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 Table of Contents

RESEARCH ARTICLE
The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and
Ambiguous Business Environment ................................................................................... 9
Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’
Behaviour ........................................................................................................................ 43
Guy Waizel, Adriana Zaiț
Interconnectedness of BRICS Financial Markets: A Spillover Analysis ........................ 63
Premananda Meher, Rohita Kumar Mishra
Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and
Unskilled) in the Indian Manufacturing Sector ............................................................... 81
Arpit Gupta, Kashika Arora
Real Exchange Rate Misalignment in Monetary Policy Constrained Economies:
Evidence from Eswatini, Lesotho, and Namibia ........................................................... 103
Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
The Russian Economic Environment and the Collapse of the Soviet Union: A
Retrospective Look ....................................................................................................... 127
Thomas L Bradley, Paul B Eberle

CASE STUDY
Property Tax in Bulgaria – The Need for Updating the Tax Base ................................ 161
Desislava Zheleva Kalcheva, Daniela Ushatova

PHD RESEARCH
The Importance of Affordable Housing in Terms of its Definition, Changing Image and
Reframing in Society ..................................................................................................... 199
Brigitte Steinhoff
Motives Affecting the Professional Image of the Medical Imaging Technician Profession
....................................................................................................................................... 213
Sarit H. Malul Markovich
Banking Service Recovery Strategies: Enhancing Relationship Quality and Behavioral
Intentions ....................................................................................................................... 227
Attia Abdelkader Ali

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 RESEARCH ARTICLE

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NonCommercial-NoDerivatives 4.0
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 Volume 17, Issue 1/2024, pp. 9-42
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0001

THE REASONS UNDERLYING THE PRESENT HIGHLY

VOLATILE, UNCERTAIN, COMPLEX AND AMBIGUOUS BUSINESS
ENVIRONMENT

JEFFREY YI-LIN FORRESTi, YONG LIU ii, ROGER A. SOLANO iii

Abstract: To help develop reliable managerial strategies in the VUCA environment, this
paper examines what unprecedentedly happened in recent decades that made the
environment appear. It demonstrates, among other results, that (i) the increasing attention
towards economic development and the formation of cross-regional economies of 1990s
made the business world more volatile than before, (ii) the massively increasing
competition and the advent of internet in 1990s represent one critical reason for the
business world to experience worsening uncertainty, (iii) the increasing use of partially
reliable or totally unreliable knowledge since the 1990s made the business world more
complex than before, (iv) the accelerated circulation of information since late1980s
motivated decision makers and scholars to shift their knowing from the realm of thinghood
to that of systemhood. That shift led to the appearance of various ambiguities for business
professionals to face. This paper concludes with managerial recommendations and
questions for future research.
Keywords: competition; competitive advantage; economic development; internet; market entry;
organizational efficiency; World Trade Organization; VUCA
JEL Classification: F63, M21, O11

1. INTRODUCTION
VUCA is an acronym that started to appear in the business lexicon at around
the turn of this new millennium; the VUCA environment, which stands for a state of
the business landscape with high Volatility, Uncertainty, Complexity, and

i Department of Accounting Economics Finance, Slippery Rock University, Slippery Rock, PA

16057, USA; email: [Link]@[Link]
ii School of Business, Jiangnan University, Wuxi, Jiangsu 214122, China; e-

mail: clly1985528@[Link]
iii Department of Management and Marketing, Slippery Rock University, Slippery Rock, PA 16057,

USA; email: [Link]@[Link]

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 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
10

Ambiguity, challenges confident diagnoses and befuddles managers, entrepreneurs

and scholars. It represents a brand-new world in which modern firms, especially
those that were once successful in the traditional scale-economy, are challenged if
they desire to remain competitive (Das, 2015; Codreanu, 2016; Muthusamy and
Kannan, 2023). Therefore, managers, entrepreneurs and business scholars are
pressured to create a different set of competitive advantages for maintaining and
achieving successes in the unprecedented VUCA environment, although such effort
will most likely turn out to be futile (Hamadamin and Atan, 2019; Hitka et al., 2019;
Pearse, 2017; Saridakis et al., 2017), from those well tested in the scale-economy
(Adler, 1995, 2012; Buzzell, 1983; Chandler, 1962, 1977, 1990). To help decision
makers be successful with their effort in the present new era, this paper addresses the
following question: Comparing to the history, what had unparallelly happened in the
recent decades in the developed economies that made large firms of the industries in
the traditional scale-economy suffer from the VUCA disruptions?
Possible answers to this question are important both theoretically and
practically. Specifically, for managers, instead of continuously clinging onto those
strategies successful in the past, they should keep their eyes open to the changing
environment so that they could meet challenges arising from disruptive
technologies, increasing global competitions, and intensifying financial volatility
(Hitt et al., 2007; Rousseau, 2000). For entrepreneurs, answers to the question
could potentially point them to new profitable opportunities (Forrest and Liu,
2022). As for policy makers, it is very realistically possible that some systemic
happenings need to be addressed through policy and regulatory means. For
example, the average time of holding the stocks of U.S. publicly traded companies
was 5 years in the 1970s; and for 2015, that number dropped to less than 6 months
(Bower and Paine, 2017). Such greatly shortened holding time reflects the
transition of investors of the past to speculators of the present. It, together with the
resulting volatility in the financial markets, produces undesirable effects on
corporate governance. In particular, over time more and more managers have
turned their attention to the short-termism in the financial markets, instead of the
disruptions arising from global competitions and technological advances
(Donaldson, 1985; Martin, 2011; Rappaport, 2006; Shiller, 2005). To address the
systemic transition from the investment of the past to the speculation of the present
in the financial markets in order to promote a healthy long-term growth of the
economy, it is suggested (Muthusamy and Kannan, 2023) that economic and
regulatory institutions can play an important role to improve the overall business
environment and the aggregate business performance of individual companies. As
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
11
for the theoretical importance of addressing the question, answers can naturally
lead to recommendations useful to guide practitioners in their regular, daily
decision making.
In terms of the contribution this paper makes to the literature, it provides the
reasons and the underlying mechanisms for each of the components of VUCA to
appear forcefully at around the turn of this new millennium in the business world.
The reasons and mechanisms represent a link between how and why VUCA
environment appears and how business entities could potentially survive and
succeed in such a new environment which is drastically different from the previous
ones. As the literature below shows that the former has not been well investigated
previously, while the focus of existent studies is mostly on the latter. When the
former is well understood, one can more readily judge whether the conclusions of
the latter can be potentially correct and reliably useful in real life.
The rest of this paper is organized as follows. Section 2 provides a literature
review, while demonstrating where this work can be placed in comparison with
other existent works. Section 3 presents the main results of this paper. It looks into
details about how and why each of the VUCA components appeared in the
business world. Section 4 concludes the presentation and provides a few
managerial recommendations and questions for future research.

2. LITERATURE REVIEW
Our review of the literature shows an increasing number of studies on
various aspects of VUCA since the turn of the new millennium, because during
these two decades, many industries of the developed economies have been
operating their business in the VUCA environment (Bennett and Lemoine, 2014;
D’aveni, 2010; Johansen, 2007; McKinsey and Company, 2020). As reported in the
business press (Autio et al., 2021; Bonnet et al., 2015; Cavusgil et al., 2021),
because of the VUCA effect (or disruption), a large number of corporate failures
had been observed, including, among others, Kodak, Chrysler, Compaq,
Blockbuster, Polaroid, and K-Mart. And fifty-two percent of the 1990 Fortune 500
firms had either gone bankrupt, been rescued out of crisis through acquisition, or
ceased to exist as a result of the VUCA disruption (Autio et al., 2021; Dobbs et al.,
2015; Vermeulen, 2017; Watts, 2009). By empirically examining the
characteristics of the failed firms, Muthusamy and Kannan (2023) suggest that
large firms, operating in industries of the traditional scale-economy, were more
noticeably affected.
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
12

Historically, the acronym VUCA was first introduced by the U.S. Army War
College to describe the more volatile, uncertain, complex and ambiguous
multilateral world (Barber, 1992). Gradually, the business world also started to feel
the existence of the VUCA phenomenon and its various escalating impacts so that
a large number of scholarly works were devoted to different topics related to how
to survive and how to succeed in this new environment. These topics include,
among others, leadership competencies (Bennett and Lemoine, 2014; Deepika and
Chitranshi, 2021), new model of business administration (Popova et al., 2018),
broader knowledge with new concepts and frameworks (Mack et al., 2016; Taskan
et al., 2022), new habit, patterns and models of exploring the unknown (Bartscht,
2015; Millar et al., 2018), new decision systems (Minciu et al., 2020), antecedents
of organizational agility and their effects on financial performance, product, and
process innovation (Troise et al., 2022), how to manage VUCA (Baran and
Woznyj, 2020).
Among all the reviewed studies, the reason that underlies the appearance of
the VUCA environment is mostly unquestioned, except it was believed as a result
of the ended Cold War (Barber, 1992) and an outcome of disruptive innovation
(Millar et al., 2018). Hence, the importance for us to address the question posed in
the previous section emerges in order for scholars to provide recommendations
useful for managing the unpredictable and challenging VUCA world.

