPublic non-financial sectorSMEs with 1-5 employees

290 30 291 646

453 505 2 572 054 872 -2 118 549

104 454 34 738

23



239 7 118 575 528 273 540 339 1 896 -12 066 29 785 3 755


225 133 367 752

715 258 511 125 2 899 204 133 592 746 46 005


199 14 752 717

811 957 2 057 655 3 598 -1 245 698

74 134 4 100


682 59 114 793

3 110 524

6 836 843 22 680 -3 726 319

86 679 2 606

Total SMEs from public sector

1 636 244 645 483

5 619 517

12 518 016

31 945 -6 898 499

149 539 7 658

Second, as seen from the table above, financial results in the private companies are positive on the average, while in the state sector they are negative. This proves the well-known conclusion that private firms are generally better performing than state-owned ones. The real situation might be even more striking, if we assume that private enterprises are motivated (again for tax reasons) to declare lower incomes and lower profits. Also, the average (net) profit of private companies employing less than five workers is several times higher than the average. This might mean either that these enterprises are weak at avoiding properly declaring their profits, or that they really are the most efficient segment of the economy.

Third, to add further to the above-mentioned conclusion, average sales per employee are highest in the smallest companies. Even taking into consideration the unreliability of the sample, we can state that labor productivity increases with the decrease in the scale of the enterprise. This is probably due to the low level of capitalization of the sector, and can be treated as an indirect argument in favor of the idea to channel the bulk of the Social Investment Fund toward labor-intensive rather than capital-intensive projects.

SMEs and the informal sector

One of the common strategies for coping with unemployment in 1997 continued to be participation in the informal sector. Estimates of the scale of the shadow economy (i.e., the portion of economic activity in the country which is unregistered and remains invisible to the tax administration) vary, but its share is probably around 40 percent. This means that 40 percent of the businesses in Bulgaria remain in a comparatively advantageous situation, utilizing the existing economic and social infrastructure (and until the introduction of currency board, also the direct and hidden subsidies, for example through subsidized energy prices) without contributing to it via the tax system.

Most of the unemployed who start their own businesses will probably do so in the informal sector. That is why the estimates of its scope are relevant to the overall picture.An informal economy, however, is better than no economy. This is especially valid in terms of unemployment. The informal sector is one of the important sources (although not the only one) of non-institutionalized employment opportunities. Employment is considered to be non-institutionalized when it occurs without regulation of the employer-employee relationship by a labor contract or a civil contract, and both sides intentionally conceal their relationship. Such relations are not registered under the Commercial Code or Executive Regulations, and take place without social insurance.

A study conducted by the Institute for Market Economics in 1996 reveals the scale of the phenomenon: almost a third of the active labor force in the country is employed in the “black” (entirely hidden) or “shadow” (partly hidden) labor market (and there are no signs of change in 1997). Every tenth legally employed person receives from his employer additional remuneration, that both sides conceal. Over 23 percent of the legal employees interviewed were occupied in

24


additional economic activity (about 10 percent of them have been hired by another company, 14 percent work in their own or family company, 7 percent engage in freelance activities and 8 percent in production cooperatives). Thirteen percent of the non-institutionally employed are registered as unemployed. Most of them are hired without any written contract, on a short-term basis (less than one month). At the same time, 23 percent of the unemployed declare that they cultivate agricultural products for themselves, and 3.3 percent of them do so for themselves and also for the market. This underlines once again the role of agriculture, and particularly the family business, in the survival of a great number of Bulgarian households in the current environment.

The survey shows an extremely large portion of hidden employment among the self-employed. They usually register a tiny fraction of their activity and pay minimal social security remittances (calculated on the basis of the minimum wage). The bulk of their activity remains unregistered, and about 80 percent of the self-employed do not declare their income. The macroeconomic outcome of this phenomenon has two dimensions. On the one hand, as a result of involvement in the “black” or “shadow” labor market, people earn entirely or partially unregistered income and avoid payment of income tax and social security remittances. At the same time, most participants in the “black” or “shadow” labor market receive aid for unemployment, temporary incapacitation, etc., from the state budget and/or the Social Security Fund (SSF). The lack of a properly working social insurance system allows a large number of individuals who receive income from non-institutionalized employment to use health and social services without contributing to the system.

SMEs account for 4 percent of the long-term assets in the economy and for 20 percent of aggregate company sales. The tables below summarize the credit statistics of SMEs and large-scale companies in Bulgaria.

Consolidated credit statistics on SMEs (in US $1,000s)1994 1995 1996

Sales 2,003,877.3 3,474,144.3 3,914,824.2 Growth (in percent) 73.4 12.7Purchases 1,320,170.8 2,308,041.9 2,818,868.6Gross Profit 683,706.4 1,166,102.4 1,095,955.6 % of Sales 34.1 33.6 28.0General, Administrative, and Selling Expenses

673,083.0 1,116,545.9 990,518.5

EBITDA 10,623.4 49,556.5 105,437.1 % of Sales 0.5 1.4 2.7Interest Expenses 52,929.6 68,808.0 51,955.1EBITDA/Interest 0.2 0.7 2.0Debt 143,273.9 231,798.1 90,581.2Debt/EBITDA 13.5 4.7 0.9

Consolidated credit statistics on large-scale enterprises (in US $1,000s)

1994 1995 1996Sales 10,080,003.0 14,868,473.0 15,794,871.3 Growth (percent) 47.5 6.2Purchases 6,574,948.3 9,718,804.9 10,796,523.3Gross Profit 3,505,054.7 5,149,668.1 4,998,348.1 % of Sales 34.8 34.6 31.6General, Administrative, and Selling Expenses

2,980,159.4 4,385,084.7 3,961,377.0

EBITDA 524,895.2 764,583.4 1,036,971.1 % of Sales 5.2 5.1 6.6

25


Interest Expenses 809,883.9 845,501.8 713,151.0EBITDA/Interest 0.6 0.9 1.5Debt 2,389,160.5 3,353,531.9 2,307,247.4Debt/EBITDA 4.6 4.4 2.2Source: NSI and author’s calculations

The data above suggest that SMEs registered higher sales growth than did large-scale enterprises. Their profitability tended to increase faster than that of big companies, as well.However, the SME proved ill-equipped to deal with global competition. Their contribution to overall exports is rather small. Recently, metals, chemicals, food, wine and tobacco account for more than 40 percent of the country’s exports. Most exports are produced by large-scale enterprises. SMEs were established primarily in the construction, wholesale/retail, agriculture, transport, and textile sectors.

What are the factors that make the life of SMEs in Bulgaria difficult?

First, very inefficient financial intermediation. Commercial banks went through a deep crisis in the first half of 1997. A high inflation rate and sharp depreciation in 1997 induced mass deposit withdrawals. Part of households’ savings returned to the banks, but a good portion remained outside banks after the introduction of the Currency Board on July 1, 1997. Reduced deposits made banks very cautious about extending credits. The bankers are much more interested in the collateral than in the business plan behind the credit project. They tend to extend credits to large-scale enterprises more than to SMEs, because of their more reliable collateral. The capital market is rather underdeveloped, and cannot be considered as a long-term source of funds. In summary, financial assistance for SMEs is close to zero. The only source of funds are the enterprises’ savings.

The second important factor is the shortage of readily available information about prices and the dynamics of the inputs and outputs markets. The empirical facts suggest that finding a market niche is a must for the success of small and medium-size enterprises. The banking system steps in when the relationships between enterprises are already established. The role of the banks is to monetize an already established business contact, and not to undertake the risk associated with the establishment of the business itself.

Central government policy

Highly unstable macroeconomic factors underlined the low level of SME activity up to mid-1997. It was extremely difficult for entrepreneurs to devise reasonable business plans, given the unstable interest rate and exchange rate. The macroeconomic stabilization after July 1, 1997 primarily addressed the monetary layer of the economy. Hopefully, the stable money supply and much more predictable economy will encourage the establishment of SMEs, which are the backbone of the market economy.

The government established the Agency for SMEs on August 6, 1997. This was the first step toward a more consistent policy aimed at promoting SMEs in Bulgaria. The Agency is supposed to keep a register of SMEs, to build up information systems relevant to the needs of SMEs, to work on programs for SME promotion, and to raise funds from domestic and external sources to finance SMEs.

Our opinion is that the Agency is not effective, for two reasons. First, it is preoccupied with the supply side of the SME problem. The people at the Agency tend to ask “How to finance SMEs?” rather than “Where are the buyers?” Second, networking is not thought of as an important factor for increasing the efficiency of the individual small or medium-size enterprise and creating new business opportunities, e. g. easier access to inputs markets, developing and marketing new products, consolidating individual products into a complete product range, etc. Inter-firm cooperation aimed at creating new business opportunities is not part of the country’s entrepreneurial culture.

The textile industry is a good example of underestimation of the value of cooperation. There is plenty of room in the Bulgarian textile industry for consolidation in producing high-quality fabrics: a lot of SMEs, many designers, and many suppliers of raw materials. Instead, a good part of textile

26


output is produced with the clients’ materials. The sustained tendency to work with client’s materials suggests poor marketing of the industry’s output and a lack of an aggressive strategy for meeting the demands of the consumers and reducing transaction costs via a collective approach to the market.

There are two important factors in the lack of an active government policy to promote cluster formation. First, the external economies of scale are difficult to identify and measure. Second, the government is short of resources. The budget is supposed to pay about US $1 billion per year on foreign debt. Given both the shortage of resources and the shortage of strong empirical evidence of external economies of scale, the government could not justify an active SME policy.

Supporting industries

Some of the most important external economies probably arise from the accumulation of knowledge. The dissemination of knowledge among companies is an important factor in lowering costs. It is reasonable to assume that education, communication, research and development are a solid base for networking. Bulgaria’s democracy inherited a good educational system and good basic infrastructure from the socialist regime. The problems arise from the decreasing expenditures on infrastructure and the human factor. The table below summarizes the consolidated budget expenditures on education, science, and transport and communication over the years 1993-1996.

Change in consolidated budget expenditure on human development and infrastructure (%)

1993 1994 1995 1996Education 100.0 76.1 64.6 45.3Science 100.0 83.7 69.7 41.1Transport and communication 100.0 67.3 52.7 33.4Source: Ministry of Finance

Government expenditures on education, science, and transport and communication decreased significantly in the 1993–1996 period. The data suggest a worsening infrastructure and human factor, which in turn hinders the dissemination of knowledge. Improving the infrastructure and education in the country would have a direct effect on SME’s and networking.

See: Annex 5

THE ROLE OF THE GOVERNMENT IN THE BULGARIAN ECONOMIC SYSTEM

The role of the government under democratic conditions is the result of many factors: historical traditions, the economic environment, cultural influences and political consensus. The transformation process allows for examination of the government’s specific alignment during the realization of the transition from a centrally-planned economy to a market economy. This transformation makes it possible for the government to change laws and the tax and redistribution system, and to conclude the privatization of state-owned property. Government policy has a significant impact on the formation of competitive advantages in the economy and the creation of a favorable business environment The changes in government regulations are aimed toward the development of competitiveness and market principles.

In Michael Porter’s model the government has an essential role in creating a competitive business environment and sustainable national advantages. Through its policy, it can regulate the distribution of capital and labor and the aggregate demand, and can increase the level of productivity.

27


As already mentioned, Bulgarian economy has achieved macroeconomic stabilization, inflation has been curbed, and the balance of payments is positive, but the slump in production has not yet been overcome. To some extend it is due to the “Survivalist strategy” of the firms. But the business environment in Bulgaria is as yet perceived as unfavorable for the creation of competitive advantages, and the responsibility for these is attributed to the government. The government is focusing its efforts on the improvement of the country’s institutional framework and on fostering structural reform and privatization. The hard budget constraints of the state budget exclude the possibility of supporting industry. So, the extend to with business community exploits a simple lobbying strategy17, it is sharing the responsibility for not used opportunities.

Economic prosperity requires economic growth and increasing exports, which are the factors for increasing the money supply under the currency board arrangement. The government does not export. It is a job for the companies. Under the currency board regime, restrictive budget and tax policy have a compulsory character. The cabinet role is attempt elimination of institutional barriers to export, prosperity and growth. In 1998, the cabinet has a budget surplus of 2% of the projected GDP, and it is a prerequisite for establishing an efficient government expenditure policy aimed at improving the education, health and social insurance systems. The government, however, has no well-articulated vision on how to achieve these objectives. But the very attempt of spending this surplus on infrastructure, and especially the infrastructure of the roads, healthcare and education (renovating hospitals and schools) is an initiative that contributes to the reduction of gaps in the general cluster between private sector and public infrastructure. The dis-investment used to so sizable that any effort makes a difference. 1998-1999 period must be a period of establishing a dialogue that inspires both government and business leaders to develop competitive strategies.

What remain on behalf of the government is still very important. The changes and amendments to Bulgarian legislation show the political will of the government to encourage market principles. A negative feature is the promotion of economic liberalization on the basis of a strong regulatory mechanism and less on laissez-faire principles. The government’s role in Michael Porter’s conception is to stimulate dynamism of innovation and to modernize through "creating an environment in which firms can upgrade competitive advantages in established industries by introducing more sophisticated technology and methods and penetrating more advanced segments."18

A policy that creates the appropriate economic conditions for competition among companies, innovation and increasing the level of productivity, can be identified as a "supporting" policy. Such a definition of supporting policy is very relative in terms of the Bulgarian economy, because of conflicts between business, the institutional framework, and legislation.

Supporting policies

A policy aimed at accelerating privatization is a prerequisite for the development of industry and the stimulation of aggregate supply.The already mentioned 1997 amendments made to the Privatization Law represent a serious step in improving the legislative framework and seeking a way to achieve economic growth. The privatization process is one of the crucial problems of the Bulgarian government. The SOE’s will be privatized by the following means: sale of shares of enterprises on the stock exchange; sale of independent units and small enterprises through competition and tenders; sale of shares of the enterprises to workers and managers under easier conditions; and voucher privatization (second wave of mass privatization). The new legislation increases the involvement and role of the Privatization Agency. A considerable number of medium-sized and large enterprises will be

17 A radical change in this strategy is perceived by Fairbanks and Lindsay (see op.cit. 252-253) as an ultimate requirement for pro-competitive and pro-growth attitudes due the fact that “with global borders shrinking, there is no time to wait for the government before making changes” (ibidem, p. 252).18 See: Michael Porter, The Competitive Advantages of Nations, p. 618.

28


privatized directly through the agency. The privatization process will continue to be under the control and supervision of the government. Some of the profitable enterprises will be privatized via the sale of shares on the stock exchange.

Independently of the pace of privatization over the past ten months, the SOE’s still hold dominant positions on the domestic market. A negative feature of Bulgarian privatization is the concentration of decision-making power and information in the government administration. The absence of information about the transactions means that privatization is not transparent, and decreases its efficiency.

Bulgaria’s transition years have marked a tendency of government action against the logic of the markets. A special case in point here is price control. Between 1991 and 1996 it was gaining a momentum which in 1997 had to be diverted through hyperinflation.

Years Controlled Prices1991 14%;1992 13.4%;1993 16.5%;1994 18.9%;1995 49%;1996 52.4 %.

In 1998 the share of the controlled prices is 15,8% of the consumer basket. Contrary to this positive development is the spirit of a government decree issued in mid-1997 which controls whole-sale contracts and profit margin of 15 prime-use products (milk, bread, meat, etc.) and these goods share in GDP is 2,78%.

Another element of institutional forcing market relations is the legal provision for a capital market. Here again administrative regulations predominate. The Commission on Securities and Stock Exchanges is not an independent institution. It is part of the Ministry of Finance, and its activity is under the supervision of the Council of Ministers. The members of the board of directors of the Bulgarian Stock Exchange in Sofia are representatives of the central administration. The role of the government in regulating business activity remains strong. This is a precondition for the imposing of bureaucratic influence. One important issue is a package of amendments to the Law on Securities, the Stock Exchange and Investment Companies. The positive sides of the law are: the rules for offering shares of public enterprises on the stock exchange, and stimulation of small shareholders’ initiative to trade. The law guarantees the rights of small shareholders and of the holders of the minority blocks of public joint-stock companies. But the changes are not certain to result in the liquidity of the capital market.

The obstacles to forcing trade on the existing stock exchange are the non-transparency of the procedure of listing the big companies, the unclear rules on over-the-counter securities trading, and the lack of trade with debt instruments. The number of transactions, though high, does not necessarily mean that a real, transparent and liquid, capital market exists. Therefore, companies cannot use the capital market to finance innovation. Thus the capital market is not a crucial factor in the creation of competitive advantages of Bulgarian production.

The main characteristic of Bulgaria’s foreign trade policy is its liberalization. At the beginning of the reform, subsidies were cut, and the quota restrictions and tariffs of some Bulgarian products were reduced. The EU Association Agreement (1994) has had a favorable influence on the competitiveness of Bulgarian products. Bulgaria was accepted as a member of WTO in 1996, and immediately afterward the decisions of the Uruguay round were implemented in Bulgarian foreign trade policy. The EU Association Agreement improved Bulgaria’s access to EU markets by decreasing the measures protecting Bulgarian products. This asymmetrical approach to the liberalization of foreign trade allows the import tariffs on industrial products to be reduced gradually. Since 1997 most of the tariffs on industrial goods have been reduced. Since the beginning of 1998 the import and export quotas for most industrial products have also been

29


eliminated. The access of Bulgarian goods to EU markets, except for agricultural products, has been facilitated as a sequence of foreign trade liberalization measures has been implemented. Agricultural products continue to be object of tariff restrictions as a result of the slower process of trade liberalization.

Since 1991 the customs tariffs have been changed several times (1991,1992, 1993, 1997), and they have been adjusted to the requirements of the Harmonized Customs Tariffs. The difference between average and weighted average tariffs shows a possibility for decreasing the tariffs even further. The level of protection of the domestic market is not high, but it has not changed significantly in comparison with 1993. The foreign trade regime is temporary, and its effect of enhancing competitiveness on the domestic market is a short-term one. The import tariffs have been reduced after the EU Association Agreement, using asymmetric approach. (The import tariffs on EU commodities in Bulgaria decreased over the course of five years, while import tariffs on Bulgarian commodities to the EU market decreased over ten years).

Values of the Average Customs Tariff*Year 1991 1992 1993 1995-199619 1997

Average customs tariff (%) 11.4 15.4 17.5 16.0 17.8Source: IME, calculations, based on Customs Tariff Column 1/1997 (Most-favored-nation treatment).* the assessment of the average tariff and weighted average tariff is on the basis of the new customs tariff, including only commodities from the first column.

With the decreasing interest rate,20 portfolio investments in government securities are not as attractive to foreigners as they used to be in 1996 and early 1997. The reason is a negative real interest rate, underdeveloped capital markets (which impede investment in corporate securities) and the 15% tax levied on government securities for foreigners.

The government uses several regulations to limit the monopoly position of the companies on the domestic market. Such regulations are the Anti-Trust Law and, license requirements. The first Anti-Trust Law was adopted in 1991, but it has not been efficiently enforced. A new Competition Protection Law was passed in mid-1998 in the midst of the public debate on competitiveness, initiated by IME. It contains proper definition of pro-monopoly practices but side regulations on communications and utilities exempt these sectors from the monitoring competencies of the anti-trust bodies. The main reason for this is the existence of big state-owned companies, and an as-yet weak private sector. A positive side of the new draft law (1998) is the definition that an enterprise has a monopoly position if it holds more than 35 percent of the relevant product market. It targets companies that limit market competition. Another positive aspect is the high penalties imposed on companies if they don't follow the legal regulations. The Anti-Trust Commission controls the monopoly structures through the establishment of fixed obligatory prices for a short-term period, as well. Such a policy is appropriate in Bulgaria, where utility structures (natural monopolies) have not been privatized and public services are concentrated in state-owned companies.

The regulations of the anti-trust bill are oriented toward controlling mergers and acquisitions. Rules are outlined in the law for when companies attempt to abuse their market power through price discrimination, price fixing, collusion and other restrictive practices. The law is closer to European standards than the previous. government intervention, aimed at the development of rivalry between companies.

The new anti-trust regulations resume strong control and aim at promoting loyal competition on the national market. Regulation of companies’ entering the national market by the Anti-Trust Commission is an administrative approach. The approach is contradictory to principles of economic liberalization, and creates conditions for rent-seeking and corruption. That is why the interference of a government institution can not force competition on the domestic market.

19 No change for these years.20 See footnote 4.

30


The Bulgarian market is small, and the existing competition is among big companies, often government monopolies. In the latter case they compete for political influence, a situation sustained by public procurement regulations. The number of suppliers is also limited. Competition among companies occurs in defined sectors, such as the textile, food, and agriculture industries, and housing construction. Competitive advantages have emerged in some industrial sectors (for example, the export share of chemicals and textiles increased last year). In fact, policies originally designed as supports do not contribute to the enhancement of Bulgarian competitiveness (as is the case with the public procurement regulations) or have a neutral or minor influence (as is the case with Environmental Impact Assessment).

Non-supporting policies

The state withdrawal from and deregulation of the education system has decreased the quality of training in the universities. A positive side to the deregulation of the system is the development of competition among newly established private universities and the traditional old state universities. Recently the government set some standards and requirements for institutions of higher education, but the universities don’t follow them strictly. At present, the educational system as a whole doesn’t have an effective influence on human resource development and has not improved the skills of the labor force.

Infrastructure is a factor in companies’ growing transaction costs. It needs innovation for the development of competitiveness. Upgrading a nation’s industry requires a modern infrastructure (transportation, telecommunications). The improvement of the infrastructure is one of the main tasks of the government. The government is now following a policy for its improvement through privatization and foreign financial support (World Bank, EBRD, EU programs). The privatization of infrastructure enterprises (Balkan Airlines, the Bulgarian Telecommunication Company, the National Electric Company, some hydro-electric power stations) is a key part of the government’s privatization program. Bulgarian and international consultants will carry out restructuring and undertake to sell the enterprises.

Concessions have to be used as a specific form of privatization for the infrastructure enterprises. At present, most of the infrastructure enterprises are state-owned and thus don't create conditions for competitive advantages for Bulgarian production.

The devaluation of the domestic currency in the "diamond" analysis is not a factor cost, because new technology and high productivity are what is decisive in creating competitive advantages. Devaluation has an effect on company strategy in terms of how much the change in prices induces the purchase power of domestic buyers to shift demand away from the foreign goods, and additionally, how much the change in relative prices effect input costs and terms of trade.Exchange rate fluctuations had an insignificant influence on competitiveness before the introduction of the currency board. The depreciation of the Bulgarian currency has stimulated exports in the short term. Depreciation of the currency is not an efficient tool for promoting exports, because the inflation rate eliminates the effect of depreciation . Also, Bulgarian industry relies on imported inputs, and devaluation decreases export revenues. The currency devaluation has not been conducive to a competitive advantage.

Now the value of the Bulgarian Lev is fixed, and guarantees the stability of exports and imports. In the long run the BGL is overvalued in relation to foreign currency and does not promote the competitiveness of Bulgarian products. Bulgarian companies have to rely on improving quality, diversification of their products and developing competition in the domestic market.

The government’s policy does not provide direct subsidies for the stimulation of any economic sector. But there are quasi-fiscal subsidies which go through off-budget account.21 Subsidies are a prominent tool used by the government to influence factor cost and to form competitive advantages. Indirect subsidies can be used, and they are cost-effective in research, education, and 21 The total amount of off-budget account in 1997 was equal to 1/8 of GDP.

31


training the unemployed. The currency board regime presses the government not to subsidize the real sector. Tax relief is advocated by the private sector as a better solution than direct subsidies, but tax relief are not appropriate tools for the innovation and growth of industry under the conditions of a currency board and indebtness of the economy of 130% of GDP. The possibilities for the creation of competitive advantages are: to give incentives to export-oriented and emerging industries and non-bank financial services, and through promotion of competition in the banking sector.

Mind-Frames

A focus group consisting leaders of business associations, two professors in economics (members of Prof. Gochev team which was the first to evaluate the applicability of Porter’s theory to Bulgaria in 1997), Sofia representative of IFC and IME team-members was asked (on June 15, 1998) to access who (the government or the private sector) is more supportive to mind-frames of the old and new thinking on competitiveness. For this purpose we used a modified version of a chart through which Michael Fairbanks and Stace Lindsay describe the two paradigms.22

Old and New Paradigms as Shared by the Private Sector and the Government

Paradigm Category

Specific Paradigm

The Old Way of Players A New Way of Players

Wealth Creation

Comparative advantage thinking

· Comparative advantage (G, PS)· Wealth is a finite and must be

divided (-, -)· Competition inhibits wealth

creation (-, -)· Nations compete (G)· Natural resource driven (G, PS)· Simple products, mass produced

(G)

· Competitive advantage (PS*)· Wealth can be infinite and must

be shared (PS)· Competition helps wealth

creation (G, PS)· Firms compete, not nations (PS)· Customer driven (PS*)· Complex products (PS*)

· Social Capital

Human relations

Centralized power and authority· Paternalistic (G)· Hierarchical organizations (G)· Success is individual oriented

(G, PS)

· Trust oriented (PS*)· Interdependent (PS*)· Meritocratic (PS*)· Team oriented (PS*)

· Human capital

· Labor and managers are fungible (G)

· Viewed as input costs (G, PS)· General education (G, PS)

· Source of competitive advantage (PS*)

· Source of infinite return on investment (PS*)

· Education as specialized, expensive (PS*)

· Learning · Linear thinking, results inform strategy choices and organizational design (single-loop learning) (G)

· Reductionist strategies (G)· Technical and

· Systems thinking, results inform mental models (double-loop learning) (PS*)

· Integrative, interdisciplinary approaches (PS*)

· Team oriented (PS*)

22 Fairbanks and Lindsay, op.cit., p. 255.

32


compartmentalized (G)· Justice and

social equity

· Redistribute finite wealth (G)· Laws as constraints (G)· Informal producers are

marginalized (G)

· Create wealth through innovation and distribute to most productive people (PS*)

· Laws as enabling investment in innovation (G, PS)

· Informal producers increasingly integrated (PS)

· Action Orientation

Organizational design

· Centralized, large, complex (G)· Purpose is to allocate resources

(G)

· Decentralized, flat structure flexible, transparent (PS)

· Dedicated to learning (PS*)

· Change creation

· Macroeconomics drives decisions (G)

· Government is master strategist, prime mover (G, PS)

· “Reactive, redesign” (G)

· Microeconomics and business strategy drive decisions (PS)

· Firm level, private sector (PS*)· Cooperative, shared vision,

explicit moral purpose(PS*)· Integrated actions (PS)· “Reorientation” (PS)

Legend: (G) - government; (PS) - private sector; (G,PS) - government and the private sector; (PS*) - private sector but to some extend; (-,-) - neither the government, not the private sector.

A careful reading of this table suggest that there is a room for dialogue. At least, it seems that nobody shares the most out-fashioned notions that “wealth is a finite and must be divided “ and that “competition inhibits wealth creation”. In general, however, the weak points in Bulgaria’s pro-competitive action frameworks are similar to those reviewed by Fairbanks and Lindsay. In other works, the majority of the elements (18 of 25) are still not dominant even among the private sector. And these are business leader that may and need to communicate the mind-frames to the public and the government. In the country’s competitiveness diamond (see the chart) strategy element may receive an assessment as “neutral”, while the role of the government is changing but, for the time being “negative”.

Particularly, warning are some of the notions which IME found in political science students’ essays (see the next section). They do not bear any representative force, but they have a value in term of interpretation bench-mark.

WHERE BULAGRIANS WANT TO GO?

World bank survey

As Djordjija Petkoski wrote, quoting a survey of the beginning of 1997, business people of Bulgaria think mainly abou the future of their own companies.23 The survey found also that youngest generation (under 18) was optimistic during the most difficult time of Bulgarian transition. About 70% of them were confident they would have a better future.24 Other generation happened to be radically negative and pessimistic.25 For this reason IME decided to consider the vision of those who are younger: university student and children.

Quotations From Essays of University student in Economics and Political Sciences23 Djordjija Petkoski, Vision of the Future, chapter 3.24 Ibidem, chapter 2, p. 4-5, 22.25 The new government elected on April 19, 1997 enjoyed highest approval rates compared to all previous government Bulgaria has had since 1990. However, when economic policy approval rates are considered, the attitudes did not change significantly. This has been found in a special IME survey of tax reforms in January 1998 ( Needs for Deregulation of the Tax Systems in Central and Eastern Europe. A Comparative Study of Bulgaria, Poland and Slovakia. Sofia, IME, 1998, chapter 3.2.).

33


[“We will spend our summer holidays in the Caribbean”]

We asked student to write a short essay on how they view themselves or the country after fifteen years. The majority of the 40 essays came from people between 22 and 22 years old. Most of them repeat political cliches.

· “… I will enroll my kid in college; pay for the individual tuition; organization for improving the birth rate; the government does not help to solve the problem.”

· “…The so the horrible problem of facing poverty can disappear.”· “… I work in local government; convincing the local government people to participate in the

local parliaments was an achievement; we create the respective information unit; we don not encourage corruption; functions- privatization-auctions- sales- feedback- decisions; the problems would come from the previous interpersonal postponed decisions and conflicts.”

· “… I think about the future and I see my home; the years would not change anything; the present is the real moment; thinking about the future is wasting time; I do not expect anything because the expectations lead to prejudice, however I explore because the explorer discovers”.

· “… There would be working foreign investment; manufacturing would have recovered; developed tourism; the government works for the country; decreased crime rates; better image; better living standard; democracy and freedom.”

· “… The future comes to us only as a result of a change in something; if a person does not manage the speed of the process properly, then he is doomed for adaptation breakdown; new political compromises; financial system for the future; new production methods; strategy for managing the state bureaucracy; movement for “total look at themselves”; development of new politics.”

· “… My forecast for year 2015: Bulgaria is a full member of the EU; second term of government for the United Democratic Forces; effective government; functioning and developed civil society; powerful highly specialized pressure groups; I practice my profession successfully.”

· “… Bulgaria does not beg for foreign investment; the currency board is a thing from the past; the international financial institutions are equal partners rather then lenders; whatever we think would depend entirely on us.”

· “… Settled life, family, 2-3 kids; emerging business; I would be self- employed; I love freedom; conscious civil society.”

· “… The United Democratic Forces [current governing party] at the end of their second term of government; we have not been accepted in the EU and NATO; the privatization has been completed; the currency board still exists; we get about $ 300- $ 400 a month; private schools, private telecommunications; there is no national capital; I work for an independent financial and political broad sheet newspaper; there is no civil marriage- atavism.”

· “… Increased foreign interests; lively real sector; stable financial system; more effective state intervention; bettered living standard; partial integration in the EU; members of NATO.”

· “… The multitude of hardships have virtually annihilated the nation’s morale; worst of all is to be born in Bulgaria - a piece of bad luck; general spiritual crisis; in time will restore Bulgaria’s faith in itself.”

· “… I gather knowledge and practical experience for a successful carrier; establish own company or work for a strongly established company (multinational corporation) to learn how things really are; learning 2-3 languages.”

· “…Better conditions for professional development in the country; improving my knowledge of foreign languages; I work in company and gather experience; having a family life is not of high priority.”

· “… Btter tax discipline; stable juridical system; decreased crime rates; lack of foreign investment; lack of government strategy for the development of certain sectors.”

· [Greek student] “… More quality goods and services; more investment; Bulgaria is not a part of the EU.”

34


· “… Only the strong will survive, however the strong will be those who know more.”· “… The economic recession will not stop soon; there is no growth in the real sector despite the

financial stabilization achieved by the IMF; we cannot attract enough foreign investment and the situation with the foreign debt worsens; Bulgaria is not attractive for the foreign investor- small market, lack of economic and legal stability, bureaucracy; sharp rise in unemployment; we are a third world country with the associated problems.”

· “… We are not members of the EU and NATO because we have not met the criteria; there are structural changes which are not “cosmetic” for the first time; the economy will be in a slightly better shape; really tight financial discipline; see- through privatization.”

· “… developed banking system which works as buffer for the traffic and disbursement of investment on the Balkans; transport network; developed tourism; the food and textiles industries are in good shape.”

· “… Economic and political improvement; developed market relations; settled foreign debt; flow of foreign investment; restricted corruption and low crime.”

· “… I want to live in a more tolerant world; choice and many colors; there is no segregation of minorities; society without taboos; Bulgaria is part of Europe; happy people…”

· “… We spend our summer holidays in the Caribbean; the cars are ecologically clean- solar panels; everybody gives their opinion; everybody takes into consideration the opinion of the others; computers are used everywhere; there is plenty of information which saves time; kids do not go school but learn everything at home using the Internet.”

· “… I would be finishing my second degree; Internet chat; my work is interesting; I travel a lot; the situation as whole is becoming normal; there is positive change in the way people think; the young, the seeking ones are changing everything…”

Children Reflect Their Future

In order to initiate in-family discussion of the future, we asked (in cooperation with the Department of Psychology of the Sofia University and Prof. Evdokija Christova), children to paint The World I Wish To Create. We collected children art from one hundred eighty kids from seven big Bulgarian cities, including Sofia. The age of the young artists is between five to sixteen years. There is no difference between their work regarding the town or the region and age. For example, we cannot say that older children vision of the world they wish to live in, is more bleak, than that of kings aged five. Out of all these 180 paintings, about 30 may be considered as original pieces of art, although all of them bear value.Works confirm the findings of the already mentioned by EDI of the World Bank and GALLUP International survey of the vision, conducted in 1997: most of them are bright and colorful, reflecting the fact that the youngest generation has lots of deeds ahead. Even those works which picture ugliest in the country, blocks of flats and regions of different cities, do not have overall pessimistic accent.However, individual pieces of art express the Self of the young artists, and there is a great difficulty to categorize.Besides all reservations, we can mention the extreme modes expressed in some of the works. One extreme is the identification with the beauty and creativity of the world through mythological and/or scientific fiction. The case in point here is the picture by Daniela Toneva, 13, from Dimitrovgrad26, titled “I’m coming or Pegasus”. It shows a brown with white wings pegasus in outer space, which is bright, painted in yellow, green and red, and beneath the pegasus, the Earth is green and blue, with no clouds. Scientific fiction is reflected best by Rossen Petrov’s, 11, Untitled from Proldiv - it shows stars and among them traveling space ships of all kinds.

26 Dimitrovgrad is a city built in Stalinist Bulgaria in a middle of the most fertile valley, in order to industrialize the most agriculture region of the country. The city is a concentration of chemical and cement industries.

35


A combination of science fiction and creativity, is the work of Stoyan Slavov, 9, from Bourgas, titled “Time Machine”. It shows a body of a creature, resembling a fly or bird, whose body is a clock and in the middle of the ziffeblatt a boy moves the arrows; there is not twelve-hour on the clock, but two one-o’-clicks, one of them painted in dark blue.On the other extreme are reflections of the “dirties” and “ugliest” parts of the kids home cities. Among them there is just one with a limited prevailing of dark colors - this is “Future Pleven Downtown” by Christo Djankov, 9. But opposite to this is the “Blockhouse” by Simeon Popov, 7 from Sofia block of flats region. It shows a multi-story panel flat house, painted as a colorful carpet.Close to it is something between a tree and a grid-line tower, drown in different color and a small piece of sky in blue with white clouds.Quite typical and really original piece “City From the Future” by Martin Marinov, 12 from Plovdiv, who sees the city as a rural combination of pretty and clean houses on the banks of a clean and reflecting houses and sky, and the sun, and green forest river.Or, another example “City of Dreams” by Plamena Avramova, 10 from Bourgas where balloons carry people (girls and kids), girls fly, there is a credo on the sun and water melons on the earth. Flying fish and a girl drinking a juice from a glass one/eight of the picture.

AGRICULTURE AND FOOD INDUSTRY

BACKGROUND

The food industry has potential to be an attractive sector and leading Bulgarian industry. A favorable climate and natural resources have served as a foundation for the sector’s development; this industry is traditional and has some unique products which could theoretically find niches on the international market.

Economic and political reforms since 1989 have been uneven, and policy roll-back towards central planning has led to deep fluctuations in economic and market stability. The last seven years have been characterized by high inflation, an unstable exchange rate, decline of output and negative GDP growth (Table 1). Within this restrictive economic environment only limited effective strategy on a micro level has been possible. Most firms, however, have adopted a “survivalist” strategy. Only in 1997, if the sound initial reforms of the first six months of 1991 are not counted, was progress achieved in introducing macroeconomic stability. But this was only after the rapid depreciation of the local currency (Bulgarian Lev, BGL) of about 3,000% between April 1996 and January 1997, accelerating inflation, and a huge drop in bank credits which caused production to decline dramatically. The most serious economic reversal since the start of transition was registered in 1996, when the GDP fell to - 10.9%, inflation rose to 311% - see next figure.

36


Growth by Sectors

-30

-25

-20

-15

-10

-5

0

5

10

15

20

1990 1991 1992 1993 1994 1995 1996 1997E1998F

GDP growth (%)

Real Industrial Production (% change)

Real Agricultural Production (% change)

As the figure shows, in 1997 agriculture managed to regain half of its decline of the two previous years.

In 1996, products of the food industry, beverages and tobacco accounted for 20% of total output, and its share in 1997 exports of industrial products was 12.2%, registering a drop of 23% compared to the previous year.

Food Industry Share in Export, 1994-1997 (BGL, mln. )1994 1995 1996 1997

Food Industry Export (FIE) 37,583 60,782 140,703 1,006,469Export of Industrial Products 206,089 339,998 819,610 7,482,071FIE as a % of export of Industrial Products 18.24 17.88 17.17 13.45Total Export 216,194 359,664 859,797 8,238,100FIE as a % of total export 17.38 16.9 16.36 12.22

Conditions

Bulgaria has good conditions for agricultural development - 55% of the territory is agricultural land. Agriculture in Bulgaria accounted for 14% of GDP in 1996 and 23% of GDP in 1997. It is a major rural activity and has had positive effects on the trade balance. Although Bulgaria has been developing as an industrial country for the last 50 years, the agricultural sector has also been viewed as an important one, given its contributions to the economy. Formerly it was considered a priority because of food security policy, food export, and the social importance of the sector.

Agricultural output has declined severely since the beginning of transition in 1990. There are a few serious reasons for this. One of them is the instability of the economy as a whole, which consequently led to a decline in demand (domestic and external). The decline in domestic demand was mainly caused by loss of purchasing power and the increased share of food expenditures in income. In addition, changes in consumption patterns, mainly from animal products to cereals, were observed. The fall of external demand was caused mainly by the collapse of trade with former CMEA countries. Bulgaria had traditionally been oriented toward the CMEA market, and the ratio of import and export to GDP was over 75% before the collapse of COMECOM (OECD, 1997). The collapse of this market was reflected by a sharp decline of GDP and increased unemployment. The crises in Yugoslavia restricted new trade opportunities with Western Europe, as the transport of perishable goods was virtually impossible.

37


Another factor in the decline of agricultural output is limited access to financial resources for the sector - shrinking subsidies, lack of individual capital and collateral, and credit problems. Attempts were made to subsidize credits “for production” of grain but they were mainly used for working capital. The stock of agricultural machinery has been reduced by about one third (EIU, 1996) since 1989, and what remains is not sufficiently maintained and/or is inappropriate for small-scale farming. Also, the entire sector and state owned enterprises (SOE’s) of the tobacco and food industries face the problem of decapitalization (transfer of profits and assets into private hands and a shadow economy), thus reducing potential for capital investments while simultaneously contributing to high political risk.