3. THE APPEARANCE OF THE VUCA BUSINESS ENVIRONMENT

As the title suggests, this section presents the main conclusions of this
research. It consists of four subsections with the first one looking at what led to the
rising volatility in the business world. The second subsection addresses the
reason(s) for the worsening uncertainty by referencing to two theorems of systems
science, established on game theory. The third subsection examines why the world
of business suffers from increasing levels of complexity. And the four subsection
argues why ambiguity appears when decision makers expand their knowing from
the realm of thinghood to that of systemhood.

3.1. The rising volatility in the business world

In the abbreviation VUCA, letter V is the first letter of volatility that
represents such a situation that it experiences major fluctuations when slightly
triggered and is subject to frequent, rapid and significant changes. An example of
volatile situations is the prices of the stock market; and another one is the rapidly
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
13
evolving industry and/or market environment in the present business world (Barton
et al., 2017; Rappaport, 2006). Because the so-called VUCA business environment
became known with the arrival of the new millennium (D’aveni, 2010; Johansen,
2007), in this subsection, we look at what had happened at the dawn of the new
century that made the business world more volatile than before. To this end, let us
look at the development of the World Trade Organization (WTO) and its
predecessor the General Agreement on Tariffs and Trade (GATT).
To offer rules for world trade, GATT was established, along with the World
Bank and the International Monetary Fund, in 1947 and functioned for nearly half a
century from 1948 to 1994. A group of 15 countries began talks in December 1945
to reduce and bind customs tariffs for the purpose of providing an early boost to
trade liberalization in the post WWII world. This round of talks resulted in a
package of trade rules and 45,000 tariff concessions affecting $10 billion of trade.
That represented about one fifth of the world’s total of the time. The concessions
came into effect by June 30, 1948, giving birth to the GATT with 23 founding
members, officially known as contracting parties. As the only multilateral
instrument governing international trade, the GATT existed and played its role
from 1948 onward until the WTO was established in 1995.
For nearly half a century, the basic principles of the GATT remained roughly
the same with additions in the form of a section on development added in the 1960s
and “plurilateral” agreements (i.e. with voluntary membership) in the 1970s. Much
of all these were achieved through a series of 8 rounds of multilateral negotiations.
The eighth, the Uruguay, round of 1986-94 led to the creation of WTO and a new
set of agreements.
During its over 47 years of existence, GATT was successful in terms of
promoting and securing the liberalization of world trade. The momentum of trade
liberalization helped trade growth consistently outpace production growth
throughout the GATT era. The addition of new members during the Uruguay
Round (1986-1994), Figures 1 and 2, can be seen as a confirmation of recognition
of this multilateral trading system. Accompanying this observation, one also needs
to note that starting in 1989, the cold war began to unwrap with various countries
of the Warsaw Pact overthrowing their Marxist–Leninist regimes, while strong
nationalist and separatist movements broke out across the entire Soviet Union. That
eventually led to the official collapse of the Soviet Union in 1991. The conclusion
of the long-term ideological standoff between the Western Bloc and Eastern Bloc
tacitly redirected the attention of the people of the latter Bloc from the state of
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
14

holding to their strong ideological beliefs to that of enthusiastically pursuing

economic development.

Annual membership increase of GATT

20
18
16
# of new members

14
12
10
8
6
4
2
0
1962

1974

1984
1948
1950
1952
1954
1956
1958
1960

1964
1966
1968
1970
1972

1976
1978
1980
1982

1986
1988
1990
1992
1994
Year
Figure 1. New members accepted into GATT from 1948 to 1994, created based on data from WTO’s
website at [Link] accessed on July 13, 2023

Total membership of GATT over time

Cumulative number of members

140
120
100
80
60
40
20
0

Year

Figure 2. Annual sizes of the membership of GATT during 1948-1994. For how this graph is
generated, see the note of Figure 1

By combining the membership data of GATT and WTO, found on the

website of WTO, for details, see the caption of Figure 1, Figures 3 and 4 are
generated. A dip in the number of members appears in 1995, where GATT closed
its existence in 1994 with 128 members, while in 1995 the WTO incepted with 115
members, four of which were not part of GATT. From Figure 3, it can be seen that
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
15
major increases in membership occurred in two periods of time. The first period is
during 1948 to roughly 1969; and the second during 1988 to roughly 2001, which
continued throughout the rest of the entire set of available data. Corresponding to
the first period, the world business recorded a very high rates of trade growth for
around 8% a year on the average (WTO, 2023). As for the second period, the data
of the WTO (Figure 3) provides a good explanation for why since the early 2000,
managers and scholars had noticed the much-increased level of volatility in the
business world.
Speaking differently, greatly increasing attention directed towards economic
development, and the formation of cross-regional economic markets of the 1990s
jointly intensified the market competition for each and every originally local
market. They broke the once stable local-market forbearances and the status quos
of the firms that used to hold solid market territories in their respective local
markets. Specifically, when local or regional markets are relatively independent of
each other, each of these markets would likely be in a state of mutual forbearance
(Bernheim and Whinston, 1990). The firms, incumbent in the market, alleviate
their rivalries by partitioning the market according to their respective strengths so
that they surrender dominance to their stronger competitors in marketplaces where
they are less efficient (Li and Greenwood, 2004). The codependence of these firms
gradually decreases the rates of market entry and exit (Fuentelsaz and Gómez,
2006; Yu and Cannella, 2012), while reducing interfirm hostility (Haveman and
Nonnemaker, 2000). However, such mutual forbearances that existed in the
relatively independent individual local and regional markets were broken by the
unprecedented international connectivity of the 1990s. That explains why
managers, entrepreneurs and policy makers have been sensing the increasing
volatility in the business world in recent decades.

180
Memebers of GATT +

160
140
120
100
WTO

80
60
40
20
0

Year
Figure 3. Annual membership size of GATT, followed by that of WTO
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
16

20
Number of new members of

18
16
GATT + WTO

14
12
10
8
6
4
2
0

Year
Figure 4. New members accepted into GATT or WTO from 1948 to 2016

By summarizing the discussions above, the following conclusion can be observed:

Proposition 1. The greatly increasing attention directed towards economic
development, and the formation of cross-regional economic markets of the 1990s
made the business world more volatile than before, as so felt by front-line
managers and academic scholars since the dawn of the new millennium.