Average annual growth in agriculture shows a diminishing scope in the last three years : in 1995 (-1.0 %); in 1996 (-7%). For the last decade (1986-1996) average annual growth was estimated to be (-2.6%).

During the last five years, the generated production in the food processing industry has declined by 22% within industrial production as a whole (See table and figure below).

Total Output in the Food Processing Industry1992 1993 1994 1995 1996 1997

Total Industrial Output (M BGL) 209,555 242,571 771,653 756,339 1,804,455

16,535,324

% 100 100 100 100 100 100Total Output in Food Industry (M BGL) 49,994 54,712 97,042 150,758 334,082 2,808,868 % 23.86 22.56 12.58 19.93 18.51 16.99

Total Output in Food Processing Industry, 1992-1996

0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

1800000

2000000

1992 1993 1994 1995 1996

Million Leva

Total Industrial Output (Ml. Lv.) Total Output in Food Industry (Ml. Lv.)

The food processing industry employs nearly 4% of those employed by SOE’s. The average number of those employed in the food industry dropped from 177,169 in 1989 to 123,304 in 1997.

Although not specifically measured, the output per employee in agriculture seems to be falling with the overall drop in production. To assess the actual number of people working in the new types of cooperatives or other structures is still difficult because of the rapid changes in these structures. Some figures show that rural unemployment rates are higher than those of urban areas. A

38


significant part of small-scale farm production is usually directed back towards its own consumption and may not be accounted for.

Crop production has been better preserved than animal production. Sectors like tobacco, fruit and vegetables have been heavily hit. Negative results in the crop sector have mainly been due to the cumulative decline in productivity. Poor weather in 1992-93 made things even worse, but this was not the main factor. The livestock sector was mainly hit by the liquidation of state cooperatives and enterprises. This could be due to the fact that the sector had been artificially boosted under the centrally planned system, but the cost-price squeeze, changes in feed supply and changes in demand patterns must also be considered.

The food processing industry is a sub-sector of the food industry which also has 15 other sub-sectors: meat processing, fish processing, dairy, canning, sugar, vegetable oils, the wine industry, the brewing industry, tobacco, the milling industry, confectionery, beverages, etc.

The largest privatization and direct foreign investment have so far taken place in the food processing industry. Approximately 25% of the total amount of foreign investment, and over 50% of industrial investment, is concentrated in the food industry. Table 3 below shows the food industry sub-sector structure of direct foreign investment. Most of it has taken place through privatization, but the process as such is insider driven. Outsiders are largely restricted to information regarding accounting losses, while insiders are best placed to buy companies because of correct valuation of these companies’ potential.

Sub-sector structure of foreign investments (1996)27

Sub-sector production Share of Total Food Processing Production %

Production Volume in US$ M

Canning Industry 38.7 103Brewing Industry 19.7 52.54Grain Processing 17.3 46Confectionery 12.8 34Dairy Processing 8.4 22.34Vegetable Oil 2.1 5.5

Source: Foreign Investment Agency

History: Food Industry Under Centrally-planned Economy

Under Communism, Bulgaria followed an orthodox path of development and its agro-food policy evolved in three phases

First Phase 1954 - 56 Collectivization: collective and state farms establishedSecond Phase 1958 Reduction in the number of collective farms (eventually the

numbers cut by three-quarters). Consolidation of state farms.Third Phase 1970 Industrialization of Food Production. Aim of creating ‘fusion’

between industrialized agricultural production units and industrial enterprises in the food industry.

The initial years of the Communist regime saw a concentration of restructuring of the agricultural part of the food chain (phases 1 and 2) followed by, in the 1970s, a belated movement towards industrialization and rationalization of the downstream sectors (phase 3). In Bulgaria the poor harvests of 1967, 1968 and 1969 acted as a catalyst to this third phase of development, but the underlying structural weaknesses would probably have necessitated policy innovation regardless. In the pre-reform period, all activities for organizing the purchase and distribution of agricultural commodities in the downstream sector were governed by the Council of Ministers via decree. The

27 There is no later data.

39


practical management of these decisions was presided over by the Ministry of Agriculture and Central Co-operative Union. The Ministry was obliged to:a) organize and manage the purchase of agricultural commodities;b) elaborate plans for purchasing;c) assure the signing and fulfillment of contracts between agriculture production co-operatives and

processing industries;d) develop the technical basis of the process.

Because of price liberalization in 1991, input prices have risen more than farm prices and consequently subjected agriculture to a cost-price squeeze. As a result, the application of fertilizers and pesticides has been restricted and this has effected many crops yields.

Prices in the centrally planned economy were fixed, so in order to supply consumers with food at a low price, the agricultural producer’s prices were also kept low, sometimes even under that of production costs. To compensate for these losses, farmers were supported by the budget. This support was in the form of deficiency payments, output bonuses, price, input and export subsidies. Since the beginning of the reforms in 1990, the system of support has changed and budgetary expenditures decreased dramatically - by more than 97% (at 1990 prices) for the period 1990-95 - due to budgetary constraints and deficits. The basic support since 1992 has mainly been through credit subsidies for spring and autumn seasonal work and tax concessions.

Price Regulations

Although partial price liberalization took place in 1990,: there were still fixed prices for some basic agricultural products. Farm-gate prices increased, but there was a ceiling on retail prices of bread, milk and diary goods, meat, sugar, vegetable oil and baby food.

In February 1991, as part of the general macroeconomic reform, most prices were liberalized. Minimum prices were introduced for some basic farm products - grains, wheat flour, meat, and milk. These were minimum prices below which any trade was prohibited, but not prices signaling market intervention. These prices were fixed on current prices, albeit below the world level, and because they did not reflect the inflation of the period, they tended to stay below the level at which they had been set. Because of this, they didn’t have real economic effect. The retail prices of thirteen food products were monitored and controlled by the so called “projected price mechanism”. Projected prices were based on the minimum producer prices and normative profit margins (percentage of production costs) accompanying the down-stream sector. There were no predetermined price ceilings for processors and traders; instead there were normative profit margins being added to the costs and purchasing prices of raw materials. The projected price mechanism was introduced as a temporary measure to control the monopolism in the processing and marketing area before completing the privatization process, and to keep the prices of food low during the restructuring of Bulgarian agriculture. However, though the prices of main agricultural products almost doubled during that period, this increase did not compensate for the rise of input prices and services. The system was considered inefficient as the increase in the prices of monitored goods was larger than that of non-monitored ones - there were some fluctuations around projected prices from 6% in 1991 to 36% in 1992. One of the explanations for this paradox was that the prices of monitored goods were much more heavily subsidized at every level of the food chain before the beginning of the transition period, and therefore could be considered an explanation for the distortions.Besides this, the level of controlled prices fell in 1991 to 10% of the consumer basket (other goods and services being public transport, communication and electricity).

In March 1993 the system was changed again - the so called “maximum prices” (ceiling prices) were introduced. There were no longer any projected prices, and a modification of the old system of normative margins, this time called “profit margins” was implemented. The profit margins were fixed for producers and processors at 12% of full production costs and for traders at 10%. As a

40


consequence of the economic crisis in April 1994, which resulted in the increase of food prices, the list of monitored goods was extended to include butter, eggs, sunflower oil, lentils, rice, baby food and others. The philosophy of the government at that time was focused on the same goals of food security, social stability and protection of consumers.

In 1995, the Price Law and the Agricultural Producers Protection Law were adopted and the “Agriculture” fund established. The so called “protective purchasing prices” (guaranteed floor prices) were considered the main support measure for basic agricultural products such as: wheat, maize, sugar beet, potatoes, beef, lamb, pork and sheep and cow milk. The main idea was to ensure the necessary quantities and so provide a “national balance”. Prices were calculated on the basis of the average production costs of representative farms plus a profit margin - 5% to 20% - and they could not exceed 85% of the national currency equivalent of the average export price over the previous 3 years. The market agents (traders and government agencies) under contract were obliged to purchase at these prices up to the pre-contracted quantities. In the case that market prices fell within a month at a certain level below the protective purchasing price (below 95% of the established protective purchasing price or if current prices went higher than 20% above the purchasing prices), the government agencies were supposed to purchase without ceilings (not restricted by national balance considerations and contracts). The intervention required a large amount of money for purchasing the supplied quantities, which under the economic reality of financial shortages was doubtful.28 For other agricultural products, the so called “target prices” (project prices) were introduced. They were based on the monitoring of market prices and accorded to the annual program for agricultural development. The objectives pursued by the “Law for state protection of agricultural producers” were the following: to support agricultural production by market interventions and price regulations under the management of government agencies; to ensure reasonable income for farmers; to promote exports by eventual export subsidies; to provide special support for the mountain and semi-mountain regions; and to ensure improvement of new farm structures by investment support. Financial sources were supposed to be provided for by the budget - partially from collected export taxes and import duties, partially from privatization and the renting or selling of state land. The main criticism to the new Law was the reverse role of the State, which is accepted as being contradictory to the creation of a competitive, free market. Also, because the protective purchasing prices were based on the average production costs plus determined profit margin, they were no incentives for reduction of costs or increase of efficiency. In addition, given that they should not have exceeded 85% of the average export value per unit, the incentive for getting higher prices when exporting remained.

By the end of 1995, the average level of prices under control had already reached 49% of the consumer basket.

The Bulgarian food industry has traditionally been an export-oriented industry. During the period of centrally planned economy (CPE) it blossomed under the conditions of COMECON markets. Two government companies, Bulgarplodexport and Bulgarplod, were respectively exporter and importer. There were enough foreign markets to implement large-scale production, there was a relatively developed domestic market, and there was full vertical integration (agriculture - food processing - packaging - marketing and trade) within the former operating structures. There were capital resources, R&D, a foodstuff machines industry, etc. In 1990, Bulgarplodexport and Bulgarplod were dismantled. Deregulated firms encountered foreign rivalry for the first time. In general, conditions declined, reasons being more than one:· The fact that the food industry had been a functioning one was not due to market forces; thus,

the collapse of the CPE automatically provoked the collapse of the industry in question.· The main foreign market, Former Soviet Union (FSU), collapsed in 1990-91 and the food

industry, being strongly dependent on this market, suffered as a consequence of these changes.

28 For 1996, because of the lack of financial resources, a protective purchasing price (guaranteed price) was established only for sugar beet and targeted (projected) prices were established for all the others main products.

41


· The commercial agreements between members of the former Council for Mutual Economic Assistance (CMEA) ceased to exist; thus, many markets were lost or the rules changed.

· Integrated or related industries had the same destiny, so the functioning of the canning industry was further blocked.

FOOD INDUSTRY COMPETITIVE ADVANTAGES

In assessing these advantages, M. Porter’s concept of different stages of competitiveness will be used. There are four stages of evolution of competitiveness which a nation or an industry goes through: factor-driven, investment-driven, innovation-driven and wealth-driven.

The Bulgarian food industry (BFI) is an example of a typical factor-driven industry. The factors are: a very favorable climate, highly fertile soil, high-quality agricultural production, low labor cost, a skilled and qualified labor-force, etc. These factors are the only sources of comparative advantages. To be an investment-driven industry, the food industry as a whole must introduce a market approach, i.e. to embark upon positive return on investment, market-based competition between firms, steady and reliable relationships with supporting industries, absence of monopolies, etc. Therefore, being still in the factor-driven stage, the challenge in front of the Bulgarian food industry is to pass into the investment-driven stage, led by competitive strategies implemented on firm and sector levels.

The availability of human and knowledge resources is one of the main factors that can be considered as a BFI comparative advantage. On one hand, Bulgaria has traditionally been an agrarian country. Agriculture, until the end of the 1950’s, had always been the spine of the national economy. The Bulgarian farmer had always been a skilled farmer. The cost of manpower had always been relatively low. During the communist period a lot was done to improve the human resources in this sector, and farming was based on big collective structures - including the institutions which provided training of specialists for agriculture and food industries: the Institute for Fruit-Growing (Plovdiv and Kiustendil), Institute for Vegetables “Maritza” (Plovdiv), Institute for R&D in the Canning Industry and Institute for Food Industry (Plovdiv). The cost of a specialist’s labor has also been low. Since the collapse of the communist regime, the classes of former state food engineers and specialists have been the main reservoir for the new generation of managers for the private food industry. Currently, the number of agriculture university students is 70% of those studying law, and post-graduates are 5% of all postgraduates.

Another factor is physical resources. Bulgaria has 6,203,000 hectares of agricultural land, and of that, 4,804,700 hectares are arable (NSI, 1997). A great part of the arable land is of high-fertile soil. This means high-quality agricultural production as an input for the food industry; thus, high-quality processed products. The climate conditions of the Bulgarian geographical position are excellent. A mild climate permits the cultivation of a wide range of crops and livestock.

In the past as well as in the most recent six years, electric power was always subsidized. This is an infrastructure factor. In 1997-1998, the power generation industry has been changing from a heavily subsidized one into an efficiency-oriented one; the price of one kWh has risen (from 2.8 cents per kW to 6.1 cents) and become a significant cost burden not previously taken into account for all industries. The power sector is a government monopoly. Prices are fixed to cover the costs of the producer and there is a cross-subsidy to households, who pay twice as less.

The transportation system is another infrastructure factor, which renders the development of industry sustainable. There was a good infrastructure, centrally planned, and at a low price. Likewise, the energy factor. During the transition period the transportation system turned into a significant cost factor. The former state monopoly in international transport “SO-MAT” is in the

42


process of privatization. Food enterprises consider transport costs high, although companies that export high quality (and/or delicacy) products have never mentioned this factor as one impeding competitiveness on international markets. The Bulgarian private international transport sector (aside from SO-MAT) is also expensive for firms, being under the constraint of efficiency. Railway transport has also always been an important supporting factor.

Before the collapse of CPE, foreign trade was managed by different state monopoly organizations like “Bulgarplodexport” for fruit and vegetables (fresh and processed), “Vinprom” for wines, “Rodopa” for meat and meat production, “Serdika”-for dairy products, etc. To find a market niche for this production on foreign markets was not a problem because firstly, the rate of export production was planned and a market segmentation within the former COMECON countries existed (i.e. Bulgaria was specialized, on that level, in food processing, wine and tobacco, textile, etc.), and secondly, nearly 90% of the production was destined for the FSU and other former COMECON countries. The markets there were not well developed and consumers had no other option. Consumers were put in a vacuum, and as a result of relatively low incomes in those countries, these markets existed. A market approach was not indispensable. The main marketing leverage was the low price. In 1990-91, the FSU market collapsed and this fact changed the rules of the game. Although the Russian market is recovering from the crisis now, the BFI cannot rely on this market as it did in the past. There are a few reasons for this: firstly, the requirements for quality and the standards of the Russian market are by now higher than in the past, secondly, because of the new-born competition on the part of the former soviet republics for the above mentioned market, and thirdly, Russia is no longer a CPE country and the quantities of imported canning production are based on demand and supply, and not on the “planned demand”.

The food industry is a capital-intensive one. The demand for turnover capital is seasonable (exceptions are the dairy and meat processing industries where raw material input comes regularly within the year). Summer/autumn is the period of purchasing raw materials (agricultural products), thus the period of highest demand for turnover capital. The return on the investments is not immediate and thus this delay in investment-return causes a lot of problems for producers facing their other duties. Moreover, given the low rates of profit typical for the industry, investments in fixed capital (new machines, equipment and technologies) are beyond the possibilities of processing firms. The supply of turnover capital and fixed capital was not a problem during the CPE period. This is the sc.. capital resources factor. The economy was following the principle of subsidies. Usually state enterprises were on a soft budget constraint and were credited by the state. With the collapse of CPE the situation radically changed. Since 1990, the process of crediting has been closely bound to the development of the banking system. The transition period was characterized by bad banking management. There has always been a lack of efficient criteria for lending loans to canning firms, especially short-term loans for turnover capital, so important to the industry in question. There is still a lack of precise rules about how a loan may be guaranteed. In fact, there are legislation rules for loan guarantees, but bank managers don’t respect them, and in practice, are not able to estimate a real rate of credit risk. Tight credit policy (because of the high rate of interest and shortage of liquidity) deprives firms of capital sources, so neither turnover capital for raw materials and short-run duties nor capital for maintenance and innovation of the fixed capital, are available. All this is to the detriment of competitiveness, and even hinders the capacity of industries to survive.

43


Firm Strategy, Structure and Rivalry

This element of the “competitive diamond” is bound more to the future than to the present of the BFI. It relates especially to the direction of Bulgarian food processing companies, and not so much to their current situation. According to Porter’s theory, this determinant is the context in which firms are created, organized and managed, as well as the nature of domestic rivalry. Most important are:· motivations of individuals, who manage and work in firms, to develop their skills as well as to

expand the effort necessary for creating and sustaining competitive advantage;· the elaboration of special firm strategies in the sphere of resource utilization, costs and prices,

innovations and technological development;· rivalry among firms in a national market which urges them to improve and upgrade their management

structures and strategies in line with achieving greater competitiveness in the world market.

For the presence of these three context conditions to exist, there must be above all a real competitive environment (market). This means free circulation of information, transparency, absence of unnatural monopolies, a uniformly distributed level of profit, tight institutional control on the quality of production following precise standard levels, a good level of management, a developed loan market, developed relationships within the industrial clusters, a good level of demand, etc. This is not the case of the BFI.

The individuals who manage and work in firms are not motivated. There is no developed market in which firms must create a special competitive advantage. Market strategies are price-based and this is due, above all, to the low price of manpower. On the other hand, the very low level of salaries means an absence of motivation to improve skills and the quality of work (both of workers and management).

The elaboration of special firm strategies is an almost impossible undertaking. This is because of the lack of steady parameters for making production and investment programs. Firstly, the supply of raw materials doesn’t provide steady parameters such as regularity, price and quality. Almost always transactions are not based on contracts and are sporadic. The supply of jars and caps presents the same kind of problems (see Cluster). Contracting is not a widespread practice. Producers are often forced to turn to foreign markets. Secondly, there are not yet steady macroeconomic parameters. In spite of the introduction of the Currency Board, the current situation is not favorable for making middle and long-run programs. Foreign trade policy, taxation and crediting are still in the fermentation stage. Thirdly, as mentioned above, the profit margins of the canning industry are rather low, so technological innovation without further investment is unachievable.

There is not a developed competitive-based national market for the food processors which would urge firms to improve. The average standard of living of the population is low and therefore the purchasing power and potential demand is rather low. In addition, there exists a tradition of partial self-sufficiency in Bulgaria. This fact exercises a strong influence on national demand for processed food products. Moreover, the Bulgarian consumer is not a mature (sophisticated) one, so national demand could not offer useful criteria for competitiveness abroad.

It is clear that, at present, there are no motivations for individuals, there are no precise firm strategies, and there isn’t a developed national market. The potential of national resources (skilled manpower, existing infrastructures, traditions, geographical position, favorable climate, etc.) is not fully utilized. As a consequence, the link between competitiveness on the national market and competitiveness on the world market does not exist.

The Cluster

Competitive advantage in some supplier industries confers potential advantage on a nation’s firms in many other industries, because they produce inputs that are widely used and important to innovation or to internationalization. In terms of the food industry, ‘related industries’ means

44


agriculture, the jar and tin industries, the transportation system, and marketing and promotion (as supply of service). Related industry is the one which supplies the canning industry with means of production (machines).

At present, there is little “clusterization” of the BFI, and this does not provide competitive advantage.

The BFI: Environmental Obstacles

Which are the main obstacles that do not allow and impede the BFI to be a competitive one?

1. Land reform has had an indirect influence on the food industry. Reinstatement of property rights over land has effected the optimal size of agricultural production. On one hand, land fragmentation has been observed since the beginning of the reform. The size of land is much too small. The average size of restituted land per applicant in Bulgaria is 0.1-0.12 ha. On the other hand, land owners have been restoring their property rights on a large number of plots situated in different parts of the territory belonging to the settlement (TBS). Obviously, land reform has led to temporary land fragmentation29. Land fragmentation and land reform have caused a huge drop in the amount of land for new vine plantations, i.e. at the beginning of the reform, new vine plantations covered 45,000 decares, whereas now they cover only 600-700 decares. Coverage has dropped by almost 70 times. These two general characteristics have had a deep impact on agricultural output (quality and quantity) and have caused an imbalance on the raw materials market. Land restitution and farm restructuring. The ongoing process of land restitution has had a negative influence on the supply side. Agriculture is the only supplier of the food processing industry. All obstacles for further agricultural adjustment have had an indirect negative impact on food processing as well. Land reform has caused temporary stagnation in agricultural production. Existing production units (Labor Production Cooperatives - TKZS) have been being dismantled. New production units have emerged. Mainly these are: (i) small individual private farms operating with very limited resources - land, labor and capital. Their production is oriented towards self-sufficiency. Some of them could provide agricultural products for the market; (ii) new co-operatives have emerged on the basis of previous TKZS; they have duplicated some of the specific features of TKZS, and they are oriented towards cereals. Thus, their market orientation is the domestic market and food security for the country; (iii) farming companies have registered under the Commercial Law. Those of them that farm land develop their farms either on the basis of leased land, or on the basis of a small amount of owned (restituted family land) and leased land. The most important characteristic is that these farms are market oriented (mainly because of the economies of scale). Structural adjustments in agriculture have caused a diminishing quantity of agricultural products on the market30. 2. Privatization has had a dual effect on the competitiveness of the food industry. On one hand, this process helps managers to develop a new range of enterprises based on private ownership. On the other hand, the process of privatization and restitution of buildings creates problems such as overly high rents or overly short rental contract duration.3. Access to raw materials. Structural adjustment has caused not only a decline in agricultural output, but also a drop in its quality. Respondents pointed out that low quality in provided products diminishes the quality of the processed products. The raised point was that processors have two options: either to purchase a limited quantity of agricultural products, sometimes with low quality and irrelevant price, or to import the necessary quantity from neighboring countries (Macedonia, Greece, Turkey, Yugoslavia). This factor plays an important role in the wine industry and the canning industry (processed vegetables). Food processing is dependent on the agricultural base, which is currently weak. The harvest in last few years has been below target. Further falls in the

29 According to experts evaluation land fragmentation is a temporary phenomenon. Expectations are that at the end of process (after completing of land reform) there will be adequate economies of scale of the farms.30 More detail information could be find in Working paper 1, where declining the output of agriculture has been discussed.

45


quantity and quality of domestic production could result in raw materials being imported, which would put pressure on costs. 4. Access to credit. Although a lot of credit institutions exist and operate in Bulgaria, a major problems is lack of credit. Lack of collateral is an obstacle for obtaining working capital credit.5. Access to information. Respondents claim that there is no transparency of information. They face a lot of difficulties trying to obtain relevant market information. Very often there is more than one source of information and the information provided can differ significantly.6. Trade regime with its instability and frequent changes has had a negative impact on the food processing industry. 7. Juridical Framework. This factor has two dimensions - the domestic juridical basis, and the necessity to develop, amend and harmonize existing laws with those of the EU. A topic under discussion concerns exercising quality control over food products. Existing Bulgarian State Standards are not compatible with those accepted by the EU. These differences make some Bulgarian products uncompetitive on EU markets (the last hot discussion was focused on dairy products and the fact that only three dairy processors have been licensed to export dairy products to the EU; the others do not meet the requirements for sanitary conditions required by the EU). The result is loss of market position.8. Inputs. The jar industry in Bulgaria has a quasi-monopoly position when compared with the food industry. Although it does not provide high production quality to national producers and the BFI’s demand has dropped, it has become export-oriented. A lot of food-processing enterprises are absurdly constrained to import jars from Turkey. The high rate of defective production or importation of jars represent much of the overall cost of the food processing industry’s production. The cost of raw materials for the Bulgarian jar industry is destined to increase. The reason is the privatization of the industrial complex “SODI - Devnia” - the main supplier of calcinated soda to the glass industries - and thus the price of raw materials for the jar industry will rise and, subsequently, prices of jars will rise as well. If the jar industry is not privatized as soon as possible, it will no longer be possible for the canning industry to rely on the Bulgarian jar industry. The production of tins during the period of CPE was mostly a supplementary activity in addition to food processing in big state manufacturing facilities. The small scale of production has rendered it inefficient in conditions of a non-planned market economy and it has almost disappeared. Moreover, the demand for this type of packaging is decreasing in developed markets. The polyethylene-based package industry, similar to jams, must raise its prices in order to be economically efficient and of good quality, A basic condition is that it be privatized. However, the higher price will mean a further cost burden on the BFI. One can see that there is only one kind of sustainable link between the BFI and package industries - efficiency on both sides. At present, there is no efficiency on either side. The package industry does not represent a source of competitive advantages for the BFI either. 9. Marketing. As mentioned above, the marketing of the BFI is at a low level. In the past, foreign trade companies, specialized in each sub-sector, managed numerous foreign trade offices, especially in the FSU and other former COMECON countries. If we assume that it was a question of marketing, it was based only on the low price of production and on agreements for mutual economic assistance. At present, the managers face many obstacles:· less information on foreign markets and lack of infrastructure to provide it;· low price is no longer a sufficient condition, production must achieve EU standards of quality and safety;· private market research is an unsustainable cost for a greater part of canning firms;· there is a lack of skill in market research; · the Russian market does not provide steady parameters for creating marketing plans.

Facing all these obstacles, managers can rely only on old personal contacts created during the CPE or on market research conducted by potential foreign clients. For the time being, there is a lack of opportunity to improve the image of BCI production on foreign markets. Marketing is not a sound base for the increase of competitiveness of the food industry.

46


Government Policy

Without a doubt, a policy for market economy and competitiveness exists. The problem is that currently there is still a lot to do and changes are introduced slowly. Land hasn’t been given back to its owners. This hinders the development of agriculture, which provides raw materials to the food industry. Meanwhile, the process of privatization has been slow and ineffective. The reasons are bureaucracy, the lack of concept, and clash of interest.

The new corporate tax law is similar to the ones of industrialized countries, but applied to an underdeveloped economy, it has turned into a large obstacle. There is no tax facilitation for firms that reinvest their profits or invest in new productive assets. The fiscal mechanism does not function, and this, together with high quotas, is a kind of catalyst for fiscal evasion. The state administration is ineffective and bureaucratic (in the negative meaning of the word). There is a lack of dialog between administration and economic operators. The irresponsibility and fear to take a position or personal decision deposited during the socialist period are still circulating within the institutions. Not only is business rendered difficult to carry out, but it also makes the process of introducing new laws or directives for development very difficult. In Bulgaria, the phenomenon of duplication of functions among institutions exists. One example is the control and licensing of wine and products of the canning industry. As a consequence, there is a high rate of skepticism, which impedes the return of confidence in state administration. It’s going to be hard to revitalize economics, confidence being absent.

The Bulgarian food industry is still in the factor-driven stage. It works below 50 % of its existing capacity. The BFI possesses the potential to “jump” into the investment-driven stage, but it must find a spiral by which to exit the vicious circle: banks don’t give loans to producers, and the producers don’t offer good guarantees or convincing business plans. The main problem is the lack of reciprocal confidence. In the investment-driven stage the competitive advantages are drawn from two determinants - the first being factor conditions, and the second a combination of firm strategy, structure and rivalry. The factor conditions will remain an important element, but as a function of market requirements. The most developed industries are the ones that are able to create competitive advantage based on local resources. Finding an exit from the vicious circle is a governmental task. For example, it could create funds to guarantee and grant loans to Bulgarian exporters. Having capital resources, the firms would invest and try to achieve the market requirements. A real market competition should be established, monitored by the Government. This will be the basis for the elaboration of strategies. Moreover, there is a lot to do towards creating of a good information infrastructure.

Although the food industry as a whole is not a competitive one31, there are sub-sectors that exercise their competitiveness. According to Porter’s theory, two sub-sectors fulfill almost all the requirements to be defined as competitive - the canning industry and the wine industry. In the next years, the industries which are most likely to perform are those where Bulgaria has a cost advantage or particular niche, and where the industry directs a substantial proportion of sales to export markets. Focus sub-sectors are:· Food - a large fruit and vegetable canning industry which is highly export oriented;· Wine and Tobacco - major export earners;The main question is - does the profitability of those sub-sectors of the food industry actually correlate with its export potential? The evidence suggests that while exports may guarantee growth in revenues, they do not necessarily enable a company to make a satisfactory profit on those revenues. Why? Because another major impact on profitability is the level of input costs, and it does not help if those costs are imported - currency exposure, together with artificially high prices make it difficult to break even. Additional “negative” influence is a seasonal timetable of production. 31 It is necessary to underline that there is potential in the cluster of food industry and lack of competitiveness should be consider as a temporary status.

47


Sector Focus and net ProfitabilityFood Industry Subsector Export

potentialCost Base

Net Profitability %

1995 199632 1997Food Very

HighDomestic 0.2 0.3 0.2

Beverages High Domestic 3.3 3.2 3.18Wine Very

HighDomestic 2.6 2.4 2.3

Tobacco Very High

Domestic 0.2 0.3 0.2

Fertilizers High Imported 6.6 5.8 5.5Source: Raiffeisen Bank, Country Report, October 1996

Bulgaria is a traditional producer of vegetables and fruit and, consequently, its own agriculture has always been a good supplier of inputs (raw materials) to the BCI. After 1989, vegetable and fruit production began to decrease. Since 1994, the trend has changed, but levels of production are still considerably lower than those of 1989 (See the following figures).

Overall vegetable production (thousands tons).

020040060080010001200140016001800

Overall fruit production (thousand tons).

0200400600800

100012001400160018002000

Grape Production

32 Net profitability for 1996 and 1997 is based on authors own evaluation. Different sources are used,

48


Grape production, 1994-1997

0

200

400

600

800

1000

1200

1994 1995 1996 1997

YearsFarming area ('000 dca) Average yield (kg/dca)Grape Production ('000 t)

The average crop yields are lower than in the past. Since 1993/94, crops of many sorts have begun to rise. The reason for the low level of crop yields is the lack of investment for seeds, agrochemical products, machines and equipment.

The Canning industry

Installed capacities are capable of producing more than 950,000t of finished products. In 1989, Bulgarian export of processed fruit and vegetables amounted to 500,000t, above all of the former CMEA. The entire production for the year amounted to 594,146t. The collapse of the Soviet market and coordination of the chain (agriculture-processing- packaging-marketing-sales) brought the production to 130,829t in 1992. In 1993, a weak increase in overall production of the canning industry (132,600 t) started. In 1995, nearly 90% of the ketchup and other tomato sauce exports were routed to Russia; the remaining part to Germany, Ukraine, Belarus, the Czech Republic, Kazakhstan, Romania, Lithuania, and Estonia. Sterilized tomatoes are predominantly exported to Russia (nearly 92%) and Ukraine; sterilized peas to Russia, Kazakhstan, Ukraine and Belarus; sterilized mushrooms to Russia, Macedonia, Jordan, Finland; other sterilized vegetables (marinated peppers, carrots, etc.) to Russia, Germany, Saudi Arabia and Kazakhstan; frozen vegetables - mostly to Greece -72.5%, France - 7.4%, Germany - 3.2% and Italy - 3.1%; jams and jellies to Russia - 38.1%, Germany - 23%, Jordan - 14.1%, the Czech Republic - 3.7% and Austria - 2.6%; frozen fruits - mostly to Germany - 50.4%, Holland - 13.3%, Greece - 10.9 %, Russia - 5.1%, France - 4.8% and Austria - 4.4%.

What is remarkable is the fact that the increase in production of processed vegetables coincides with the decrease in production of processed fruits from fruit-trees. The reason is the higher dynamism of the one-year cultures. This kind of agriculture production is more flexible to react to a constantly changing economic environment than is the perennial plant.

In southern Bulgaria the concentration of this sub-branch of food industry is higher compared to that of northern Bulgaria. The highest number of means of production are concentrated in the Plovdiv and Pazardjik regions, followed by the Stara Zagora and Jambol regions. In the outlying south regions (the Rhodope Mountains) there are no canning industry manufacturing facilities. In northern Bulgaria the highest concentration is in the Pleven and Veliko Tarnovo regions. The

49


Rousse and Montana regions follow. The firms situated in Dobritch and the mountain and semi-mountain northern regions have a commercial activity as well.

There are two channels by which the processing of fruit and vegetables are provided. The first one is what remains of state enterprises. The second one is the private canning enterprises. Given that the process of privatization is an ongoing process, it is impossible to specify the share of state production and the share of private production. According to some research, the share of private enterprises is about 1/4. What is certain is that state enterprises are destined either to be privatized or to disappear. To state and private enterprises there could be added the channel of dealers. It is a question of organizers with skills in marketing and information on the markets (above all foreign ones). They stipulate contracts with the producers (private and state enterprises) and supply markets or stipulate different contracts with the whole chain (from agriculture to packaging of final products), thus organizing and controlling the entire process (included transport), and supplying the final markets.

The marketing of the Bulgarian canning industry is at a very low level. There are a lot of obstacles in front of it. Almost nothing from the former foreign trade representative offices of “Bulgarplodexport” remains, and it is logical, given the need of big investment, to run these offices within the power only of centralized or developed economies. Diplomatic bodies don’t contribute enough to advertising Bulgarian production abroad. Moreover, information about foreign markets, technologies, related industries etc. doesn’t circulate within the country. On the other hand, the marketing preparation of the Bulgarian managers is not so high and, in an international context, it is a serious problem. They rely on the exploitation of international contacts established in the past. Furthermore, the exploring of new markets and establishing new contacts is rendered difficult by visa problems.

Obtaining loans is one of the main obstacles that this industry faces. Credit security requirements render the supplying of fresh money almost impossible. Often, one who needs a credit falls into a vicious circle - in order to obtain a loan the subject must guarantee his solvency, depositing an amount of money equivalent or even higher with reference to the loan. This fact arouses a lot of “timidity” in the individual who has a good idea with which to start or continue a business. However, seldom does the individual asking for a loan present a convincing business plan, either because of inability to express the good idea or because the idea is not good. Thus, not only part of supply, but also part of demand is rendered ineffective. Interest rates are hopeless. The mortgage mechanism has not yet started to function; thus, land ownership can’t serve as a guarantee.

Nevertheless, the canning industry may have the potential reserves in the near future to shift from the factor driven stage to the investment driven stage.

Output : type of food products, beverages and tobacco1989 1990 1991 1992 1993 1994 1995 1996

Vegetable cans - t. 304,563 244,414 184,972 81,268 86,779 143,220 134,405 127,300 of which: Sterilized 205,772 157,293 117,621 52,587 56,000 84,235 76,704 64,636 Tomato paste 59,516 49,704 30,223 11,684 3,685 13,410 28,283 12,565Fruit cans (excluding pulps)- t. 289,583 210,871 80,322 49,561 45,821 31,233 31,603 49,627 of which: Marmalade 6,606 6,440 5,377 3,461 3,968 3,072 3,582 4,165 Jams, table jellies 28,743 12,394 9,096 6,249 6,165 4,052 3,618 5,220 Compotes 93,444 65,911 21,261 21,798 19,422 8,991 6,095 17,428 Fruit pasteurized juices 101,932 89,149 29,957 2,742 5,240 5,592 2,230 3,390 Fruit syrups 14,023 5,278 1,106 474 934 1,032 31 8Baby Food - t. 18,919 12,311 12,069 7,548 8,604 11,104 3,063 2,481

See: Annex 6

50


SLUNCHEV PLOD LTD REVISITED(a case study of canning company)

Attempting to figure out how a Bulgarian company weathers macroeconomic shocks and political instability through international competition, between 1996 and 1998, has been monitoring a company from the canning industry. Here some results and observations.

Background

SLUNCHEV PLOD OOD33 is a private Bulgarian company established in 1994 by six physical persons and one legal entity - CARESBAC Bulgaria AD34. The company is specialized in the production and sale of delicacy vegetable cans and dried fruits and vegetables. It is located in Plovdiv. In June 1994, the joint venture was registered and was named Slunchev Plod OOD with a capital of 2.3 mln. BGL. The team of six specialists owns 65% and CARESBAC Bulgaria AD - 35% of the shares of the newly established company. The physical shareholders contribute 1.5 mln. BGL in cash and assets (machines), contacts and know-how, while CARESBAC contributes 3.5 mln. BGL in cash.

The joint venture gives Slunchev Plod a good starting point - the shareholders contribute work, knowledge, know-how and machines, while their partner contributes money and assistance. The partnership with CARESBAC helps obtaining financial resources for buying new machines, renting a building and financing the working capital needed. For that contribution CARESBAC becomes a partner with 35% of the equity of Slunchev Plod; it is supposed to share profits and losses (i.e. the risks of entrepreneurship). Otherwise, Slunchev Plod would have been forced to draw bank credit (if it succeeded to arrange it) on strict and heavy terms - a liability that might turn to be a heavy burden if repayment problems occur.

In 1995, Slunchev Plod receives subordinated loans from CARESBAC Bulgaria - a short-term one for working capital and a long-term loan for capital expenditures. In the same year the capital of the company is increased to 6.8 mln. BGL. In August 1996 Slunchev Plod OOD signs a contract for a revolving credit line for 170,000 USD which is used for working capital. The access to credits solves a serious problem, stemming from the seasonal character of the canning industry. In late summer serious financial resources are needed for raw materials and packing while the money invested are recovered in December - March when goods are sold and payments received. The availability of credit lines makes Slunchev Plod more flexible and able to expand production. The table below shows the increase of sales and the share of export for the last three years:

Market orientationYear Receivables from

salesDomestic Market Export

BGL % BGL % BGL %1994 9,049,353 100 161,641 2% 8,887,712 98%1995 19,650,644 100 1,499,362 8% 18,151,282 92%1996 87,931,260 100 75,194,710 86% 12,736,550 14%1997 796,200,334 100 235,241,719 30% 560,958,615 70%1998 (IQ) 275,238,126 100 30,809,616 11% 244,428,510 89%

33 The abbreviation “OOD” in Bulgarian stays for limited liability company.34 CARESBAC Bulgaria is a joint venture established by the governments of Unites States and Bulgaria to facilitate equity lending to the emerging private sector in Bulgaria, especially companies dealing in agriculture, food industry and related areas. CARESBAC Bulgaria is a Bulgarian-American investment fund, specialized in microcredits (between 25% and 49%) in small and medium sized private Bulgarian companies. The purpose of CARESBAC is to invest in the sphere of agribusiness - agriculture, food processing and all industries associated to the former two industries. CARESBAC just started its operation in the country; it managers were looking for committed entrepreneurs and a business to invest. Slunchev Plod was one of their first projects; CARESBAC accomplishes its objectives by providing equity financing up to 350,000 USD and technical assistance in marketing, accounting, technical and other issues.