3.2. The worsening uncertainty in the business world

In the abbreviation VUCA, letter U is the first letter of uncertainty that
occurs when the matter of concern evolves unpredictably. In the stock market, for
example, it is not clear if the S & P 500 index will go up or down or by how much.
Similar to what we did in the previous subsection, we, in this subsection, look at
what had happened around the time when this new millennium started that made
the business world experience worsening uncertainties than before.
Corresponding to the surge in the number of new members in the WTO
during the late 1980s and the entire 1990s, as discussed in the previous subsection,
emerged in 1989 were commercial internet service providers in the US and
Australia (Clarke, 2004). Evolving gradually, but surely, the last restrictions on the
use of the Internet to carry commercial traffic were removed in 1995. Due to the
advent of internet, the development of the knowledge-based economy accelerated.
The loosening of protective trade regulations directly made markets change faster
than ever, while customers become less patient with increasing numbers of service
providers and product suppliers than ever before. One important consequence of
these drastic changes in the business landscape is the ending of the advantages that
made many commercial companies iconic, such as the 163-year-old Alliance Boots
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
17
(UK), forcing many companies to think and act more quickly, more decisively, and
more candidly. They think more about the future than ever before in order to
capture fleeting opportunities and act as an organic whole; they break down
internal organizational solos, create courageous leaders to engage in creating
and/or capturing opportunities and moving away from strategies and practices that
no longer represent the future (McGrath, 2013, p. ix).
To see why the new business environment made markets change faster and
customers less patient than ever, assume that (i) the market of concern is served by
m (= a natural number) firms that provide horizontally differentiated products; (ii)
each of these firms has a base of loyal customers; (iii) the incumbent firms are risk-
neutral, well aware of the pricing strategies of other rival firms so that they respond
by employing the strategy of Nash equilibrium based on self-analyses. Then the
following result holds true (Forrest, Nicholls et al., 2020, p.89).
Theorem 1. In the Nash equilibrium, when the competition of the afore-
described market grows with an increasing number of firms entering the market,
the base of loyal customers for each incumbent firm will gradually diminish.
By combining what this theorem says with the appearance of internet in the
1990s and the discussion in the previous subsection regarding how more and more
peoples from around the world turned their attention to economic development, the
world economy globalized quickly. Along with such a trend of globalization, an
increasing number of firms from different parts of the world started to participate
in the competition for the same customers by offering their versions of similar
products or brand-new products. Hence, speedy changes of markets, which were
sensed at around the turn of the new millennium, were caused by forever appearing
new competitors unstoppably entering the markets; and customer patience became
less because they could easily move from one product to another.
In particular, from Figure 4, it can be seen that the 1990’s witnessed a major
spike in the membership in the World Trade Organization (either under the name
of GATT or WTO). Happening either accidentally or not, this decade was also
accompanied by the unprecedented international connectivity of the post-Cold War
world (James and Steger, 2014), partially due to the development of internet. Such
increased global connectivity and interactions, known as globalization, have caused
a growth in the international exchanges of products, goods, services, ideas, beliefs
and cultural elements. The corresponding expansion of markets in the eyes of
individual firms liberalizes the economic activities and removes cross-border
barriers for trades, making the formation of global markets more feasible than ever
before (National Research Council, 1995). Advances in transportation and
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
18

telecommunication infrastructure have been major contributing factors for the

development of the globalization, and made economic and cultural activities
around the globe more interdependent of each other (Wolf, 2014).
Proposition 2. The massive increase in business competition, made possible
by the end of the Cold War and the advent of internet in the 1990s, represents one
critical reason for front-line managers and academic scholars to feel the worsening
uncertainty in the business world since the dawn of the new millennium.
Next, let us look at the worsening uncertainty of the business world from the
angle of competitive advantages’ sustainability and transiency. To this end, let us
quickly recap how economic activities got off the ground initially and evolved over
time (Forrest, Nicholls et al., 2020).
In early times, when living in primitive conditions, people made what was
needed around home themselves, while trading surplus of goods with others. These
simple exchanges of goods formed the very beginning of business transactions. As
limited by low population density, modest tools for production, transportation, and
communication, minor environmental obstacles in today’s standard easily limited
the exchange of goods and services to local, small-scale shops. Because these
independent shops mostly provided living necessities, they delivered mostly
identical set of goods and services with some minor differences. As better tools for
production and transportation became available, better practices of management
were implemented in individual shops. The natural desire for better living enticed
people to invent new tools, design new methods of production, and introduce
efficient ways of management. With word of mouth and improving technology of
communication, such newbies were passed around the land. Hence, a circulation of
know-hows, especially skilled people and resources started to form. Now,
Bjerknes’s (1898) Circulation Theoremiv guarantees the appearance of abstract
eddy motions over the land consisting of migration of people, spread of knowledge
and information, and transportation of goods. That depicts how first local and then
regional markets were initially formed and why all markets have conditions and
barriers against new entrants.
This brief expression of early-stage economic development explains how
and why incumbent firms naturally have their respective competitive advantages as
part of the conditions and barriers that help the firms occupy their market shares
while preventing new comers from entering the market. That also elucidates why

ivThis theorem shows that nonlinearity mathematically stands (mostly) for singularities and in terms
of physics it represents eddy motions. For the validity of employing this theorem to explain
economic issues, see Forrest, Nicholls et al. (2020).
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
19
competitive advantages of the past seem to be sustainable; and indeed, they were
for the most part sustainable. For these early stages of economic development,
most strategic tools and management frameworks were developed for one
dominant and overarching purpose – develop a sustainable competitive advantage.
Opposite to why competitive advantages of the past seem mostly sustainable,
we analyze next what had happened at the dawn of the new millennium that
brought the business world into the era of transient competitive advantages. To this
end, the heightened attention toward economic development in the late 1980s and
the entire 1990s and the fast-emerging commercial use of internet in the mid-
1990s, as discussed above, made important know-how information widely
available in an unprecedented fashion and helped remove many insurmountable
barriers of the past for the general public. And, the modern engineering technology
helped quickly turn the design of an imagined product into reality at reasonable
cost. Speaking differently, due to the reasons listed here, the amount of time
needed for the public to find out what entailed in a successful competitive
advantage was greatly shortened; and the life cycle of a technology was greatly
shortened. Hence, newer competitive advantages have to be frequently introduced
and evolved into fresh formats quickly (McGrath and MacMillan, 2000), while the
outcomes of many implemented “advantages” are unknown. That was at least part
of what happened at the dawn of the new millennium that made the business world
suffer from worsening uncertainties.
Proposition 3. The transiency of competitive advantages, started to appear
in the 1990s, represents one critical reason for front-line managers and academic
scholars to feel the worsening uncertainty in the business world since the dawn of
the new millennium.
One traditional approach for a firm to achieve the certainty of market
success is to manage itself well, while developing quality products and recognized
brands. Historically, each iconic firm of the past scale-economy achieved its
success with a favorable position within a well-defined industry by developing and
then exploiting a long-term competitive advantage (Adler, 2012; Buzzell, 1983;
Chandler, 1990; Josefy et al., 2015; Muthusamy and Kannan, 2023). However,
recent business headlines, such as Fuji (film)’s story (Kunii, et al., 1999; Inagaka
and Osawa, 2012), indicate that this approach is no longer sufficient for any firm to
remain on top in the world economy. The downfalls of many once-storied
companies were caused by their practices designed on sustainable competitive
advantages. Their ingrained organizational structures and management systems
became culpabilities when these firms needed to surf the waves of fleeting
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
20

opportunities (Forrest, Nicholls et al., 2020). To succeed in the new environment of

rising volatility and worsening uncertainty, companies have to invest in new
advantages and pull resources from declining ones, as suggested theoretically by
what is discussed above and anecdotally by McGrath (2013). At the same time,
they need to design and apply innovative strategies regarding which market(s) to
compete in, and how to competitively win by regularly looking into the future.
Another conventional approach for a firm to achieve the certainty of market
success is to make its asset size as big as possible, because, as it has been believed,
the larger a firm is, the better chance it can secure advantages against rivals and the
higher returns it can fetch (Coase, 1937; Josefy et al., 2015; Mason, 1939).
However, considering the fact that the present world of business is in the era of
transient competitive advantages (Forrest, Nicholls et al., 2020; McGrath, 2013),
the larger a firm is, the more it suffers from organizational inefficiencies (Forrest
and Orvis, 2016) and the more it experiences its organizational inertia (Lin, 2009).
That is, within the present business environment, the larger a firm is, the more it
experiences a disconnect between its size and financial performance. In the rest of
this subsection, we will analytically prove this conclusion.
It is shown (Lin, 2009) that when a firm enjoys perfect capital markets (i.e.,
it has access to sufficient finance to fund its ventures), it generates profit in two
dimensions – the product it offers and the personnel it employs. Let us now focus
on the personnel dimension. Assume that each employee hired by the firm on
average costs $𝑝𝑝𝑊 and brings in $𝑝𝑠𝑊 in revenue. Assume that, due to the
increasing demand of the product market, the firm’ staffing need, in order to satisfy
the market demand, is 𝑛𝑊 = 𝑛𝑊 (𝑝𝑠𝑊 ). Then, the profit 𝑃𝑊 the firm generates from
its personnel is given as follows:
𝑃𝑊 = 𝑛𝑊 (𝑝𝑠𝑊 )(𝑝𝑠𝑊 − 𝑝𝑝𝑊 ) − 𝑂𝐼 𝑛𝑊
𝑟 (𝑝𝑊 )
𝑠
((1)
where 𝑂𝐼 (≥ 0) is known as the inefficiency coefficient, and 𝑟 (> 0)
represents the order on how the staffing need makes the organizational inefficiency
worse. Evidently, if 𝑂𝐼 = 0, it means that the particular organization does not suffer
from any organizational inefficiency. However, Theorem 2 below, cited from Forrest
and Orvis (2016), suggests that 𝑂𝐼 = 0 is impossible in real life. So, 𝑂𝐼 > 0.
Theorem 2. Inefficiency always exists in the organizational system of any
firm that has at least one full-time employee whose personal system of values and
beliefs is not in total agreement with the organization’s mission, where the concept
of organizational efficiency is defined as if its employees help reach the defined
mission of the organization.
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
21