51


"Slunchev Plod" OOD Markets, 1994-1998 (First Quarter)

USA5%

Germany34%

Russia15%

Slovenia15%

Turkey1%

Domestic Market

30%

Greece2%

Long-term assets and sales

The company rents from a state-owned meat-processing plant a 4,000 m2 area with a 1,500 sq.m. building, which was properly reconstructed for the purposes of food processing. The balance value of the long-term assets of Slunchev Plod is 4.2 mln. BGL, but their market value amounts to 15 mln. BGL or 220,000 USD. Machines account for the highest share - they have been designed and constructed by the professionals at Slunchev Plod. If bought from West European machine- producers, their price would be three times higher. The shortage of free financial resources and the desire to establish an own production has always forced the team to cut down expenditures and if possible, to make their own, custom-tailored machines themselves. These machines may not be automated to the degree the West European machines are, but this allows for taking (competitive) advantage of cheaper labor. Forty people are employed in the company (excluding the shareholders) on a permanent contract and up to 400 seasonal workers are hired. Salaries are twice as higher as the average level of salaries in the region. The social impact of the employment policy of Slunchev Plod is very favorable, since the seasonal workers hired are mainly gypsies among whom the rate of unemployment is very high.

The table above shows that Slunchev Plod’s sales have been increasing each year. The annual production capacity is 700 - 800 tons of sterilized canned products, i.e. more than 1.2 mln. jars (370 gr. and 720 gr. jars are used). The share of exports is stable, even though a greater increase in the absolute and relative value of exports has been stipulated in the business plans Slunchev Plod. Exports have two major directions: a stable one, i.e. the German market, where the company has good contacts and stable positions:

· in 1994, 55% of exports went to this market, · in 1995 - 22% · in 1996 - 43%;· in 1997 - 27 %· and in the first quarter of 1998 - 34 %,

and a dynamic one - geographical regions and countries in which the company had some presence or to which it currently directs its efforts:

· Russia (1995 - 10% of exports, 1996 - 19%, 1997 - 20%, IQ 1998 - 16%), · USA (1994 - 30%, 1995 - 8%, due to the shrinking market of dried tomato, 1997 - 6%, IQ 1998 - 5%),· Turkey (44% in 1995, IQ 1998 - 1%),

52


· and only 3% (in 1996) to Greece, Croatia, Slovenia, Georgia, which decrease to 1% in IQ 1998.

The last two groups of dynamic countries of destination are interesting, as products sold there are subsequently re-exported: from Turkey - to Germany, from Greece - to Cyprus and from Croatia and Slovenia - to Italy. The simple reason is that these countries have an easier access to the large markets - larger import quotas or simply better traditional relations and contacts.

Marketing is of crucial importance to the products of Slunchev Plod. Their processed food products are based on traditional Bulgarian recipes and meet West European taste and quality standards. The markets of these products are highly competitive (a large number of sellers) and the quality and packing requirements are extremely high. Slunchev Plod follows strictly the quality controls and meets the high requirements of processed food markets. More efforts are needed in the area of promotion of its products since Bulgarian producers are not known and they have not traditions of presence on these markets. One exception is the Russian market - the Bulgarian canning industry was a major mass product supplier of the former USSR countries (peeled tomatoes, pickled cucumbers). However, the market niche of Slunchev Plod is the premium market of processed food - delicacy products of the canning and drying industry - and it has to enter a more demanding and difficult for penetration market, even though it is often stated that the Russian market can absorb “anything”.

Promotion is important, since it may help the establishment and strengthening of contacts with a number of companies. Because of its limited access to foreign markets, Slunchev Plod has to sell to buyers who are neither proved, nor stable and who change their demand each year or just disappear. Slunchev Plod thus strongly needs more “emergency exits” in case of failure of buyer. The limited access to foreign markets weakens the company’s position in negotiations and very often it has to accept unfavorable financial conditions - lower prices and unfavorable payment schemes (most often payment after delivery).

The Bulgarian market is quite difficult, because it is very price sensitive and yet it is not ready to accept the delicacy, high-end products of Slunchev Plod. Nevertheless, delicacy-product shops are being established in the bigger cities and the company should gain its positions there.

Short Conclusions

Summarizing the history of the establishment and the development of Slunchev Plod, we can draw some conclusions about the success of the very hard work of the six Bulgarian professionals who decided to establish a profitable private business:

· a team of food processing industry professionals, possessing significant experience and good contacts. They provide a good example of practical realization of the nation’s intellectual capacity;

· Slunchev Plod produces processed foods, based on traditional Bulgarian recipes and meeting West European taste and quality standards. They have unique recipes for high-quality products, based on raw materials, traditionally produced in Bulgaria (pepper, tomato, eggplant, etc.). Some experts claim that even the taste of Bulgarian tomato is unique. The red peppers also have a specific taste and consistence (they are more fleshy);

· in general, profit margins of processed foods are low and the orientation towards delicacy food products was well motivated (higher profit margins may be reached there). Besides, delicacy foods are usually more labor intensive (unique packing, some manual preparation, etc.) and labor costs in Bulgaria are still low compared to Southern Europe;

· the professionals at Slunchev Plod design and make themselves custom-tailored machines for the production of their own products (pepper baking machine, peeling machine, etc.), which gives them at least two advantages - their machines are unique and they are cheaper compared to comparative producers. The company did not lock huge investments in fixed assets and rather used the cheaper local labor;

53


· the joint venture with CARESBAC Bulgaria AD helps Slunchev Plod secure financial resources and assistance in the field of financial management, accounting, planning. The shareholders of Slunchev Plod state that they are lacking an expert with financial and marketing degree who could participate in the management of the company. The financial management of the company is satisfactory, even though more analytical work is desirable;

· the marketing is of crucial importance for the future success of the company. First, it sells on foreign markets which are not traditional for Bulgarian exports (excluding Russia). Second, the product group of delicacy processed foods requires higher investments in promotion and advertising in order to reach the market niche it is oriented to. The limited contacts press Slunchev Plod to accept unfavorable payment terms and prices. Probably, the company should invest in this field (participation in exhibitions, business trips, advertising in specialized magazines, etc.);

· the management of Slunchev Plod has a clear vision for the company’s future development and they continue to work and develop their business, in spite of the unfavorable economic environment (described in more details below). Certain delays are observed though, e.g. in output growth (up to 2,000 tons sterile cans) and the introduction of new product groups ( production of 500 - 600 tons of dried fruits and vegetables, eventually - frozen fruits and vegetables). More importantly, however, the management of Slunchev Plod has a clear vision that now they should concentrate on marketing and promotion of their goods on existing markets, as well as on the penetration of new markets. Gaining certain market share on the local market would be desirable, but the current situation (decline of consumption, devaluation of local currency, etc.) does not stimulate any efforts in that direction.

Brief Analysis of the Balance Sheet and the Profit and Loss Account

The tables presented below show the financial statements of Slunchev Plod for the last three accounting years - 1994, 1995 and 1996. Amounts in the accounting documents are expressed in BGL, as required by the Bulgarian accounting regulations and standards. Figures were converted from BGL into USD, using the annual average exchange rate of BGL, which may produce significant distortions. To give just a feeling of the order of magnitude of the financial numbers, we present, below the table, the average annual exchange rates of USD for the three years under consideration.

The Balance Sheet

The “Machinery and equipment” item prevails in Fixed assets. The value of machinery and equipment, expressed in USD, is very low because most of the machines are made by the owners themselves and are recorded at their cost value. Inflation was high in 1997, but machinery and equipment have been recorded at their balance-sheet value, which is several times lower than their market value. This offers a convincing example of the adverse impact of inflation on entrepreneurs, when reevaluation of fixed assets is not possible. Depreciation allowances are low, and, to further aggravate the situation, they are based on balance-sheet value (not on market value). Companies are additionally burdened by the fact, that lower depreciation leads to higher Earnings before Interest and Taxes and higher Net Income, hence to higher Profit tax payment.“Current assets” illustrate the specifics of canning industry in Bulgaria - very strong seasonal pattern of production and unfavorable payment conditions with West European partners. The balance sheet shows the financial status of a company as of the end of the year, as required by the Bulgarian accounting regulations. However, the production season of canning industry starts in July and ends in March in the next financial year. The mismatch between the production season and the financial year may hinder the proper financial analysis. For example, “Work-in-progress” (in “Inventories”) presents unfinished production from the accounted period of time, which will be sold during the next year and revenues will be recorded in the following accounting period. Slunchev Plod keeps a relatively high level of “Work-in-progress” - these are jams and pickled products in the process of production, as well as already canned products (in jams or tins), which have a 45 statutory period for quality checking.

54


As we stated above, the unfavorable position of Bulgarian exporters in West European markets is made evident by “Receivables from sales”. Slunchev Plod usually is paid 45 to 60 days after dispatching the products, which, given the difficulties in obtaining credit, seriously burdens exporters. “Other receivables” shows the liabilities of the Government, stemming from the VAT credit, which is usually returned with a delay of several months, even if the company is registered on one-month VAT period. The delay in VAT credit return is accompanied by time-consuming bureaucratic procedures.

“Financial assets” are relatively high, when compared to “Borrowings”. Slunchev Plod has both short- and long-term loans, on which interest is paid; it has significant financial assets in cash as well. The production cycle ends in Spring and as of 31 of December the company is very active - it needs credits for its everyday activity, as well as cash for the payment of materials, packing, transportation, labor, etc. This explains the relatively high amount of cash. The canning industry needs seasonally large working capital and any credit resources are welcome, especially since the access to them in Bulgaria is so difficult and slow. The company has received a subordinated five-years credit from its partner CARESBAC and a revolving (short-term) credit from the Bulgarian-American Investment Fund. In 1994 the credit from CARESBAC is short-term and only in 1995 it is changed into long-term credit. In August 1995 Slunchev Plod receives the revolving credit for the financing of the second half of the season. That’s why, by the end of the year the company has just been using the money and they have been shown in “Short-term loans”. In 1996 the working capital of the company is financed additionally by personal sources of partners, which is recorded in “Other payables”.

Profit and Loss Accounts

The value of turnover is permanently increasing - from 218,000 USD in 1994 to 554,000 USD in 1996 (average annual exchange rates are used). The “Operating profit” figure is acceptable, given the current conditions in Bulgaria (17.4% in 1994, 7.2% - in 1995 and 14.2% - in 1996). It falls in 1995, due to rising costs of materials (they actually triple), while revenues double for the same period. Revenues are generated mainly from sales of goods and services. In 1996 their growth rate is lower - 78%. The remaining 22% are financial revenues from positive exchange rate valuation adjustments. The strong devaluation of the Bulgarian currency in 1996 results in a rising financial income. If accounting was kept in hard currency, this income would not have been registered, nor any profit tax would have been calculated. Slunchev Plod is adversely affected by the fact that it sells in hard currency usually with 45 - 60 days deferred payment. When revenues are received they are accounted for in BGL, at the current exchange rate, which generates profit and draws profit tax payment. The value of cash in high inflation periods is not lost, since payments are received in hard currency, but profit tax is decreasing the funds, which could be used for investment or working capital (simple or extended reproduction of the production cycle). This artificial increase of financial revenues is typical for all exporting companies, working in a high inflation environment.

Since March 1997 inflation has been falling and in May 1997 it stands at 8.9%. The depreciation of the Bulgarian currency has been curbed and from July 1, 1997 a Currency Board has been introduced, whereby the exchange rate to German Mark was fixed (1 DEM will be equal to 1,000 BGL). The impact on exporters will be favorable35, for several reasons: · full internal convertibility of Bulgarian BGL will be introduced; · the fixed exchange rate will eliminate the uncertainty, generated by exchange rate fluctuations;· the Board will be a factor for keeping inflation low. Lower inflation means lower interest rates

and easier access to credit resources. Under the Currency Board entrepreneurs of Slunchev Plod will see their financial risks partially reduced and they will be able to devote their efforts mainly to the production and marketing of their excellent products.

35 A negative effect of the Board may be connected to overvaluation of Bulgarian currency. It is stated that the real exchange rate should be 1,100 - 1,200 BGL. Information is not proved and we does not discuss in particular this question. Any way, if that proves to be true, and will affect negatively Bulgarian exporters.

55


Slunchev Plod and the Business Environment

We should make several points regarding the difficult conditions in which Bulgarian private businesses work and we will use Slunchev Plod as an example:· the Government does not provide any incentives to private businesses, even producers. There are

no preferential credits, no tax deductions, nor other relieves. Quite the opposite: investments are not deducted from profit and profit tax is due on their amount (they are only depreciated); if VAT credit is to be returned to the company, it is delayed and it can only be received after a strict tax report from the tax authority (it takes time and the management is involved each time);

· a related point is that the canning industry is a capital-intensive sector, because significant resources are to be invested in machinery and equipment, while the active production season last for half an year with high capacity utilization and a well-selected product list. The return on investments does not come immediately, which increases the financial burden on an infant private entrepreneurship in Bulgaria;

· agriculture has been destroyed. The transfer of property on land is delayed, neither incentives, nor preferential financing are provided to agricultural producers. The access to bank credits is also limited and difficult. Price fluctuations are rather high for agricultural products and producers are unwilling to fix prices. For that reason the planning of costs is not possible. It is difficult to secure contracts for the supply of raw materials, which leads to difficulties in production planning (alternatively, the company has to rely on incidental suppliers, which is not its policy);

· there are only two state-owned producers of jars (whose products are of low quality). They enjoy a monopolistic position and they even have two price lists - for state-owned and for private companies. It is impossible to negotiate terms, prices or penalties;

· the bank system works against businesses because payments are delayed;· there is a general lack of proper information, concerning the overall situation, expected exchange rates

and inflation; besides, access to market information on prices, contacts, etc. is rather limited;· there is no certification of products according to ISO 9000. The company would like to obtain

certificates for its production, but there is no supplier who would even plan to be certified. That should also be part of a government policy for standardization and certification;

· the business culture in Bulgaria is still low. The contractual terms are often changed or are violated. Only few newly-founded businesses can survive and often they change their field of activity.

Despite these problems the people at Slunchev Plod believe that the situation will stabilize and they will be able to reveal the potential of the Bulgarian food processing industry.

Balance Sheet of Slunchev Plod OOD as of 31 December, 1994 - 1997ASSETS LIABILITIES (th. BGL)

1994 1995 1996 1997 1994 1995 1996 1997A. Fixed assets A. EquityI. Tangibles I. Capital1. Buildings, lands, forests

1. Authorized capital

2,300 6,800 6,800 6800

2. Plant and equipment 348 3,835 3,815 23,960 2. Additional capital 2,700 1,500 1,500 15003. Other 26 521 628 3,446 Group I total 5,000 8,300 8,300 83004. Tangible fixed assets 138 17 6,424 II. Reserves 0Group I total 512 4,373 4,254 33,830 III. ProfitII. Tangible assets 1. Undistributed

profit847 2,394 1167

1. Incorporation and 2. Current year profit

847 1,547 6,869 17393

expansion costs 48 44 62 24 Group III total 847 2,394 9,263 185002. Products of R&D 0 Section A total 5,847 10,694 17,563 26800

56


3. Patents, licenses, B. Borrowingsknow-how, trade marks 19 -14 510 I. LoansGroup II total 48 63 48 534 1. Short-term loans 3,546 11,460 240 24406

9III. Financial assets 2. Long-term loans 3,500 18,276 559821. Participation's 0 3. Debenture and bonds

loans0

2. Other long-term securities

0 4. Other loans 0

3. Long-term loans 0 Group I total 3,546 14,960 18,516 300051

Group III total 0 0 0 0 II. PayablesSection A total 560 4,436 4,302 34,364 1. To suppliers 702 2,740 3,079 95343B. Current assets 2. For participation 0I. Inventories 3. To employees 2 90 2,159 53521. Materials 647 1,443 3,032 56,663 4. To the budget 665 200 2,832 45242. Work in progress 2,538 9,890 20,394 329,664 5. To social

insurance308 41 223 4773

3. Products 3,332 6. Other 371 10 32,514 171442

4. Young and fattening stock

0 Group II total 2,048 3,081 40,807 281434

5. Merchandise and containers 0 150 1,361 III. FinancingGroup I total 3,185 14,665 23,576 387,688 1. Investments 0II. Receivables 2. Other 01. From sales 2,208 4,152 19,766 134,626 Group III total 02. From participation Section B total 5,594 18,041 59,323 58148

53. From shortages and deficits 0 C. Deferred income 04. From arbitration and judgment

5. Other receivables 485 842 4,657 20,013Group II total 2,693 4,994 24,423 154,639III. Financial assets1. Cash in BGL 47 1,427 3,888 11,8942. Cash in foreign currencies

4,953 3,213 3,240 12,135

3. Securities, bullion and gems

0

Group III total 5,000 4,640 7,128 24,029IV. Deferred expenses 3 0 17,458 7,565Section B total 10,881 24,299 72,585 573,921C. Receivables on subscribed shares

0

Total ASSETS 11,441 28,735 76,887 608,285 Total LIABILITIES

11,441 28,735 76,886 608285

D. Off balance sheet assets

0 D. Off balance sheet liabilities

Profit and Loss Account of Slunchev Plod OOD for the period of 1994 - 1997Expense items

1994 1995 1996 1997 1994 1995 1996 1997I. Ordinary expenses I. Ordinary income

57


1. Decrease of products in store

3,330 20,394 1. Net income from sales

19,650 91,365 735389

2. Cost of materials 2. Production subsidesa) materials 4,752 16,563 43,883 651,945 3. State budget grantsb) hired services 2,513 3,079 18,708 129,655 4. Cost of fixed assets 1,6003. Personnel costs 5. Increase of productsa) wages and remuneration

1,788 5,742 11,972 100,622 in store, work in progress

2,538 10,685 10,504 329693

b) social security costs

438 1,152 2,148 21,234 6. Other income 53

4. Depreciation 38 383 1,011 1,782 Total I 2,591 31,935 101,869 1E+065. Other costs 83 309 2,722 24,269 II. Financial income6. Book value of sold merchandise

2,377 3,129 25,185 7. Income from interest

316 160 144 813

Total I 9,612 29,605 86,903 975,086 8. Income from participation II. Financial expenses 9. Income from transactions7. Interest on loans 591 1,117 5,131 26,281 with securities 8. Losses on securities

10. Gains from currency

131 812 29,068 128036

9. Losses from currency exchange rate fluct.

104 148 24,728 153,876 exch. rate fluctuations

10. Other 2,784 9,676 Total II 447 972 29,212 128849Total II 695 1,265 32,643 189,833 III. Extraordinary

incomeIII. Extraordinary expenses 11. From management

operations10. From management operations

20 2 1,255 12. Other 35 1485

11. Other 250 258 35 344 Total III 35 1485Total III 270 258 37 1,599IV. Taxes12. Profit tax 663 267 4,629 11,50513. Other taxesTotal IV 663 267 4,629 11,505Total expenses 11,240 31,395 124,21

21,178,02

3Total income 3,038 32,942 131,081 119541

6V. Current year profit 847 1,547 6,869 17,393 IV. Current period loss 0 0 0Grand total 12,087 32,942 131,08

11,195,41

6Grand total 3,038 32,942 131,081 119541

6

COMPETITIVENESS OF THE WINE INDUSTRY

Background

The wine industry is the most competitive sector of the Bulgarian food industry. It consists of 45 wineries and produces about 12% of the national food processing output. Bulgaria is a major international exporter of grape wines.

Major products of the wine industry are: bottled, broached and table wines - 23 varieties of white and red wine with registered trademarks of origin; 24 types of white and red wine from designated geographic regions; natural sparkling wines; wine distillates; grape must; high-alcohol beverages

58


(brandy, cognac, vodka and sweetened spirits - vermouth, other aperitifs, anise-flavored brandy, mint alcohol, fruit liqueurs); vinegar; tartaric acid; grape concentrate; whisky.

There are wineries in every region of Bulgaria. The highest concentrations are in the Burgas, Plovdiv, Sliven, Haskovo, Stara Zagora and Pazardjik regions of southern Bulgaria, and the Veliko Tarnovo, Targovishte, Pleven, Vidin, Rousse, Shoumen and others regions in northern Bulgaria. The winery of the city of Sofia is specialized in conservation, bottling and marketing. In 1996, 226,404,000t of grape wine were produced, distributed by regions: Burgas - 35.7%, Lovetch - 23.7%, Plovdiv - 13.2%, Rousse - 8.6%, Varna - 8.2%, Haskovo - 7.9%.

The wine industry could be an example of how competitive advantage has been achieved, when founded on tradition, skill and favorable natural resources. Wine has traditionally been an important sub-sector of the food industry in Bulgaria and a key Bulgarian export item. The wine industry in which production is 90% export-oriented has the greatest relative share in sector sales (about 1/3 of the total sales). The transformation process caused a deterioration of the wine sector, and the vineyards under cultivation have dropped from 130,000 ha. in 1990, to 94,000 ha. during last two years. As a result of the efforts to improve the conditions of the wine sector in the last few years, wine grape production in 1996 reached 518,700 tons - about 30 % more than the average 1993-1994 level. Nevertheless, production is still below the annual quantity of 600,000 tons in the 1970s and 80s. There are about 45 operating wineries which use between 40% to 80% of their capacity, and produce 12% of the total food processing output. The installed production capacities are capable of processing some 650,000 — 700,000t of grapes per annum; domestic demand is fully met and a considerable proportion is exported. The principle technology base allows for the manufacture of products which meet all international standards and ensures a closed process cycle. After 1991, bottling line equipment has been mainly imported from Italy. The remaining part has been Bulgarian or imported, chiefly from Germany and France.

Nearly 33% of total wine industry output is routed to the domestic market. The remaining 67% is for export. Bulgaria is one of the major exporters of grape wines. In 1996, grape wine exports accounted for 183,365t, up by 6.54% against 1995.

Bulgaria has signed a special wine trade agreement with the EU. Under this agreement Bulgarian wines enjoy preferential duty treatment, with duties equaling 40% of the basic duty for imports to the EU. The position of Bulgarian wines in European Markets is significant — more than 50% of exported bottled and broached table wines. The major importers of Bulgarian wines are the United Kingdom, Germany, Sweden, the Netherlands, Finland, Denmark, and Belgium. Sparkling wines are predominantly exported to the countries of Central and Eastern Europe — over 94% in 1997; broached wines are mainly sold to Germany. The major exporters of Bulgarian wine are the Bulgarian Vintners Company (BVC), Domaine Boyar, Wine of Westhorp, International Wine Services, and Wine and Spirits International. In 1996, grape wine exports were mainly to Great Britain — 25.4%, Germany — 8.3%, and the Netherlands — 7.1%.

According to Porter’s model, the wine industry could be classified as an investment driven industry. In comparison with the canning industry, marketing is well developed, external market shares have been maintained by high quality and lower price, and there are no objective obstacles blocking access to information.

59


Wine Production, 1996 ('000 liters)

DomesticMarket

33%

Export67%

19941995

19961997

164.7

248.1226.4

136.1

0

50

100

150

200

250

Wine Production (Mln L)

Wine ProductionWine Brand Produced

Quantity Marketing

1996 Domestic market Export'000 l '000 l '000 l

White Wines High Quality 19,903 7,270 12,633Red Wines High Quality 34,525 10,347 24,178Table White Wines (incl. country and regional) 46,830 13,894 32,936Table Red Wines (incl. country and regional) 38,329 16,979 21,350Sparkling White Wines 8,413 1,810 6,603Sparkling Red Wines 180 161 19Low alcoholic Wines 4,372 1,289 3,083Dessert Wines 652 31 621Vermouths 4,215 285 3,930Others 8,705 1,242 7,463

Total * 166,124 53,308 112,816

% 100 32% 68%* Produced amount of wine in Suhindol LVK is not included.

60


Export of Bottled and Broached WineQuantity of Bottled Wine ('000 l) Quantity of Broached Wine ('000 l)

Countries 1993 1994 1995 1996 1993 1994 1995 1996Canada 1,441 1,077 1,386 2,530 0 0 0 0Denmark 615 955 1,829 2,548 0 0 0 0Finland 978 675 592 495 739 624 620 454France 132 326 689 1,528 1,808 3,274 7,846 5,704Germany 2,700 1,281 3,087 7,720 12,038 8,731 10,280 12,077Japan 0 0 0 0 3,056 3,023 7,049 5,343The Netherlands 4,551 5,770 7,301 8,733 18 378 358 517Norway 547 1,559 2,020 3,473 99 621 1,352 919Poland 5,198 3,002 4,259 6,105 0 0 0 0Sweden 1,427 1,477 1,365 1,334 1,593 1,723 1,904 1,555Switzerland 0 0 0 0 532 1,005 799 767Ukraine 586 1,480 6,798 7,787 64 312 991 686Latvia 278 519 1,174 2,857 38 47 152 244Lithuania 53 105 224 396 0 0 0 0Kazakhstan 229 1,314 1,011 2,266 0 0 0 0Russia 13,994 45,198 43,819 13,756 1,836 7,960 10,071 3,398Moldova 35 194 7,470 30,117 0 86 3,487 8,000Gorgia 23 112 750 1,388 38 10 315 679United Kingdom 31,093 28,629 32,463 37,986 2,851 3,375 3,123 2,483USA 737 631 710 1,415 140 47 260 777Others 3,663 3,442 3,721 4,368 643 2,686 2,929 2,960Total 68,278 97,746 120,668 136,802 25,493 33,902 51,536 46,563Source: Ministry of Agriculture, Forests and Agrarian Reform, Association of Wine producers and traders

See: Annex 7,8

DOMAINE BOYAR AD: COMPANY PROFILE

Domaine Boyar was formed in Sofia in 1991. Initially it was registered as a Limited Liability Company under the Commercial Law with a capital of 50,000 BGL, the minimum amount required for registration. In 1997 Domaine Boyar was re-registered as a Joint Stock Company with a new name - “Domaine Boyar Sofia”. In 1991 a marketing company of the same name was opened in London, initially representing four of Bulgaria's most important wineries. By March 1997, this had increased to eleven. Domaine Boyar Limited now supplies most of the key multiple retailers in the UK, and in 1994 also formed a joint venture in Germany, a subsidiary in Belgium and an affiliated office in Denmark. Most recently, in April 1997 the company opened an office in Austria. Domaine Boyar AD is a large private company. The Domaine Boyar team is committed to expanding sales of Bulgarian wine throughout Europe and beyond.

The company main activities during the initial period were directed to wholesaling, retailing and marketing of wines. Domaine Boyar is now enlarging its operating activities in wine production. Firm strategy is directed towards the whole chain - from grape producer’s to wine consumers. Following this strategy Domaine Boyar AD has bought two wine producing plants - in Shumen and in Yambol. In Shumen the company has 80 % of shares and has total control over the wine production. The other owner is a cooperative “Div Dijavol”. They bid in an auction announced by the Ministry of Agriculture and bought the plant. In Yambol the wine plant has been privatized by the employees and managers of the Vinprom Yambol. Domaine Boyar participated in the privatization process and obtained 34% of the shares. This is in fact is blocked quota. Consequently, Domaine Boyar AD is using different approaches of control and management in these two places.

61


Positioning on the markets

Domaine Boyar AD are well known on an international markets. Their activity is export oriented. Domaine Boyar has an excellent image on the UK’s market. They are the main wine exporter there. Bulgarian wines cover 4-5 % of the market in UK. For a lot of years Bulgaria kept fourth position. The invasion of Australian wines moved Bulgaria to the fifth place. The main features of Bulgarian wines that make them competitive on UK market are good quality and low price for that quality. Domaine Boyar export wines in Benelux, Denmark, Canada, Norway. Keeping already taken position on the international markets is very difficult. The competition is very high. The “wine fashion” is dictated by New Zealand, Australia, Chile, Republic of South Africa. They take the offensive to the European markets and displace traditional exporters from European markets. Consequently, prior task to Domaine Boyar is to develop a new strategy.

Domestic market takes only 15 % of the overall activities of Domaine Boyar. There are a lot of obstacles impeding development of domestic growth strategy.

Brief analysis of balance sheets and profit /loss accounts of Domaine Boyar

“Domaine Boyar Sofia” has been registered at the end of 1996, and that’s why a balance sheet for 1997 is available. This do not give opportunity for any comparison and analysis.

Balance Sheet of Domaine Boyar Sofia as of 31 December1997ASSETS LIABILITIES

1997 1997A. Fixed assets A. EquityI. Tangibles 50,778 I. Capital 50II. Tangible assets 0 II. Reserves 0III. Financial assets 1,592,072 III.Financial Result 41,571Section A total 1,642,850 Section A total 41,621B. Current assets B. BorrowingsI. Inventories 276,160 I. Loans 18,504II. Receivables 57,579 II. Payables 365,463III. Financial assets 14,241 III. Financing 0IV. Deferred expenses 26,870Section B total 374,850 Section B total 383,967C. Receivables on subscribed shares

0 C. Deferred income 0

Total ASSETS 2,017,700 Total LIABILITIES 425,588D. Off balance sheet assets D. Off balance sheet

liabilities

Profit and Loss Account of Domaine Boyar Sofia for the 1997Expense items 1997 Income Items 1997

I. Ordinary expenses 666,825.00 I. Ordinary income 774,264.00II. Financial expenses 60,789.00 II. Financial income 26,305.00III. Extraordinary expenses 40.00 III. Extraordinary income 485.00IV. Taxes 31,631.00 Total income 801,054.00Total expenses 759,285.00 IV. Current period loss 0.00V. Current year profit 41,789.00Grand total 801,074.00 Grand total 801,054.00

62


COMPETITIVENESS OF THE BULGARIAN WOOL TEXTILE INDUSTRY

Background

The wool textile industry was the first industry established in Bulgaria, which historically used to be an agrarian country. The first factory was built in Sliven by Dobri Jelyazkov. Several decades later another wool textile industrial center emerged in Gabrovo. Nowadays Kazanluk and Sofia are also considered to be wool textile regions. The fact that the wool textile industry was in fact the first industry built up in industrial terms, with relatively modern equipment and concentration of operations, was the determining factor in choosing it for our study. Traditions dating from the Middle Ages, as well as wide availability of the basic raw material, sheep’s wool, laid the basis for the industrial development of wool fabric production. For five centuries Bulgaria was a part of the Ottoman empire, and during that period its development was limited to the confines of the agrarian sector. Industrial development started later than in other European countries, with the exception of the wool textile industry, which had the necessary raw materials, traditions and skilled labor, as well as access to the Turkish market, very large at that time.

Once the country was independent, in 1894 a law for the stimulation of local industry was passed, under which the government stimulated the wool textile industry by introducing protective duties, lower taxes and import duties for machinery and equipment, easy access to credits and a number of other facilitative industrial production incentives. The result of that positive government policy was that in 1935 there existed in Bulgaria 63 wool textile companies comprising serious industrial potential, concentrated in the regions of Gabrovo, Sliven and Sofia. Up until the Second World War, the wool textile industry grew steadily and was able to pass through economic crisis situations with only a slight decrease in production.

After the Second World War, the country was in deep crisis, with serious reparation liabilities. In 1949 the Law on Nationalization was introduced, and all existing industrial companies were nationalized. The idea was to establish a large-scale industry, for which factories are combined into single large state-owned companies on a regional basis. In the course of nationalization some part of the existing assets were destroyed. In fact, only in the 1960s and ’70s did the modernization of industry start, when new machinery and equipment were imported and installed in the companies. That is when the large-scale production of wool textiles began, because Bulgaria played the role of an industrial supplier of garments to the USSR. For that purpose there were large tailoring companies established, which used wool fabrics to make outer-wear garments. More than 90 percent of the wool fabrics produced were indirectly exported. The planned economy decided what would be produced, how, in what quantity, and at what price. Supply and distribution were centralized. Direct exports were arranged through one or two specialized foreign trade organizations. These are the factors which led the companies to exist in quite an “artificial” environment. These are the reasons for the difficult situation into which wool textile companies fell after the decentralization of the economy and the liberalization of trade. Most of them were not prepared to deal with market economy conditions. They have had to introduce their own supply of raw materials, calculate costs in real terms, introduce financial management and managerial accounting, arrange access to credits and most importantly, to find new markets, because the former USSR markets have disappeared. The Bulgarian economy itself has passed through serious economic and political problems, so there are a number of internal and international negative factors to be overcome. This is the situation now: operation is at 30-35 percent of capacity, no investment is being made, the local market is small and the competition for international markets is strong.

Based on the fact that the wool textile centers are Gabrovo, Sliven, Kazanluk and Sofia, we chose five wool textile companies, which we visited and whose managers we spoke with. The companies

63


whose managers we met were: NITEX-50 EAD, Sofia – Mr. Kolarov, Fintex AD, Gabrovo – Mr. …….., Lanatex AD, Tryavna – Mr. Ryadkov, Katex AD, Kazanluk – Mr. Azalov and Slitex AD, Sliven – Mr. Kovachev. Slitex AD and Katex AD were privatized in 1997. Fintex has been put into insolvency by its main creditor, the leasing company Bulgarlising. Privatization procedures have been started for Lanatex AD, but nobody has privatized it yet. Nitex AD was put on the list for mass privatization (as was Slitex), but only 10 percent of it was privatized, because of the company’s high liabilities.

Factors

The human factor

Availability of work force - as mentioned in the beginning, Bulgaria has traditions in the wool textile industry starting from the Middle Ages and passing through industrialization to the end of the 19th century and beginning of the 20th century. The textile industry was developed at that time mainly in Gabrovo and Sliven and their surrounding regions. Later, factories were established in Kazanluk and Sofia. The wool textile companies existing today are based on the nationalization of already existing smaller private factories, a process started and finished in 1949. For example, FINTEX, Gabrovo, is made up of 15 workshops today, of which 12 used to be private. Initially SLITEX, Sliven, was a conglomerate of five workshops outside Sliven and one workshop in the town. Later, a major part of the equipment was moved to a new site in the town, but some of the out-of-town facilities were still used. The existing facilities, labor and management gave a basis for the further development of the wool textile industry, having a skilled workforce available and traditions in the field.

Even though they did not have any such strong traditions, Kazanluk and Sofia also did not have problems in availability of an educated and skilled workforce, because Bulgaria has a relatively well-developed high school education system. In the '50s and '60s of the 20th century much emphasis was put on technical university education. As of 1996 there are 40 universities and more than 250 technical schools in Bulgaria. In the technical universities there are more than 50,000 students, while in the specialized technical secondary schools there are 145,000. These numbers show that theoretically there is no problem with the education of specialized and skilled engineers and workers. The problem is that over the last two or three decades there was a shift from the traditional light industries, like textiles, to heavy and high-tech industries, like electronics, machine building, and the chemical industry, which were stimulated by Communist government policy. Our discussions proved that nowadays fewer educated young people start work in textile companies for several reasons, including non-competitive salaries compared with industrial companies and the fact that young people prefer to stay in bigger towns with more possibilities for good and well-paid jobs.

These problems are reflected in the unavailability of appropriate people for the second-tier management of wool textile companies. In general, the availability of workforce is a positive factor for the textile industry. Economic crisis and the decline of industrial production have closed down a number of companies. The official level of unemployment is 14 percent, but according to unofficial data it is as high as 20 percent. There is a shortage of work, rather than of workforce. Even though the salary level in wool textiles is lower than in services, energy, construction and some sectors of machine building, it is still attractive for people over 40 years of age with a secondary school diploma. The specialized workers are women, for whom it is the only possibility for permanent employment. The general workers are men who haven’t got high qualifications for other options. The problem indicated above shows a potential shortage of skilled textile engineers, chemists and economists in the near future, who could be the basis of management improvement and the development of the textile industry.

64


Salaries - the average level of salaries in the wool textile industry is around BGL 150,000 per month. It is lower than the average salary level in the country, equal to BGL 190,000. Privatized textile companies report higher salaries, which shows that management and organization in them are more efficient. The share of labor costs (salaries and social insurance) has been varying between 23 and 28 percent of total production costs, based on the P/L accounts of wool textile companies for 1996 and 1997. The figures are distorted by the fact that wool textile companies produce for export using raw materials provided by the buyer. That means that only part of the cost of materials is included in the production cost structure. If all material costs are taken into account, then labor cost’s share would be 15 to 18 percent. Here is the place to point out that very often the factories play a social function; even though production has decreased, the number of employees is not decreasing, as well as the fact that generally too many people have been employed, based on bad organization of production and labor. In a company with better management, the same turnover and production in natural units is reached with 20 percent fewer people employed, which gives the possibility for the company to pay a salary 20 percent higher.

Management - the members of the top management in all wool textile companies are engineers, which is a trend reminiscent of previous years, when production was the most important thing and almost no attention was paid to finances and marketing. Top managers understand changing conditions, but still concentrate mostly on production and investments; they think in natural terms without considering the priorities of the market. The top management consists of a chief executive manager, a production manager, a commercial manager and a chief accountant. Another problem is connected to the constant change in chief executives. Some of the factories, for the period from 1989 to1998, have had at least two or three management changes. The second tier management is comprised of skilled, qualified and experienced people with over 15 years of experience in the field. These are the production/workshop managers and accountants. Commercial/trade managers have been gaining strength since 1991/1992, when the former commercial links of indirect export mainly to the former USSR countries were destroyed. Still, their role is not so strong and active as it should be.

Production factors

Assets - production assets are relatively new for this industry. Most of them (60 to 80 percent, according to their balance sheet value) were put into operation in the 1970s. The remaining part (which varies between 20 and 40 percent, depending on the company) are modern, and have been operating since 1987-89. Only one company reported investments in equipment and machinery for 1997, due to the fact that it was privatized by the Privatization Agency and the privatizing party is obliged by a contract to make US $5 million in investments over five years. On the other hand, the company with the highest share of new equipment is heavily indebted. The new assets were bought on lease from a state-owned leasing company, which in April 1998 put the company into insolvency.

The equipment is relatively modern, but still not enough so to follow the latest developments in the field of the finishing and printing of clothes. Even though in wool textiles the technological revolution has been slower, even compared to cotton textiles, Western European countries have much modern equipment that is fully automated (we have a competitive advantage in this field, with cheaper labor), and most importantly, it can produce higher quality fabrics – stretch, fine finishing, etc. The equipment in Bulgarian factories can produce third-quality and classic types of fabrics, which are much cheaper and used in the mass production of garments.In all of the companies a problem connected to a "bottle neck" of some operations was mentioned — usually they have enough capacity for yarn production and weaving, and lower capacity and quality in finishing and printing.

Privatization procedures: restitution - some of the wool textile companies are based on previously established private workshops, which were nationalized in 1949. Now the law gives the former owners the right to take back the nationalized facilities in real terms. Most of the companies have

65


returned some of the workshops (mainly the buildings), and now rent them from the owners. One of the companies will suffer seriously, because it will be obliged to return most of the buildings and some part of its equipment, which will totally destroy its operation.