The first-order condition of maximizing 𝑃𝑊 in equation (1) is

𝜕𝑃𝑊 𝑑𝑛𝑊 (𝑝𝑠𝑊 ) 𝑊 𝑊 𝑊) 𝑟−1 (𝑝𝑊 )
𝑑𝑛𝑊 (𝑝𝑠𝑊 )
= (𝑝𝑠 − 𝑝𝑝 ) + 𝑛 𝑊 (𝑝𝑠 − 𝑟𝑂𝐼 𝑛 𝑊 𝑠 =0
𝜕𝑝𝑠𝑊 𝑑𝑝𝑠𝑊 𝑑𝑝𝑠𝑊
Therefore, it follows that
𝑑𝑛𝑊 (𝑝𝑠𝑊 ) −𝑛𝑊 (𝑝𝑠𝑊 )
=
𝑑𝑝𝑠𝑊 𝑝𝑠𝑊 − 𝑝𝑝𝑊 − 𝑟𝑂𝐼 𝑛𝑊
𝑟−1 (𝑝𝑊 )
𝑠
The solution of this differential equation is
𝑟 (𝑝𝑊 )
(𝑝𝑠𝑊 − 𝑝𝑝𝑊 )𝑛𝑊 (𝑝𝑠𝑊 ) − 𝑂𝐼 𝑛𝑊 𝑠 =𝐶 ((2)
where 𝐶 is the integration constant. So, we have
𝑟 (𝑝𝑊 )]
[𝐶 + 𝑂𝐼 𝑛𝑊 𝑠
𝑛𝑊 (𝑝𝑠𝑊 ) =
𝑝𝑠𝑊 − 𝑝𝑝𝑊
Substituting equation (2) into equation (1) provides
𝑃𝑊 = 𝐶 ((3)
+
Based on what are assumed, when → 𝑝𝑠𝑊 (𝑝𝑝𝑊 ) ,
meaning that the profit
each employee is expected to generate for the firm is approaching zero, the staffing
need 𝑛𝑊 (𝑝𝑠𝑊 ) → 0. Hence, equations (1) and (3) imply that 𝑃𝑊 =
profit from peronnel → 0. That is, 𝐶 = 0.
Theorem 3. If a firm meets the increasing demand of its product market by
hiring additional employees, then the organizational inefficiency created by the
newly hired employees will sooner or later erase the expected increase in the output.

3.3. The world of business with increasing levels of complexity

In the abbreviation VUCA, letter C is the first letter of complexity that
stands for the difficulty of separating issues and factors from one another due to the
reason that some of the issues and factors are intricately intertwined. When a
manager needs to make decision, for example, a complexity appears when he
cannot determine which factors are more important than others (Forrest, Nicholls et
al., 2020). To see what unprecedentedly happened in the recent decades that made
large firms of the industries in the traditional scale-economy suffer from such an
increasing level of complexity, let us look at Kyocera Corporation, Japan. It is a
large global firm with $15 billion sales revenue and 70,000 employees, and
conducts its business as a constellation of more than 3000 small, customer-focused
business units. Although these units operate independently, they managerially
cooperate with each other to achieve corporate-level synergy and profit growth.
Collectively, the firm manufactures a wide range of different products targeting
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
22

different product markets, such as ceramics of industrial grade, systems of solar

power generation, equipment of telecommunications, document imaging
equipment for offices, electronic components, semiconductor packages, cutting
tools, and various supplies for medical and dental implant systems. For more
details, see Inamori (1999).
The reason why we look at the organizational structure of Kyocera, which is
referred to as the shoaling form by Muthusamy (2015), is because it represents a
competitive advantage appropriate for the firm to successfully ride waves of
transient competitive advantages of the present era (McGrath, 2013). And, it is an
effective way to reduce the opportunity cost of not committing much in any one
particular potential and the investment risk that amasses with the large-scale
integration of assets, as the iconic firms of the traditional scale-economy used to
do. Speaking differently, Kyocera’s organizational structure enables the company
to possess such characteristics as market agility, enhanced customer service, and
entrepreneurial drive, all essential for success in the present business world
(Forrest, Nicholls et al., 2020).
What made firms like Kyocera successful is the network-like organizational
structure that consists of small independent units. They are efficient in what they
individually do, innovative in how they can creatively improve on what they
produce and offer to the market(s), and dynamic in how they are able to change
with the forever changing customer preferences (Birch, 1987; Contractor, et al.,
2010; Forrest and Liu, 2022; Muthusamy and Kannan, 2023; Rossi-Hansberg and
Wright, 2007). And, due to the emergence of knowledge and information economy,
as a consequence of the advent of internet and the appearance of a large global
population interested in pursuing economic gains instead of continuously locking
themselves in their earlier realms of ideological nature, large firms have been
disaggregated into aforementioned networks of relatively independent small units
(Benkler, 2006; Kogut and Zander, 1996; Teece, 2003).
At this junction, let us cite the following results from Forrest, Nicholls et al.
(2020, p.48, 68), where by consumer surplus, it means the totality of all price
switchers, who make purchase decision based on whose price is the lowest.
Theorem 4. In the Nash equilibrium of the market that is described in
Theorem 1, at least one new enterprise enters the market profitably, as a competitor
of the incumbent firms, if and only if the size of the consumer surplus is greater than
or equal to the magnitude of the smallest loyal customer base of the incumbent firms.
Theorem 5. In the Nash equilibrium of the aforementioned market, a
sufficient and necessary condition for at least one micro firm that introduces a
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
23
particularly improved version of the product to enter the market profitably is that
the number of consumers who are looking for that particularly improved version is
of a size > 0. And, the micro entrant can charge a higher price than that of the
incumbent firms, where the amount of additional charge depends on how badly
consumers look for that particularly improved product.
In particular, Theorem 4 implies that the large global population interested in
pursuing economic gains suddenly appeared within a short period of time in the
originally calm market. Therefore, the incumbent firms’ original state of mutual
forbearance within the market is broken, throwing the earlier calm of the market
into chaos, and the managements of the firms into a new environment of an
increased level of complexity. These firms now have to face new competitions
from some never-before-seen rivals, while having no knowledge about how these
rivals would compete with them. In other words, the reason why the original
market was calm is because the incumbent firms were mutually forbearing; their
rivalry was mitigated by market division in proportion to their respective strengths
(Bernheim and Whinston, 1990). They cede dominance to their stronger
competitors in those market segments where they are less efficient, while in
exchange the latter do the same in segments where the former are more efficient
(Li and Greenwood, 2004). The firms’ codependence gradually motivates them to
de-escalate rivalry (Yu and Cannella, 2012). Consequently, the rates of entry and
exit in the market decrease (Fuentelsaz and Gómez, 2006), and interfirm hostility
declines (Haveman and Nonnemaker, 2000). However, the sudden huge increases
in the consumer base, the number of newly appeared competitors, the market size,
broke the existent forbearance, leading to a much-increased level of complexity in
terms of the form and intensity of competition, product varieties, consumer
preferences, production routines, management styles, and others.
Adding to this elevated level of complexity is the micro entrants of the
market, as indicated by Theorem 5. Their appearance and profitability have been
ensured since the 1990s by new technological advances, in particular, the
introduction of flexible manufacturing systems, lean production, modularization,
and continuous improvement techniques (Liker, 2004; Womack et al., 1990).
Proposition 4. The suddenly enlarged population interested in pursuing
economic gains in the 1990s and the accompanying introduction of flexible
manufacturing systems, lean production, modularization, and continuous improvement
techniques, jointly made the world of business more complex than before.
In the previous discussion, one clearly unaddressed gap in the logical
reasoning is: Why did the knowledge and information economy emerge out of the
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
24