Raw materials – the industry was established mainly due to the availability of raw wool. Bulgaria used to be a traditional producer of raw wool; until the middle of the 19th century it worked for the Ottoman Empire. In the ’50s of this century, in correspondence to new market requirements, elite merino sheep breeding was established for the supply of quality wool. In 1991-92 an unsuccessful agrarian reform led to the termination of industrial sheep breeding and the number of sheep decreased from 7.9 million in 1991 to 3.3 million in 1995. Raw wool production decreased from 28,000 tons to 12,000 tons over the same period of time. In 1997 only 1,500 tons were bought by textile manufacturers. The merino sheep herds were destroyed, and if any wool-producing sheep remained, the buy-out and initial wool processing structures were destroyed. Bulgarian producers were reoriented to the import of wool from Russia, Ukraine, Tadjikistan and Uzbekistan, and eventually from Australia. The numbers show a reorientation of supply: in 1992, 177 tons wool were imported, and in 1994, 4,040 tons. This trend is the same for finished products (woolen woven fabrics); in 1992, 433,000 meters were imported, and in 1994, 1,122,000 meters. In 1996-97 the import of raw wool and wool woven fabrics was double the export. Bulgaria transformed from a net exporter to a net importer of raw wool and wool woven fabrics. The numbers show that in 1990, 43.3 million square meters of wool fabrics were produced, while in 1996 production dropped to 13.1 million square meters. The strongest years of wool fabric production were 1985-87, when 57.7-60.3 million square meters of wool fabrics were produced annually.The supply of raw wool is complicated and expensive, because not all producers have direct access to the wool market. They pass through a number of intermediaries, which increases the price of the raw material. For that reason most of them buy cheaper, but lower quality, wool. Some of the companies mentioned that beginning this year they would buy directly from Russia, which would improve their negotiating capability and the price/quality ratio of imported wool.

Supporting factors

Energy – if there was hidden subsidizing of textile production, it was based on low energy costs. Over the last three years electricity prices have increased, and their level is close to international levels. This year the price of gas increased, thus additionally increasing the energy costs of most of the textile companies, which use gas for steam production.

Supporting materials: dyes – there are Bulgarian producers, but their quality is low and producers import quality dyes from Germany and Switzerland. Supporting materials: synthetic fiber – locally produced.

Climate – the climate in Bulgaria is suitable to create a demand for woolen textiles. Woolen clothes are partially substituted for by cheap imports from China and Turkey of low quality sportswear — mainly sports jackets.

Infrastructure – destroyed wholesale structures for the collection and initial processing of wool, as well as for the wholesale of woven fabrics. Up until 1991 these functions were centralized by two or three state-owned companies, which were closed down and have not been replaced by alternative private structures. The collection of wool disappeared, due to the decrease of the sheep stock. The wholesale structure was replaced by a number of small traders, who run two, or maximum three shops.

Capital markets - Bulgaria passed through serious problems in the financial sector in the last decade. At the beginning of the '90s the banking sector was developed by the emergence of a number of banks. The lack of strict regulations for capital adequacy led to most of them being closed down in 1996. Now regulations are serious and the interest rate is lower, but banks are reluctant to give credits due to the high risks connected to general economic terms and the financial

66


stability of producers. If a company fulfills all bank requirements, sometimes the signing of a credit contract is very long and bureaucratic. Beside loans, there are no other developed financial instruments for the crediting of producers. Banks prefer to give credit backed up by a mortgage, covering the credit at 180-200 percent. Wool textile companies use working capital credits, if any. None of them has used investment credits for the last five to seven years, due to low levels of foreign investment and restrictions on the banking system providing capital. On the other hand, the loss of traditional markets and increased competition limits the return on investments and restricts wool textile companies from applying for investment credits. This is a controversial moment, because without any restructuring of the existing companies, something which is connected to credit lines, the industry will suffer more from serious declines in production and lost market positions.

Demand

The history. Local demand had been a driving force in the development of the wool textile industry only toward the end of the 19th century. Manufacturing of rough and heavy wool fabrics and homespun had been established mainly for local supply. Historically, Bulgaria as a part of the Ottoman empire for 500 years from 1393 to 1878 had economic relations with Turkey, and if any industry was developed, it was used for supplying the huge Turkish army. Local demand and supplying the Turkish army were the driving forces for the involvement of more people in wool textile industry. Developed animal breeding and the local availability of wool were strong factors for that. Production was quite primitive, and the finished products were coarse. Statistics show that even in the ’20s and ’30s of this century, fine wool clothes were imported from France, England and Germany, and small quantities of wool fabrics produced in Bulgaria were exported to Turkey and Greece. Until the middle of the 20th century, Bulgaria was an agrarian country, with 80 percent of the population living in villages. Local demand concentrated on thick and coarse fabrics, suitable for winter clothes. The urban population rather used fine imported clothes.

Industrialization of Bulgaria. In the ’50s and ’60s, after the nationalization of the existing assets of the wool fabric industry, the wool textile industry was built up, and its capacity was extended to a degree several times higher than local needs. The communist orientation of development isolated the country from any relations with Western Europe, so imports from those countries had to be replaced by local production or imports from the socialist bloc. The availability of wool gave Bulgaria the role of wool fabrics producer.

The so-called socialist division of labor placed upon Bulgaria the burden of huge production of wool and cotton fabrics. Parallel to that development, a garment industry was developed, and textiles were exported indirectly via the export of finished products (garments) to the USSR. In 1985 (one of the strongest years for wool fabric production), the export of garments reached the level of US $200 million, of which 85 percent was exported to the USSR. Regional cooperation within the socialist bloc ensured Bulgarian producers access to the huge Russian market, but the planned economy gave distorted indicators to the producers who paid attention mainly to the volume of goods produced. Most of the producers did not know for whom and at what price their products were produced, because orders were placed centrally, through centralized foreign trade organizations. Prices were fixed and did not give any real indication of value to producing companies. The only indicator of market demand was the single centralized foreign trade organization for the export of textiles and garments to the West, which placed orders with the factories for exports to Germany, England and the United States. Still, no indicator of value or prices reached the producers, because accounts were settled internally, using a fictitious exchange rate.

The conclusion. Local demand has not been a strong factor for wool textile companies in the last four or five decades. All textile producers used to export indirectly 95 percent of their production, and only the remaining 5 percent was oriented to the local market. Producers were never interested in the level of local demand. Only some leftovers of orders for export were sold locally.

67


Nowadays. Again, wool textile producers export 95-98 percent of their production, mainly to the United States, Canada, Spain, Germany and Israel. Today they would be interested in sales on the local markets; the problem is that local garment production, wholesaling and retailing structures have been destroyed. The former centralized and monopolist wholesalers and retailers have disappeared, and only small traders have emerged since then. Garment producers have serious financial problems, or they have difficult access to working capital, and for that reason they work for export with the fabrics of the ordering party (or the buyer). This is a way to limit the need for working capital to cover labor, overhead and a small part of materials. There are positive signs of interest in locally-produced fabrics, but producers are not prepared to react and satisfy the recovering demand. Their feeling for the market is not strong, and sometimes they stock thousands of meters of fabrics for the local market, which cannot be sold because of their bad quality, boring colors or old-fashioned style.

Limited demand. The economic crisis in the country limits demand to that for basic products. The structure of expenditures shows a decline in expenditures for clothes and shoes, from the average 11 percent of total expenditures in the ’80s to 7.2 percent in 1996. A major portion of expenditure is reserved for food and home maintenance cost – it increased from 40 to 53 percent over the same period of time. The officially reported average monthly salary in the country was DM 180 in April 1998. At the same time the price of one meter of wool fabric varies between DM 8-12. Projections of growth in domestic consumer demand show a slow increase, since it will take time for real earnings to recover from the decline of recent years. Fintex owes DM 14 million in principal and interest. It will be impossible to repay the loan, even though the credit was used in its entirety, for modern, high-capacity equipment. There are several reasons: the change in market conditions and decreasing demand in the former Soviet republics, as well as difficult access to new markets, a lack of local raw materials (wool), and restitution problems. If the company is not split into workshops and/or liquidated, some time will be needed for its recovery.(For example, in the ’70s and ’80s, the costs of the state-owned company, specialized in the buy-out and initial processing of wool, were 20 BGL per kilogram of washed wool, while it sold to the wool textile companies at BGL 5.60)

Strategy, structure and rivalry

There is a general feeling that the world wool textile industry is going through a time of changes and uncertainty. Production capacities are being moved in the direction of Asia — mostly China, India, and Turkey. This puts the Bulgarian producers in a worse position, since labor costs in the Asian countries are as low, while the Bulgarian textile factories cannot match the level of investment in new equipment that textile factories in the Asian countries are making.There is also significant competition from closer international rivals, such as Czech, Romanian, and Ukrainian producers, which compete on both the price and quality margins. Bulgarian managers claim that the Czech Republic is actively subsidizing the local producers, making them competitive, while the Bulgarian government is doing nothing of the sort.

There is no attempt to compete with the world leaders, such as Italy. The explanation is that the Bulgarian facilities are built for satisfying the needs of a mass consumer, cheaply and at lower quality. One of the managers explains that there are three broad quality categories of woolen cloth, the first being the highest and the third being the lowest quality, and all Bulgarian facilities produce the third one. But this was contradicted by other managers, who state that they are also producing fabrics of higher quality, which will put them in the second category. Nobody is aiming at the first category. There is no internal competition, because only one of the factories works well in the local market, while the rest export more than 90 percent of their output. The claim is that the level of Bulgarian demand cannot utilize even half of the production of one of the bigger factories, and that cheap and low-quality non-wool imports are very popular in Bulgaria now. The structure of the Bulgarian wool textile industry includes six or seven firms, four of which are the largest and produce close to 90 percent of the total output. All the managers complain that the world market for

68


woolen textiles and clothes is ruled by a relatively small group of people. At the same time, there is a firm conviction that there is a saturation of woolen textile production capacities on the world scale. This puts the few buyers of woolen textiles in a strong bargaining position, from which they can dictate the terms (prices, quality, assortments, designs, etc.) to the woolen textile producers.

The strategies employed by the Bulgarian wool textile firms are predominantly short-term and price oriented. All the managers express a desire to compete at higher quality, but understand that their main competitive advantage is in the low price for the quality they offer. Many of the managers closely follow the trends in the world markets for the final product, namely the developments of new assortments, designs and fashion preferences on the clothing market. However, they say they have no money for market research, based upon which to try to discover competitive niches based on satisfying specific needs based on quality rather than price. One of the managers said: “I would like to pay to someone to work out a complete strategy for me, but I don’t have the money.”

The Bulgarian managers are trying to find markets through establishing personal contacts with potential buyers at trade fairs (the Interstoff), through professional contacts, and by distributing samples. However, the effort is not very active, and the general feeling is that they are waiting for the clients to find them, rather than the other way around. The managers’ strategic horizon is extremely short. Every single manager named the goal “to survive this year” as their major strategic concern. There were only two exceptions; one manager claimed that he thinks about three years ahead, without being able to act upon his thoughts, and one other said that he actually is working out plan for new investments for the next five to six years. The attitude of the others can be summarized in the claim that they don’t need a person to work out a long-term strategy and the corresponding plan of activities, because even if this person comes up with something definite, they will not have the means to implement it. This means that the Bulgarian wool textile industry does not have a strategy geared toward competing, but only toward survival. This makes it vulnerable to fluctuations in the environment, and basically dooms it in a longer-term perspective, because the new investments necessary for survival in the long run are not being made, with insignificant exceptions.

An interesting observation about the firms’ strategies is that all but one of the top executives had come up through the ranks of the industry, and specifically from production. The sole exception was a person from outside, with a formal education in economics, and he was the only one who talked about the importance of marketing studies and strategic advice.

Another interesting observation is that the only firm which has actual investment plans for the next several years was privatized through cash privatization, and bought by a firm that is closely associated with one of the Bulgarian banks. This is also the only firm in which cost cutting and energy saving programs are already in place, and it produces its output using about 20 percent less workforce than its comparable competitors. So the evidence seems to suggest that ownership matters when it comes to strategy.

The Cluster

The cluster of related industries, firms and production procedures around the Bulgarian woolen textile industry is in relatively bad shape. During the years of the planned economy, the whole process of wool production, wool processing, cloth production, clothing manufacture and export to the COMECON countries, mainly the USSR, was managed by people and organizations outside of textile production, mainly the Ministry of Industry, the clothing manufacturers and the export monopolies in Bulgaria, and the Ministry of Trade and the large wholesalers in Russia.

After the collapse of the COMECON in 1990, two devastating things happened to this cluster: first, wool production in Bulgaria collapsed, many of the merino sheep herds were exterminated or exported abroad, and thus the local raw wool base disappeared; and second, the Russian market diminished and almost stopped buying Bulgarian clothing. At the same time, the state monopoly structures in Bulgaria were demolished, and the connections between the different links of the chain

69


disappeared. The industry found itself weightless, having lost its supply base and its single major market. Given this situation, it is amazing that most of the factories are still operating. At present, the supply of wool is mainly from Russia, but the prospects there are not very good. First, the Russian market is subject to a strong presence of organized crime, which does not allow competition. Second, the number of sheep in Russia has been decreasing as well, the quality of the wool has been falling, and the price rising. This makes Australian wool, which is of high quality but expensive, ever more attractive. In any case, the disappearance of local wool production, which was a major part of the Bulgarian woolen textile industry cluster, has put the Bulgarian firms in a much worse competitive position than they used to occupy.

None of the managers of the textile firms even suggested that backward integration toward wool production might be possible, even though there are some high-quality merino sheep herds left in northeastern Bulgaria. It seems like it would be a good competitive move to integrate backward, buy merino sheep, expand and try to improve the quality of local wool production, and compete on this basis. Such an approach would be a consistent solution to the raw material problem, which has plagued all Bulgarian wool textile firms in the last decade. It would provide Bulgarian producers with yet another competitive advantage, because one of their more important markets, in which they are trying to expand, is the European Union, which requires a certificate of the origin of imported goods. Since the wool comes mainly from Russia, it creates a serious paperwork problem, which will disappear if Bulgarian wool production is revived.

Instead of such an approach, the firms have oriented themselves toward working with the client’s materials; i.e., in providing services to the “kings” of the industry. This behavior is consistent with the short-term horizon of the decision makers. Another problem in the cluster is the lack of financing. To illustrate the importance of this issue, it should be mentioned that the only firm in the branch, which has more-or-less stable access to financing, is the only one in which the outlook for the future is calm and relatively optimistic. In other words, such a form of horizontal integration seems to be improving the competitive situation of the firm in question. The lack of finances, however, is an exogenous problem for the Bulgarian woolen textile industry – it is a characteristic of the overall business environment in Bulgaria, reducing the competitiveness of the whole Bulgarian economy. The textile managers are trying to circumvent the credit deficiency by using different informal personal connections and by delaying payments to suppliers for as long as they can. This, again, is a short-term solution, and can only lead to lower competitiveness in the future.

A third problem behind the cluster is the education of specialists. The educational system in Bulgaria has suffered through the transition years, and attracting good specialists is not easy. The textile firms, with one exception, claim that they recognize the problem, but do not possess the necessary means to invest in their own cadres. It seems that there are unexplored opportunities on this front, because the level of special professional high schools and higher education in Bulgaria is still high, and there are still good specialists who can provide the necessary training. A very important direction in which the cluster may improve is by forward integration; namely, by merging with clothing manufacturers. At the present moment, the Bulgarian textile factories and the Bulgarian clothing manufacturers do not even talk to each other, with only one exception. The bigger textile factories do not even notice the potential local partners downstream along the production chain. The textile firms produce fabrics for foreign clients, while the clothing manufacturers produce clothes also for foreign clients – separately.

It is claimed that an important hurdle is the Value Added Tax (VAT), because wool is imported as a temporary import without paying VAT, and after the cloth is ready, it has to be exported, otherwise VAT will be due. So the textile producer has a strong disincentive to sell to Bulgarian clients. This problem can be overcome by forward integration, because then the wool will never leave a single firm, and thus no VAT will be due. Such a development is not to be seen in the cluster, however. The continuing situation involves everybody fending for himself. There are significant problems in establishing long-term relationships with the other members of the cluster.

70


Every one of the firms is trying to keep clients for more than a year, but even the ones which succeed cannot lure them to sign contracts with a duration of more than a year. This makes the whole cluster extremely fragile, nervous, and characterized by a low degree of trust and confidence in both the market and the partners. The level of cooperation between related organizations is also low, and this not only reduces productivity, but threatens the livelihood of many of the firms.

In conclusion, it seems that the cluster around the Bulgarian woolen textile industry is not well developed. Its performance may improve dramatically if vertical integration takes place, or if at least long-term relationships with mutual trust are established. This is not the case at present.

Government policy

The general feeling in the industry is that if the government helps, things may get better, but if it doesn’t, they won’t. In this sense, the government’s policy toward the textile industry, and toward industry in general, appears to be important, and needs to be formulated and explicitly stated. Managers still seem to rely heavily on the state, while the state is not giving a definite signal as to whether it will “help” or not, and if so, how.

The major problems for the textile industry in terms of its relationship with the government are the heavy tax burden and the tariffs on imported materials, especially the ones which are not produced in Bulgaria. Another point of criticism about the government is its inability to create a business environment conducive to productive activities and characterized by low inflation, stable exchange rates, and predictable policies. All of these desires, however, seem to have been met, at least to some extent, during the last year, but none of the managers noted it.

It seems that some of the institutional arrangements are very damaging to the industry. In first place, the VAT exemption for temporary imports creates a potentially serious barrier to the possibilities for building a cluster based on imported raw wool. This is due to the fact that the wool fabric producers have a strong incentive to import wool temporarily, not paying VAT for the temporary import, process it, and sell it to a foreign client in one of the free trade zones, which counts as an export. Then the foreign client contacts the Bulgarian clothing manufacturer, and again under the temporary import regime, VAT is not paid. The problem is that this arrangement prevents the creation of a cluster and introduces the foreign agent as an additional link, whose sole purpose is to help avoid VAT.

Thus, the VAT tax regime blocks the forward development of the cluster. At the same time, none of the managers seems to feel that this is an incentive for organizing the cluster backward and improving raw wool production within Bulgaria. The situation with the required certificate of origin is similar. This requirement for importing goods into the European Union is burdensome to Bulgarian wool fabric producers, because their raw wool imported from Russia comprises more than 20 percent of the value added in the final product, so that it cannot be considered a Bulgarian product under European Union standards. It seems like the managers are waiting for the government to do something about it, while they themselves are, once again, ignoring the incentive to help develop the local raw wool production base.

It seems that the major task of the government regarding the woolen textile industry in Bulgaria will be to privatize, to enforce hard budget constraints, and generally to create a stable environment. However, in order for the industry to become competitive in the world market, it needs to develop a cluster, and the government may help in this respect only by providing the necessary institutional arrangements — for example, resolving problems related to the temporary imports VAT regime.

71


See: Annex 9

SLITEX JSC, A CASE STUDY

Background

Slitex AD is the biggest joint stock company for the production of wool textiles in Bulgaria. It has a full production cycle, from the input of washed raw wool to the finished fabric, including a small tailoring workshop.

Slitex AD is located in Sliven (central-eastern part of Bulgaria). The town is considered to be one of the three textile centers in Bulgaria, with a high concentration of wool and cotton fabric production. Sliven is also the town with the earliest traditions of organized industrial wool textile production. The first wool processing factory was established in 1834, which makes it the fist modern industrial enterprise in Bulgaria, and at the beginning of the 20th century there were seven factories.

The history of Slitex began in 1891, when the private company “Andonov & Mihailov” was established. It existed until December 1947, when nationalization occurred and the communist government took over the company from its owners and made it a state-owned one. At that time, the company was the biggest textile company in the country, with modern (for its time) machinery and equipment, a full production cycle and a developed wholesale network in Sofia. The number of employees in the 1940s reached 460.

From nationalization in 1947 until 1953, the company operated without any changes. It was managed by a managerial team, and was given a new name: “Georgi Dimitrov.” It was considered to be owned and run by the workers (a statement which seems quite populist today, but is actually not far from the truth for that period). The years 1954-59 were a period of the concentration of production and enlargement of existing companies into the so-called “combinats” (combined factories). Slitex became the core of the established wool textile combinat, in which were involved another six companies. The company was moved to a new site, where it still resides. The machines and equipment were moved, production continued and was concentrated at five sites; two within Sliven and four outside of town. In fact, the transformation finished ten years later, in 1963, when all of the new construction works were completed.