advent of internet and the appearance of a large global population interested in

pursuing economic gains? To address this question, let us first examine the concept
of information economy and that of knowledge economy. By information
economy, it means the economy that focuses on information-related activities and
the industries that involve more or less such endeavors as computer programming,
system design, telecommunications, and others (Coiera, 2000). Because various
manufacturing processes are being digitized (Liu et al., 2021), information
economy can be naturally seen (Castells, 1997) as a stage of economic
development after those of hunting, agriculture and manufacturing. On the other
hand, by knowledge economy, it means such an economic system that all
productions are knowledge based, leading to advancement in technical and
scientific innovation (Powell and Snellman, 2004). In such an economy, values are
created and/or captured through employing such intangible assets as information,
knowledge, creative ideas, and consequent practice (World Bank, 2007, p. 4) by
mobilizing the capability of identifying and solving problems and by applying
wisdoms from multiple disciplines (Kofler et al., 2020, p. 29-41). For companies,
intellectual properties, such as patents, copyrights, trademarks and trade secrets,
become the key underlying their business successes in knowledge economy
(Westeren, 2012).
From the definition of information economy, it follows readily that when the
internet demonstrates its ability to quickly spread information (such as what is
happening in different parts of the world and what actions certain major business
players are taking) and knowledge (such as various knowhows), the so-called
information economy appears naturally due to the corresponding emergence of
tremendous profit opportunities. In the same vein, the knowledge economy can be
seen as originated from more and more knowhows becoming publicly available
than before along with the advent of internet. Many of the once privately held
knowhows used to be parts of the magnificent business successes of the storied
firms. When these secrets that were tightly held in the past are revealed to the
public, not many firms, if any at all, can directly employ them to create new
business successes. Hence, a natural way of thinking is how one can adopt them in
different settings and for varied purposes. That is where knowledge from multiple
disciplines comes into play. That is also where the level of complexity of the
business world starts to rise drastically. Speaking in the language of systems
science (Forrest, 2018; Klir, 1985), this drastically increasing level of complexity
reflects how managers, entrepreneurs and business scholars have started to transit
their scope of knowing from the realm of thinghood to that of systemhood. That is,
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
25
when the entirety of the business world is seen as a system with homeomorphic
(although different) parts, a once tightly held know-how could be applied, either
directly or indirectly with some modifications, to other areas of business activities.
Of course, for this end to play out successfully, relevant knowledge from multiple
disciplines will be needed.
When applying knowledge from different disciplines to a creative
application of newly revealed knowhows or to the development of a new
knowhow, the range of validity of the employed knowledge becomes important and
questionable. Specifically, in the present space of knowledge, many conclusions
that are stated as if they are universally true are consequences of investigating
limited scenarios by using such methods (e.g., those that are statistics-based or
those that are calculus-based) that are constrained by various limitations and
conditions (Forrest and Liu, 2022, Section 1.2). This situation often appears in
business-related disciplines. For example, innovation has been seen as an important
factor for wealth generation since the time of Adam Smith (1776). However,
studies on innovation, although in huge volume, are not able to agree on a
commonly acceptable definition of the concept. Researches on what might make a
firm innovative have used different proxies to represent the variable
‘innovativeness,’ while the derived conclusions are stated as if they are generally
true for however innovativeness is defined (Becheikh et al., 2006; Camison-
Zornoza et al. 2004; Crossman and Apaydin, 2010; Forrest, Nicholls et al., 2020;
Hobday 2005; Lansisalmi et al. 2006; Peres et al., 2010; Pittaway et al. 2004;
Schumpeter, 1934). Practically applying the conclusions of these studies also
makes decision makers face a greatly elevated level of complexity, because related
studies had identified over sixty determinants of innovativeness, while the reality is
that natural science and mathematics cannot tell exactly how three bodies (which
can be readily seen as three variables) would interact with each other (Forrest,
Nicholls et al., 2020; Lin, 2019).
Similar situations widely exist in business-related disciplines. For example,
beyond the difficulty of defining the concept of customer value propositions
(CVPs), adopted CVPs do not always lead to expected outcomes due to the
complexity that customers do not always know what they need (Forrest and Liu,
2022; Payne et al., 2017). Studies on the Industrial Revolution have produced
different and inconsistent lists of causes for why and how it was initially triggered
and then magnificently evolved. However, practical applications of the lists had led
to miserable consequences and great failures (Forrest, Zhao et al., 2018).
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
26

When established knowledge is immediately needed for practical

applications, as discussed above, the knowledge of concern must be reliable and
valid first. However, this is generally not the case. For example, when faced with
the devastating aftermath of economic disasters, in particular, the 2008 financial
crisis, people tend to ask why economic theories did not help predict the arrival of
the disasters and the severity of the aftermath. To this end, the reality is that the
existing economic theories are unable to accomplish what the public wishes for.
The underlying reason why these theories are so incapable of practical applications
is described very well by Paul Krugman, a 2008 Nobel laureate in economics, as
follows in New York Times (2009-09-02),
The economic profession went astray because economists, as a group,
mistook beauty, clad in impressive-looking mathematics, for truth… As memories
of the Depression faded, economists fell back in love with the old, idealized vision
of an economy in which rational individuals interact in perfect markets…
Unfortunately, this romanticized and sanitized vision of the economy led most
economists to ignore… things that can go wrong. They turned a blind eye to the
limitations of human rationality that often leads to bubbles and burst; to the
problem of institutions that run amok; to the imperfection of markets … that can
cause the economy… to undergo sudden, unpredictable crashes; and to the dangers
created when regulators don’t believe in regulation.
Another example of theories that are incapable of wide-range practical
applications is management science. Specifically, one of the central tenets of this
science is to increase the long-term profitability of the firm so that its shareholders’
wealth can in turn be enhanced (Barton et al., 2017; Donaldson, 1985; Rappaport,
2006). The problem with this tenet is that it assumes that each and every firm goes
after the purpose of making an increasing amount of profit. However, this
assumption is simply not true for the general world of business, because there are a
lot of firms that exist for other purposes, such as those that are community-own
(Altman and Altman, 2021) and those that are widely recognized as permanently
failing organizations (Seibel, 1996). As a matter of fact, it has been recently
recognized (Forrest, Shao et al., 2023) that firms generally prioritize or optimize
the realization of their respective missions. To this end, of course, profit
maximization might be the mission of SOME firms. Hence, when firms studied in
the present management science interact with firms that are not considered in that
science, it can be expected that those profit-maximizing firms would act at least
slightly differently when they deal with nonprofit-maximizing firms, such as those
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
27
established to provide help to battered women and those that mainly employ the
handicapped. For more related discussions, see Forrest, Nicholls et al. (2020).
By summarizing what is discussed above, we have the following:
Proposition 5. The increasing amount of practically employing either
partially reliable or totally unreliable knowledge in business activities since the
advent of the internet in the 1990s has made the world of business more complex
than before.

3.4. Ambiguity that appears within the systemic view of the world
In the abbreviation VUCA, letter A is the first letter of ambiguity that
describes a situation that is difficult to understand exactly what the issue under
concern is due to a lack of clarity. Information, such as a market signal, for example,
can be interpreted in different ways; the intended outcome of an action is not the
same for all parties involved. In the stock market, information is asymmetrically
available to the public and many unseen factors affect prices. This subsection
investigates what unprecedentedly happened in the recent decades that possibly made
the managements of large firms of the industries in the traditional scale-economy feel
increasingly ambiguous regarding what they deal with routinely.
The previous subsection indicates that when many once tightly held
knowhows become publicly available due to the advent of internet, many managers
and entrepreneurs naturally think about how to adopt those knowhows, which had
created successes for many storied companies in the past, in different settings.
Other than the need to mobilize knowledge from multiple disciplines, this way of
thinking also makes these businessmen and businesswomen critically examine the
resources available in their spaces and how these resources can be readily
employed for them to enter other product markets. Specifically, at around the turn
of this new millennium, a huge number of new consumers and nonexistent
competitive companies entered the business world, as discussed in Subsection 3.1.
Initially, these new consumers were, by definition, part of the market surplus in the
business world. Therefore, Theorem 4 implies that some of the previously
nonexistent companies will enter the corresponding product markets, as
competitors of the incumbent firms, by making use of their existing production
capabilities and by mobilizing available resources. Figure 5 provides a figurative
depiction of this situation, where the so-called world of business is the white area,
while the sounding grey area represents the new territory from which new
consumers and previously nonexistent companies labelled E1 – E4 come from. In
this case, Theorem 4 says that some of the companies from the grey area would
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
28

modify their product designs and then their production procedures so that their new
products can enter of white area to compete with the firms that are incumbent in
this white region. In terms of what is discussed in Subsection 3.1, the grey area in
Figure 5 stands for the totality of the land mass and the local economies from
which the majority of the new members of the WTO is from.
At the same time when the consumers from the surrounding grey area in
Figure 5 merge into the expanded world of business, and when the firms from this
area enter the white area, some of the firms, such as those labelled E1 – E4,
incumbent in the white area utilize the opportunity to expand their business
territory into newly expanded are. This situation is like the situation regarding how
and why domestic firms want to go international (Forrest, Trebing et al., 2019).

Figure 5. New consumers and nonexistent firms

Figure 6. New territory and expansion into new markets

In the aforementioned two-way expansions of the business world, those

micro firms, either from the central area or the surrounding region in Figures 5 and
6, pick up the remaining price switchers. They successfully accomplish this end
because of the recent advances in communication technology and flexible
manufacturing systems (Liker, 2004; Womack et al., 1990). The appearance of
these micro firms and the intensifying competition of the entire business world
jointly make customers less patient than ever before. That, according to Theorems
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
29
1, 4 and 5, constantly keeps all competing firms on their cautious toes so that they
are forced to continuously seek newer product designs, more efficient production
routines, and better management skills.
By summarizing what is discussed, we have the following conclusion.
Proposition 6. The drastically enlarged population of potential consumers
and suddenly appeared new competitors in the late 1980s and the entire 1990s have
greatly intensified the market competition and lured the managers and
entrepreneurs in the expanded world of business to think and reason systemically
both in theory and in practice.
When managers, entrepreneurs, and scholars started to transit their scope of
knowing from the realm of thinghood to that of systemhood, ambiguity naturally
appears. In the following, we argue for this point from several different angles.
First, in scholarly areas, many clearly understood phenomena become ambiguous
as soon as one revisits these phenomena by using the logic of systemic thinking.
The situation here is similar to, but different from, that just described above
regarding the reliability and validity of knowledge. For instance, in middle-school
algebra, one generally has access to the following problem: Three people, named
A, B and C, are looking at a particular job. Assume that A and B can complete the
job together in 2 hours, A and C in 4 hours, and B and C in 8 hours. Now, if all
three of them work together, how many hours do they need to finish the job? One
typical approach to solving this problem by ignoring irrelevant factors is the
following.
Assume that A, B and C can individually complete the job in x, y, z hours.
Then, we can establish the following model to describe the given scenario:
1 1 1
+ =
x y 2
1 1 1
+ =
x z 4
1 1 1
+ =
{y z 8
1 1 1
So, in one hour, A, B and C can jointly complete (2 + 4 + 8) /2 portion of
the job. So, these three individuals need 4/7 hours to complete the job together.
Here, the idea of ‘ignoring irrelevant factors’ is the key for the successful
resolution of the problem. However, in real-life, solving this problem is extremely
difficult, because these three people surely interact with each other in one way or
another, while they may have individually different abilities regarding the job of
concern. Additionally, the said job might have its structure so that certain parts
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
30

need to be completed before some other parts can get started; and many external
factors may influence the progress of the job’s completion, such as delays in
supplies. That is, even when such a middle-school algebra problem is concerned
with, a real-life, systemic analysis of it makes it clear that a general ambiguity
appears in terms of how to solve the problem.
Another example is the well-known law of one price, which explains why the
prices of commodities, assets and securities remain the same across markets
regardless of exchange rates of money. The common argument for the validity of this
law goes as follows. If an asset is priced lower in one market, then investors will dive
in and buy the asset in that market while selling it in a more expensive market to net
a profit. Because of such arbitrage behaviors, the supply and demand will eventually
level out the prices across different markets. Evidently, this argument becomes
invalid if real-life constraints are considered, such as varying degrees of availability
in different market locations, transportation costs, taxes, tariffs, among others. For
more in-dept discussions along this line, please consult with Klir (1985).
Second, when some spirited entrepreneurial managers like to employ just
revealed, previously tightly held knowhows to find new business opportunities, they
face the ambiguity about what the market is signaling. In particular, Theorems 4 and
5 say that the size of market surplus can be used directly to inform prepared minds
regarding where a profit opportunity is located and what magnitude of the expected
profit will be. However, the trouble in practice is that for any chosen product, there is
a market surplus due to the forever changing consumer preferences. So, the
ambiguity each spirited entrepreneurial manager has to deal with is how to choose
the right product market(s) to consider based on the resources available to him/her,
because in each specific moment of time, some opportunities bring forward with
more benefits or profits than others. For example, after analyzing various anecdotes
of great successes, Malcolm Gladwell concludes (2008, p. 56) that “all the outliers
we’ve looked at … were the beneficiaries of some kind of unusual opportunity.”
Table 1. Fourteen richest Americans who were born within 9 years of one another (Gladwell, 2008)
Birth Birth
Ranking Name Ranking Name
Year Year
1 John D. Rockefeller 1839 44 James G. Faire 1831
2 Andrew Carnegie 1835 54 Henry H. Rogers 1840
28 Frederick Weyerhaeuser 1834 57 J. P. Morgan 1837
33 Jay Gould 1836 58 Oliver H. Payne 1839
34 Marshall Field 1834 62 George Pullman 1831
35 George F. Baker 1840 64 Peter Arrell Brown Widener 1934
36 Hetty Green 1834 65 Philip Danforth Armour 1832
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
31
To make the point clear, Gladwell lists 75 richest people in human history by
using the value of current US dollars. Although the list includes queens, kings and
pharaohs from centuries ago, as well as contemporary billionaires, Table 1 lists those
14 Americans among the 75 names who were amazingly born within 9 years of one
another in the mid-19th century. Other than their hard works and individual talents,
the magnificent successes of these 14 Americans represent how they benefitted from
the greatest transformation of American economy in its history during the 1860s and
1870s. It is during these two decades in the US that the railroads were built, Wall
Street emerged, and industrial manufacturing started in earnest. By comparing these
two decades with the birth years of the 14 great successes, Table 1 indicates that
what really matters is how old you were when the economic transformation took
place. By conducting the same kind of analysis for the magnificent successes
achieved during the recent personal computer revolution, Gladwell produced a
similar conclusion. By generalizing this calendar analysis of the past successes, one
can naturally imagine to employing the most recent Fortune Global 500 to theorize
which economic sector(s) are currently providing the most opportunities.
Third, when one product market is identified, one ambiguity managers
have to face, among many others, is how to time the entry. By entry timing, it
means when an entry into a new market taes place. And, before determining
when to enter a product market, a needed due diligence is to first find out
whether the target market is in expansion or contraction. That can be determined
by checking whether incumbent firms focus on integration (i.e., managing most
activities internally) or modularity (i.e., increasing partnering with and
outsourcing to other players) (Baldwin and Clark, 2000; Forrest, Amatucci et al.,
2017; Markman and Waldron, 2014). Specifically, if the market expands, the
incumbent firms will be spending most of their efforts on grabbing as much
territory as possible, as new territories become available, which, to observers,
will seem to be integrating. On the other hand, if the market contracts, some of
the originally profitable segments of the market become at least not as profitable
as before. So, consequently in this case, the incumbent firms have to trim their
operations in these relevant segments. That end, to observers, seems to be the
case that these firms focus more on modularity. Speaking differently, integration
is associated with power and concentration of the greatest firms (known as the
generalists), which demotivates entry, while modularity entices micro entrants
and specialists to penetrate generalists’ markets (Christensen et al., 2004; Forrest,
Amatucci et al., 2017; Markman and Phan, 2011).
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
32

After having determined the stage of the market either in expansion or

contraction, the next step is to determine when to materially enter the market. In
this regard, Lieberman and Montgomery (1988) proposed the concept of first
mover advantage (FMA). It means how extra time over later entrants allows first
and/or early movers to build their bases of loyal customers and develop
capabilities. Such lead time can help produce advantageous market positions and
early gain perpetuations. However, studies, e.g., Levesque et al. (2013), Lieberman
and Montgomery (2013) and listed references there, also suggest that time benefit
later entrants because first and early movers have already uncovered relevant risks,
uncertainties, and potential capability gaps, and suffered from various costly
mistakes. In other words, in empirical studies of market entry timing, there is a
seemingly reasonable logic that can be used to explain both (i) why first and early
movers achieve better outcomes and (ii) why later entrants displace first movers.
Although empirical studies produced such embarrassing situation, researches
conducted since the time when FMA was initially proposed in 1988 have
confirmed the fact that entry timing really matters for the performance of
companies, even though particular contingencies and antecedents can well dictate
the timing of a specific market entry (Fosfuri, et al., 2013; Szymanski, et al., 1995;
VanderWerf and Mahon, 1997). Due to this reason, by developing a general theory
of market entry timing, Forrest, Amatucci et al. (2017) conclude that in real life
established and successful business entities should not be early movers of any new
market, if all possible, until some first and early movers have demonstrated the
existence and depth of the market.
Proposition 7. When commercial internet service providers emerged in
1989 and when the last restrictions on the use of the Internet to carry commercial
traffic were removed in 1995, the accelerated circulation of information and
knowledge motivated managers, entrepreneurs, and business scholars to shift their
scope of knowing from the realm of thinghood to that of systemhood. That has led
to the natural appearance of various ambiguities for these professionals to face.