In the ’70s and the beginning of the ’80s, a fair amount of new machinery and equipment was installed for the replacement of already exhausted nationalized equipment. At that time the so-called socialist integration was being built up, and the Bulgarian woolen textile industry was oriented toward the huge USSR market indirectly, based on sales to tailoring companies which exported the finished garments to the Soviet Union. At the beginning of the 1980s annual production reached 9 million meters, and production capacity was in full use.

As of 1982, the company was producing 16 percent of the country's wool textile production and 25 percent of its wool fabrics. The production program covered all types of worsted and carded fabrics, blankets, worsted and carded yarns, as well as curtains, industrial nets, shoe fabrics and other industrial products. It was one of the first companies to start using wool in combination with cellulose and synthetic fibers. The number of employees at that time was 4,500 people.

The year 1982 was the company’s peak, and merits an analysis of what made the success of the company possible. It had been developing successfully for the previous 15 years for the following reasons:

1. The assets obtained by nationalization were in a good shape and presented a stable basis for further development. In the '70s the development of light industry was still attracting some of the attention of the central planners, and these became the years when the old equipment was replaced by more modern machines, imported mainly from Poland, the GDR, and West Germany. Later, in the late '70s and the early '80s, the communist regime started stressing the importance of heavy

72


industry. Therefore, no investments were planned for the so-called light/textile industry, which was considered less prestigious according to communist doctrine.

2. The eastern part of the country used to be a big sheep breeding region, and all the needs for raw wool were satisfied by local and regional producers. In the '70s, the chemical industry started the production of synthetic fibers, which became another input used by Slitex. Thus, the resource base was in place, and the command system provided for the stability of the supply relationships.

3. Woolen textile production traditions were very strong, especially in the Sliven region, where there existed special technical schools, and a relatively cheap and well-qualified labor force was not hard to find.

4. The energy used by the factories in their production was obtained at highly subsidized prices. They were fixed at a central level, without following international prices and relations. A large part of the oil and gas for the industry was bought from the USSR at preferential prices or through barter deals.

5. Investments were centrally-planned and provided. There was no need for investment credits, and working capital was limited because deliveries and sales were often centrally distributed.

6. Wholesale and retail infrastructures used to be quite well-developed, despite being concentrated in the hands of one or two monopolistic state-owned structures. The greater part of production was oriented toward garment manufacturers, through a very strictly centralized organization, under which the so-called “economic unions” were the “umbrellas” above the producers in a given industry, and were responsible for the placement of the output. Direct export to Western European and American clients was carried out through another monopolist: Industrialimport (a state-owned foreign trade organization, which made the chain shorter, but completely isolated the textile manufacturing factories from contact with the final consumers of their products). The internal market was small, because the orders for direct or indirect export were almost completely using up the existing capacity. Nevertheless, at that time there was a good variety of wool fabrics on the domestic retail market.

7. Demand was organized by the trade intermediaries, and Bulgaria was given a major role in woolen textile production within COMECON, so that Slitex did not have to worry about placing its output — even when producing at full capacity.

When the political changes began in Bulgaria in 1989, Slitex began to suffer, together with all the rest of the woolen textile industry. With the beginning of land reform and land restitution, many of the high-quality merino sheep herds disappeared — they were either exported or destroyed — due to the lack of ability on the part of the old socialist agricultural organizations and the new private owners to support them. Thus the woolen textile industry lost its domestic raw material base.

Almost at the same time, around 1992, the Soviet/Russian market disappeared. Here the problem had two sides. First, the Russian market stopped relying only on Bulgarian clothing and became the target of other competitors. Second, the monopolistic structures ensuring the placement of the output of Slitex were dismantled, and the company was left to fend for itself, without any experience in the marketing of its products. Thus, in a sense, within two or three years Slitex lost almost everything it had behind it and next to everything in front of it, along the value-added chain.

At the same time, the deteriorating condition of the Bulgarian economy made credit very scarce, and new investment became almost unthinkable. The well-developed network of technical schools and universities also began to lose its ability to produce qualified professionals during the economic crisis. Also, many of the better young specialists opted to leave the country and seek employment abroad. In short, every aspect of the textile cluster suffered severe setbacks.

Current situation

73


The response of Slitex to the severely worsening business environment was to decrease production, and by the mid-1990s Slitex was producing around 40 percent of its maximum output during the ’80s, or around 3.5-3.7 million meters of wool fabrics per year. Its production is nearly evenly split between worsted-type and carded fabrics consisting of 100% wool, combined wool-polyester and wool-polyamid. Apart from this main production, Slitex also produces small quantities of blankets, knits, and men’s trousers. The production cycle is three to four months, which is considered slow, and decreases the turnover. At the same time, demand is highly seasonal, with all the major clients buying between December and June, and placing no orders during the other half of the year. The slow turnover coupled with the seasonality and fluctuations in demand account for much of the firm’s financial trouble.

Production is mostly geared towards export; around 70 percent of the output is exported, either as cloth or as clothing. Slitex’ foreign markets are predominantly the United States and Canada, less so to Western Europe, and during the last year, to the Ukraine. Slitex is the biggest Bulgarian exporter of woolen textiles to the United States. The exports are made both through direct contacts with foreign clients and through the services of the intermediaries who inherited the previous monopolist Industrialimport. The other 30 percent of output is sold on the domestic market, mainly through direct sales to retailers.

Slitex owns about 30 percent of the woolen textile production capacity and produces around 25 percent of all finished woolen materials in Bulgaria. This makes it the largest player in the Bulgarian woolen textile industry. Its main competitors are Katex AD from Kazanluk, which specializes in worsted fabrics and holds a share of around 20 percent of the country’s finished woolen materials production; Fintex AD from Gabrovo, which produces worsted and carded fabrics, as well as knitting yarns, but is in a very complicated financial and legal situation, which has led to a decrease in its production share down to 15 percent of all woolen finished materials; and the smaller Nitex-50 AD from Sofia and Lanatex AD from Tryavna, which jointly hold a share of about 20 percent in the production of finished woolen materials.

Slitex was included in the mass privatization program, as a result of which it was privatized by the Doverie (Trust) privatization fund, which ended up owning BGL 672 million of its registered capital, or 57.5 percent. The new owner has introduced some changes in management, and is trying to develop a strategy for the firm. Over the last three years (1995, 1996, and 1997), Slitex has recorded increasing profits, even though their sales, denominated in US dollars, have been declining. The major reason for this is the foreign currency crisis of 1996 and 1997, when net profits ballooned due to purely financial exchange rate adjustments. This is not expected to happen in 1998.

At the same time, at the beginning of 1998, the book value of firms’ assets in Bulgaria was adjusted for inflation, and increased several times, which will increase depreciation and decrease the profits of all firms, including Slitex. It will not be a surprise if Slitex records a loss in 1998, even if its management does everything right.The production costs of the firm are approximately evenly split between wages and benefits, production materials, and energy and overhead. Slitex employs 2,300 people, and the average monthly wage is BGL 140-145,000, which is close to the national average for this branch of the textile industry. The number of administrative personnel is around 100 people. There are plans to downsize, on both the production and administration levels.

The Interview

On May 19, 1998, at around 2 p.m., Dipl. Eng. Ivan Kovatchev of Slitex granted an interview to a team of experts. His previous position was as managing director of Slitex, but the new owner appointed him as a treasury officer, and appointed an economist as managing director. One interesting circumstance about this meeting was the fact that all requests for it were continuously declined, until Mrs. Magdalena Kotupova, a representative of the Doverie fund, i.e., of the owner,

74


organized it. She was also present at the interview. Another interesting detail was the presence of a member of the board of directors of the firm, who was previously a member of the economic police. He did not take part in the interview, and did not present a business card.

The beginning of the interview showed a certain lack of regard for tradition, as the information that one of the members of the interviewing team was a distant relative of the founder of the woolen textile industry in Sliven, Dobri Zhelyazkov, was met with complete indifference. Then, while reviewing the recent history of the firm, Kovatchev expressed a strong feeling of nostalgia for the 1980s, when Slitex was able to spend large amounts of hard currency annually for new equipment. Another strongly expressed feeling was the displeasure of being “in the hands” of suppliers (“The Russians are constantly raising the price” of raw wool), and of wholesalers (“The whole market is run by a small group of Americans”). In response to a question about company strategy, Kovatchev answered with a wry smile, aimed at the owner’s representative: “The strategy is to survive this year, after the last one.” At the same time, his answer to the question about the price strategy of the firm was: “None of the prices are good.” These two very interesting quotes go a long way toward describing the overall strategic situation of the firm. There is a definite lack of a pro-active approach, and a lack of market thinking and recognition of the fact that market prices provide signals according to which optimization may be achieved. The same attitude was displayed in Kovatchev’s answer to the question of whether the firm is interested in devoting personnel and resources to developing a long-term market strategy: “We don’t have the money, and we don’t need such people, because we ourselves can do what they would do.” In a sense, this quote contradicts the previous one, because it is difficult to imagine that a strategic consultant would ever claim that none of the existing prices are good. It is also difficult to imagine that the same person or persons whose main concern is to survive this year will be very effective in devoting some part of their time and efforts to the creation of a long-run strategy.

Another telling moment in the interview was the description of the relationship between the Slitex management and the local energy suppliers. Generally, Slitex pays its bills regularly, but when it is late sometimes, the suppliers’ managers “show an understanding about our situation,” because “we have known each other for a long time.” The attitude is generally the same when talking about servicing bank credits. It shows that Slitex is making an attempt to soften the hard budget constraints through the use of old friendships and personal relationships, and this is still another indicator that the management’s thinking is geared toward solving short-term problems around the market rather than investing in a long-term reputation through the market.

The Diamond

The analysis of Slitex AD, based on the data from the firm, its performance, the company history, and the interview, allows for the composition of a qualitative estimate of its competitive situation, based on the methodology of Michael Porter. Under this methodology, the competitive position of the firm on the international markets, as well as that of the industry or of the economy as a whole, is evaluated by analyzing its situation within four aspects of its business environment: the factors of production; strategy, structure and competition; the characteristics of domestic demand; and the cluster of related industries. The following summarizes these four elements of the competitive situation of Slitex AD.

Factors

1. Available workforce - there are traditions in the region, a specialized secondary school was opened, as well as a number of high schools around the country, which ensure an educated work force.There is still a qualified work force available in the region, even though salaries in the factory are relatively quite low. In an average size town, such as Sliven, the unemployment rate is relatively high, because most of industrial companies slowed down and reduced their workforces during the period of economic transition. Middle-aged workers prefer to work for a lower salary, but have a

75


somewhat secure income. But for those who are younger, the possibilities offered are not so attractive, and they still move to bigger towns, or go to the private sector, or the gray economy, or leave the country. Thus, the turnover rate of the workforce for Slitex is relatively high, especially for young specialists, which hurts the overall quality of the labor input. The situation of the labor force in the firm has a neutral effect on its competitiveness: labor is well qualified, but not highly paid and not very productive (Slitex produces lower output with more workers than one of its major competitors, Katex).

2. Management - the former executive manager used to be an engineer. Recently he was appointed as a treasury officer and an economist was made the executive manager, who still needs time to get to know the business Maybe this change will improve the management of the company and more attention will be paid to finances and marketing. The company was recently privatized by mass privatization, and a privatization fund acquired 58 percent of its shares. Representatives of the fund sit on the Board of Directors and control it. Slowly, efforts are being made for better financial management, as well as for the establishment of contacts with foreign clients. Recently, the privatization fund was transformed into a holding company, giving it the possibility to give credits to its subsidiaries, such as Slitex. This factor also has a neutral effect on the competitive position of the firm, as there is a high turnover rate, especially on the second tier specialist level, and the top officers are good production specialists, but leave a lot to be desired in their approach toward the market.

3. Assets - are still in an acceptable shape, due to slower physical and technological depreciation. No investments have been made since 1987, when equipment was imported for the last time. The equipment available is suitable for the production of average-quality fabrics. There are bottle-necks in some operations connected to finishing works, which improve quality of the cloth (such as aperture, printing). To reply to new requirements of the wool fabrics markets, new machinery is needed, or at least there is a need to introduce new technologies of production. The lack of a clear strategy is part of what stops the process. In this respect, one positive factor is the fact that privatized companies can use profit tax exemption for five years, starting from 1997, if new investments in long-term assets, such as machinery and equipment, are made. Slitex has used this profit tax exemption and will have to make new investments for exempted value. The problem is that in the textile industry machines are expensive relative to the amount of the exemption, and it cannot cover all the investment needed. Despite their age, and the need for new investments, the machines and equipment are not a great impediment to the competitiveness of the firm, and their effect is evaluated also as neutral.

4. The raw materials situation of Slitex is unfavorable. The collapse of domestic raw wool production made the company shift its orientation toward imported Russian wool, which it buys in Bulgaria from specialized trading companies. The quality and quantities of Russian wool produced are decreasing, so prices are going up. Small quantities of Australian wool are used for the production of high-quality fabrics. Generally, there is imported wool available, but while it is not bought directly from the producer or from a big dealer, its prices are higher. Slitex buys washed wool from a company that is located on the same production site and used to be a part of Slitex. This "wool washing" facility was taken quite artificially from the company and quickly privatized, so Slitex buys washed wool from it at a higher price. Another reason for the higher price of washed wool, as well as of wool tape (imported from Hungary, France, and Italy) is the insufficient negotiating capability of the management, as well as purchasing in small quantities because of the shortage of working capital. The overall evaluation is that the raw material input situation has a negative effect on Slitex’ competitiveness .

5. The climate in Bulgaria, and specifically in the Sliven region, is favorable for woolen textile production. It allows for the breeding of merino sheep, and the reasons merino wool is not produced are not related to the climate. The moderate climatic conditions also allow for relatively low costs of preserving the constant temperature within the workshops, which is technologically

76


necessary to the production process. The climate has a potentially positive effect on the competitiveness of the firm, if it invests enough to be able to utilize this advantage.

6. The situation with the wholesale and retailing infrastructure is one of the basic problems of the company. It was taken out of the former "sterile and artificial" socialist situation, in which there was no market and sales were centrally organized. The absence of any larger wholesalers and retailers prevents the company from making a serious presence on the internal market, and it sells irregularly to small buyers. This factor has a negative effect on the competitiveness of Slitex.

7. Communications facilitate improved production and lower transaction costs, through adequate telephone and road communications, but they still need a lot of improvements. These infrastructures have a neutral effect on the competitiveness of the firm.

8. Energy prices have nowadays reached the world level, and energy costs are part of the increased cost structure. It is difficult to follow the share of energy costs in the total cost of production, because the company has its own steam production station and produces the steam itself, thus included in costs of materials. Energy costs amount to approximately 4 percent of production costs. Nevertheless, the share of energy costs is lower than in other companies. Given the good “relationships” with the managers of the local power producers, the energy factor has a positive effect on the competitiveness of Slitex.

9. Capital markets - they were not important earlier, because in the planned economy the role of money and capital was limited. Nowadays the company is using working capital credits from two banks, Raiffeisen and Biochim. It has well-established relations and easy access, because it is the biggest industrial company in the region with good financial indicators. The high interest on credits in 1996 and 1997 increased the financial costs of Slitex. In 1996 it paid BGL 247 million at an annual turnover of BGL 2,243 million (11 percent), in 1997 — only 1 percent of revenues. It seems the company tries to limit its use of credits. Other financing instruments are not used. The overall access of Slitex to financing has a neutral effect on its competitiveness.

Conclusions

Summarizing the evaluations of the effects of all production factors, the conclusion is that, qualitatively, this side of the diamond has a neutral effect on the competitiveness of Slitex AD.

See: Annex 10

77


RECOMMENDATIONS

Below we would like to focus on recommendations in their applicability to the region, taking into account current crisis and ideas for post-war Balkans. The individual countries recommendations must be outlined at a later stage, say in July, when it will be clear what individual governments manage to accomplish in the first half of 1999. Also we would like to add recommendations for the donors’ support to business studies and business associations, we think civic structures like guilds, chambers of commerce, universities and public policy institutes, being part of IFI’s, multi- and bi-lateral programs, have an important role to play in promoting competitiveness.

A) Re channeling regional assistanceVision of region’s competitive precondition · low tariff barriers; · competitive market environment; · free exchange of goods, services, capital and ideas; · utilized market potential of about 110-120 million (including Turkey);· well functioning infrastructure; · easy accessibility of all the sights and corners of the Balkan peninsula,· stable and transparent exchange rate mechanism (preferably, currency board regimes) and

transparent and stable prices.

CoopereationRespective efforts should aim at facilitated access to outside markets and of outside capital to local markets and cross-country co-operation of businesses and specific industry sub-sectors, and need to pass the following stages:

· to secure regional and individual countries political stability;· to agree on joint strategies to strengthen regional economic order;· to negotiate and skip “national” preferences for selected sectors; · to enforce open public procurement procedures; · to facilitate trade through lowering tariff and non-tariff barriers

IFI’s “regional” approach“Regional” means provision of external financing on the pre-condition of implementing regional cooperation rules of the game, institutional design and transparency. The underlying principle of the international players’ attitude should be: related to individual country circumstances approach, provision of funding under the condition to implement policies that benefit the region and its links to international markets. Countries effected by the Kosovo crisis should have “priority” position in IFI’s cooperation, provided deteriorated performance is due to external factors. Principles of the EU single market do not contradict policies that would be good for the post-war Balkans. There is no conflict with the declared policies of the IFI’s either.

Economic policy instrumentsAs in the case with Bosnia and Herzegovina, in the new aftermath of the crisis, FR Yugoslavia, respectively Kosovo and Montenegro, would probably be implementing rebuilding and stabilization programs.A “stability treaty” for others will have features already formulated at different fora (EU finance ministers, IMF and the World Bank Board Meeting, EBRD Annual Meeting, G-8, UN ECE, etc.):

· political and investment guarantee schemes;· financing infrastructure (say, creation of a Balkan Infrastructure Association);· support for the balance of payments; debt forgiveness;· structural reforms and development programs;· free trade and payment agreements.

78


Policy guidelines would secure:· leading role for the private sector and foreign investment,· transparent procedures for granting and implementing projects.

B) Re support to policy institute and business associationsThe general recommendation is to focus research of facts and achievements in competition world-wide. Services extended by business associations to members and the community as such should aim at improving and promoting competitiveness. If this mission is not followed, we will be witnessing a repetition of the phenomenon described above: chambers and guild seek to defend monopoly position.More concretely, support to both business associations and studies should been performed to identify to what extent business and professional associations manage to advocate and promote change (sustain) for:

1. Competitive business environment. It is also important what the term “competitive” means. In Bulgarian everyday business language it refers to: anti-trust regulations (when legalistic view is used) and cheap labor, resources and currency. Contemporary competitiveness is based rather on:· innovation,· clustering,· uniqueness (of goods and services offered),· quality,· rivalry as a business strategy,· low transaction costs that promote flexibility (as background factor).2.The latter foundation of competitiveness requires efficient functioning market institutions. Institution of special attention here would be registers, capital markets, commodity exchanges, land markets, etc. 3.Elasticity of prices. This is to mean lack of government intervention in price setting.4.Low costs of information supply and low transaction costs. In general, this implies access to information, reduction of regulation and bureaucracy and coordination between government institutions5.Easy access to the market and the factors of production. This could be achieved through abolishment of monopolies, licensing or special privileges to business or professions.

In order to facilitate the assessment of what is good and what is bad for the promotion of competitiveness and the knowledge support to businesses, we attach a comparison of pro- and-non-competitiveness ways of thinking.

79

COMPETITIVE ADVANTAGE OF REGIONS - …ime.bg/pdf_docs/papers/C-A-R.doc · Web viewThe economic recession will not stop soon; there is no growth in the real sector despite the financial

Documents