4. CONCLUSION
This paper addresses the question, raised in the introduction of this paper,
which is mostly unquestioned in the literature: comparing to the history, what had
unparallelly happened in the recent decades in the developed economies that made
large firms of the industries in the traditional scale-economy suffer from the VUCA
disruptions? By referencing to the historical membership data of the General
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
33
Agreement on Tariffs and Trade (GATT) and the World Trade Organization
(WTO) and by employing game-theory-based results of systems science, that is,
Theorems 1, 4 and 5, this paper is able to derive the following main conclusions,
among others:
 The greatly increasing attention directed towards economic development, and
the formation of cross-regional economic markets of the 1990s made the
business world more volatile than before (Proposition 1).
 The massive increase in business competition (due to the Cold War being
ended) and the advent of internet in the 1990s represent one critical reason for
economic men to feel the worsening uncertainty in the business world
(Proposition 2).
 If a firm satisfies the increasing demand of its product by signing up additional
employees, then the corresponding rising organizational inefficiency will
eventually eliminate the expected increase in the production output
(Theorem 3).
 The increasing employment of knowledge that is partially reliable or totally
unreliable in business activities since the 1990s has made the business world
more complex than before (Proposition 5).
 The accelerated circulation of information and knowledge in the late 1980s and
the entire 1990s has helped to shift the way of knowing from the domain of
thinghood to that of systemhood (Proposition 7). This shift made the business
world suffer from a variety of ambiguities.
The significance of these results is that other than describing the reasons
why VUCA environment appears, they provide the exact mechanisms through
which these reasons eventually heightened the intensities and elevated the
severities of the volatility, uncertainty, complexity and ambiguity of the business
world. With such fundamental reasons and mechanisms well understood, we can
next pay revisits to many previous studies on how to survive and how to succeed in
the VUCA environment to reconfirm which suggestions are potentially workable in
practice and which ones will not produce desired outcomes.
Regarding the practical usefulness, what are developed in this paper collectively
lead to the following recommendations for decision-making business leaders.
 As the membership of the WTO is approaching its maximum (Figure 3), firms
need to focus more on how to improve their competitiveness by monitoring the
appearance of such innovations that might be potentially disruptive.
 Firms, especially those small and medium sized, need to invest more in such
R&D that focus on the reconfiguration of newly exposed knowhows so that the
reconfigured knowhows can be employed to generate profit in unconventional
ways.
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
34

 Firms that are of large size need to invest more in such R&D that focuses on
developing the next profitable competitive advantage, such as more efficient
lean production systems, better modularization, and continuous improvement
techniques.
 Firms that occupy leading positions need to invest more in reconfirming such
general knowledge that will be directly used in their design and production of
new products.
 To satisfy the increasing demand of a firm’s product, the firm needs to find
ways to raise productivity without elevating its organizational inefficiency
(Theorem 3), such as increasing its level of automation and/or digitization of the
related production (Liu et al., 2020).
As for potential future research, building on what has been achieved in this
paper, one can simply carry out the aforementioned exercises of reconfirming the
conclusions of previous studies on how to survive and how to succeed in the
VUCA environment. For instance, we can immediately reconfirm what are
suggested by the following authors, among many others, as mentioned in the
section of literature review: Bennett and Lemoine (2014), Deepika and Chitranshi
(2021), Popova et al. (2018), Mack et al. (2016), Taskan et al. (2022), Bartscht
(2015), Millar et al. (2018), Minciu et al. (2020), Troise et al. (2022), Baran and
Woznyj (2020).

5. APPENDIX
To make this presentation self-contained, we outline the proofs of Theorems
1, 4, 5 in this appendix, because they are frequently cited to derive conclusions in
the previous discussions. For relevant detailed technical proofs, please refer to the
related sources from which these results are cited from.
Before anything else, let us first normalize the boundary conditions. Based
on the assumption about the product market, given above Theorem 1, there are four
variables that need to be normalized – the selling price 𝑃𝑖 , the magnitude 𝑁𝑖 of the
base of loyal customers, the production cost 𝐶𝑖 and the expected maximum selling
price 𝑀𝑖 to the loyal customers of firm 𝑖 (= 1, 2, …, 𝑚). Then, the following
inequalities hold true:
𝐶𝑖 ≤ 𝑃𝑖 ≤ 𝑀𝑖
and
𝐿𝑖 (𝑓1 , 𝑓2 , 𝑓3 , … ) ≤ 𝑁𝑖 ≤ 𝑈𝑖 (𝑓1 , 𝑓2 , 𝑓3 , … )
where 𝑓1 , 𝑓2 , 𝑓3 , … stand for all factors involved in the production and marketing of
firm 𝑖’s product. Hence, there are 𝛼𝑖 and 𝛽𝑖 ∈ [0,1] such that 𝑃𝑖 = 𝐶𝑖 + 𝛼𝑖 (𝑀𝑖 − 𝐶𝑖 )
and 𝑁𝑖 = 𝐿𝑖 (𝑓1 , 𝑓2 , 𝑓3 , … ) + 𝛽𝑖 [𝑈𝑖 (𝑓1 , 𝑓2 , 𝑓3 , … ) − 𝐿𝑖 (𝑓1 , 𝑓2 , 𝑓3 , … )]. If we use 𝛼𝑖 as the
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
35

normalized value of 𝑃𝑖 and 𝛽𝑖 the normalized value of 𝑁𝑖 , then 𝐶𝑖 and 𝑀𝑖 will be

respectively normalized to 0 and 1.

Outline of the proof of Theorem 1. According to the proof of Theorem 3.2 in Forrest,
Nicholls et al. (2020), the assumed market does not have any pure strategy and
nonsymmetrical mixed strategy Nash equilibrium. Let 𝐹𝑖 (𝑃) be the price distribution of
Firm 𝑖 (∈ {1,2, … , 𝑚}). The assumption that an increasing number of firms enter the
market implies that the consumer surplus 𝛽 satisfies 𝛽 = 1 − 𝛼 > 0, where 𝛼 is the
magnitude of customers loyal to one of the incumbents. Assume that there are 𝑛 new
entering firms by uniformly randomizing their price P over the interval [0,1], where
their cost bases are normalized to zero and the reservation values for loyal consumers
to make purchase from his/her firm to 1. Then, the profits of incumbent Firm i are
given by
𝑚
𝛼𝑃 + 𝛽𝑃(1 − 𝑃)𝑛 ∏ [1 − 𝐹𝑗 (𝑃)]
𝑗≠𝑖

and the objective function of Firm i is

1 𝑚
𝑚𝑎𝑥𝐹𝑖(𝑃) 𝐸(Π𝑖 ) = ∫ {𝛼𝑃 + 𝛽𝑃(1 − 𝑃)𝑛 ∏ [1 − 𝐹𝑗 (𝑃)]} 𝑑𝐹𝑖 (𝑃).
0 𝑗≠𝑖

From this equation, it can be shown that the symmetric equilibrium price strategy of the
incumbent firms is
−1 𝑛−1
𝐹(𝑃) = 𝐹𝑖 (𝑃) = 𝑃𝑚−1 (1 − 𝑃)−𝑚−1 ℎ(𝑃)
1
1 𝑛−1
𝛼 𝑚−1
where ℎ(𝑃) = 𝑃𝑚−1 (1 − 𝑃)𝑚−1 − (𝛽) .
1
It can be shown that ℎ(𝑃) reaches its maximum at 𝑃 = 1/𝑛 and ℎ (𝑛) > 0, implying

𝛼 1 1 𝑛−1 1 𝑛 1 1
< (1 − ) = (1 − ) (1 − ) .
𝛽 𝑛 𝑛 𝑛 𝑛 𝑛
So, when 𝑛 → ∞, 𝛼 ⁄𝛽 → (1⁄𝑒) × 1 × 0 = 0. This is, the base of loyal
customers for each incumbent firm gradually diminishes when an increasing
number of new firms enter the market. QED
Outline of the proof of Theorem 4. (Necessity) Suppose that one enterprise
enters the market. So, each incumbent firm establishes its selling price after
considering the prices of the entrant and other existing firms. So, by solving the
 Jeffrey Yi-Lin Forrest, Yong Liu, Roger A. Solano
36

equilibrium indifference condition of Firm 𝑘, we obtain the following symmetric

equilibrium pricing strategy:
1
𝛼 𝑚−1
𝐹(𝑃) = 1 − ( )
𝛽𝑃
where 𝛼 is the average magnitude of the incumbent firms’ bases of the loyal
customers. From the need for 𝐹(𝑃) to be a well-defined probability distribution,
we produce 𝛽 ≥ 𝛼.
(Sufficiency) Assume that 𝛽 = 1 − 𝑚𝛼 ≥ 𝛼. It then suffices to show that
there is one business enterprise that will profit expectedly by competing in this
market with the incumbents through employing a uniformly randomized price
strategy over the interval [0,1], where the entrant’s cost is also normalized to 0. In
this case, the expected profits of the entering firm are:
𝛼⁄ +∞
𝛽 ((4)
𝐸𝑒 (Π) = ∫ 𝛽𝑃𝑑𝑃 + ∫ 𝛽𝑃[1 − 𝐹(𝑃)]𝑚 𝑑𝑃
0 𝛼⁄
𝛽
𝛼⁄ 𝑚
𝛽 1
𝛼 𝑚−1 ((5)
𝑚
=∫ 𝛽𝑃𝑑𝑃 + ∫ 𝛽𝑃[1 − 𝐹(𝑃)] 𝑑𝑃 + 𝛽 ( )
0 𝛼⁄ 𝛽
𝛽
where the first term on the right-hand side of equation (4) stands for the expected
profits of the entering firm when its selling price is the lowest in the marketplace
and when it captures the entire segment of switchers. The second term of equation
(4) is equal to the entering firm’s expected profits when it is in direct competition
with the m incumbent firms.
It can be shown that the second term on the right-hand side of equation (5) is
≥ 0, while other two terms > 0. So, the expected profits 𝐸𝑒 (Π) is greater than 0.
That is, there will be at least one new firm that will enter the market to compete
with the incumbents. QED
Outline of the proof of Theorem 5. This theorem can be readily shown by
slightly modifying the previous argument for Theorem 4. All details are omitted.
 The Reasons Underlying the Present Highly Volatile, Uncertain, Complex and Ambiguous Business Environment
37

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ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0002

POTENTIAL EFFECTS OF ADVANCED CYBERATTACKS ON

CYBERSECURITY SOFTWARE BUYERS’ BEHAVIOUR

GUY WAIZEL i, ADRIANA ZAIȚii

Abstract: This research paper aims to develop a comprehensive understanding of

cybersecurity buyer behavior by integrating multiple theories. Specifically, we examine the
Theory of Buyer Behavior, the Theory of Reasoned Action, the Theory of Planned Behavior,
the Stakeholder Theory, and their relevance in the context of advanced cybersecurity attacks.
The paper proposes a new model, the Cybersecurity Buyer Behavior Effect Model (CB2EM),
which synthesizes insights from these theories to predict the potential effect of advanced
cybersecurity attacks, including zero-day supply chain attacks and stealth techniques attacks,
on cybersecurity buyer behavior. Through a systematic review and analysis of the selected
theories, we identify commonalities and complementarities, ultimately creating a unified
framework that enriches our understanding of how cyber incidents shape buyer decisions.
The CB2EM is expected to provide marketers and cybersecurity vendors with valuable
insights to effectively address buyer concerns in a rapidly evolving threat landscape.
Keywords: stealth techniques; buyer behavior; zero-day, supply chain attacks;
cybersecurity software
JEL Classification: M3, M310

1. INTRODUCTION
Advanced cybersecurity threats are on the rise, with attackers increasingly
employing sophisticated techniques such as Living off the Land Binaries and
Scripts (LOLBins and LOLScripts), as well as zero-day supply chain attacks
targeting vulnerabilities within software systems. The cybersecurity landscape is
witnessing a paradigm shift due to these advanced cyberattacks, particularly as they
expose data privacy concerns and lead to breaches impacting numerous sensitive
organizations concurrently. By leveraging these techniques, attackers can
effectively circumvent traditional security measures, including Endpoint Detection
i Doctoral School of Economics and Business Administration, Alexandru Ioan Cuza University – Iași,
Romania, [Link]@[Link]
ii Alexandru Ioan Cuza University of Iaşi, Faculty of Economics and Business Administration, Iaşi,

Romania, azait@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Guy Waizel, Adriana Zaiț
44

and Response (EDR) systems, by exploiting legitimate Windows tools and an array
of vulnerabilities present in both IoT devices and computers. The ramifications of
such attacks reverberate across various industries in both the public and private
sectors, thereby challenging the stability of global economies.
This research paper aims to explore how advanced cyberattacks impact the
thoughts and actions of those purchasing cybersecurity software. To achieve this,
we thoroughly review relevant existing studies. We then relate the connection
between cybersecurity buyer behavior and the landscape of advanced attacks by
comparing established theories in buyer behavior. Our analysis incorporates
theories such as the Theory of Buyer Behavior, the Theory of Reasoned Action, the
Theory of Planned Behavior, and Stakeholder Theory. By combining these
theories, we identify important implications and introduce a new model called the
Cybersecurity Buyer Behavior Effect Model (CB2EM). This model is designed to
predict the potential effects of advanced cybersecurity attacks on the decision-
making of cybersecurity software buyers.
Through our research findings, this paper enhances the comprehension of
how those buying cybersecurity software interpret and react to the changing threat
environment. Moreover, the CB2EM model acts as a valuable resource, predicting
the diverse consequences of advanced cyberattacks on the cybersecurity software
market. This aids stakeholders in developing well-informed strategies to reduce
risks and bolster overall cyber resilience.

2. LITERATURE
2.1. Advanced Cybersecurity Threats - Stealth Techniques
Living Off the Land Binaries (LOLBins) hacking techniques have been in
use by hackers for over a decade (Campbell & Graeber, 2013). LOLBins are
executable files that come pre-installed as part of the Windows operating system,
legitimate utilities, executables, DLLs, and libraries that hackers can exploit for
their malicious purposes. In a joint report published in May 2023, CISA
(Cybersecurity and Infrastructure Security Agency) and Microsoft highlighted the
use of such techniques in attacks targeting critical infrastructure within the United
States (CISA, 2023; Intelligence Microsoft, 2023).
Attackers employ these techniques with the intent to conceal their actions
using legitimate tools like Windows PowerShell, effectively evading detection.
This concealment strategy has been in practice for years, as evidenced by a 2016
Symantec report (Symantec, 2016). Windows PowerShell, a legitimate utility pre-
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
45
installed on all Windows operating systems, offers capabilities such as execution
directly from memory, rapid remote access, lateral movement potential, and the
ability to obfuscate actions. It often blends seamlessly with routine IT
administrative tasks, making it an attractive choice for hackers engaging in fileless
malware techniques (Sudhakar & Kumar, 2020), such as the downloadstrings
technique employing WebClients.
Moreover, hackers utilize techniques like "Invoke expressions" (IEX) within
PowerShell, alongside various obfuscation methods achievable through tools like
Invoke-Stealth (K, R., 2021) and encryption via msfvenom within Metasploit
(Metasploit, 2023). These tactics facilitate the loading of potent tools into memory,
such as Redrabbit (Github, 2023), enabling the execution of commands
encompassing activities such as scanning, brute forcing, password extraction,
encoding and decoding, establishing reverse shells, employing keyloggers, and
more. To further evade detection, hackers even resort to renaming LOLBins before
execution, thus thwarting endpoint solutions that rely on predefined detection
patterns. Research has demonstrated attackers' ability to bypass endpoint protection
solutions (Karantzas, G., & Patsakis, C., 2021), presenting a significant challenge
for security solutions and Security Operations teams in detecting their movements.
Furthermore, hackers exploit Microsoft's Antimalware Scan Interface
(AMSI), a tool designed for software communication that facilitates tasks like
requesting scans of files, memory, or streams (Gallagher, S., & Gallagher, S.,
2021). Additionally, DLL sideloading techniques are frequently employed to
execute malicious code (Labs, T., 2023).
In summary, the utilization of LOLBins and associated stealth techniques
underscores the evolving sophistication of cyberattacks. Hackers' adeptness at
leveraging legitimate utilities and concealing their actions in complex ways
amplifies the difficulty of detecting and countering such threats.

2.2. Advanced Cybersecurity Threats - Zero-day and Supply Chain Attacks

Drawing from documented sources, it becomes evident that malicious
actors such as the CL0P group are adept at exploiting vulnerabilities to achieve
their objectives.
In a concerning instance, the CL0P group targeted a vulnerability known as
CVE-2023-34362 within the MOVEit security file transfer software. This
exploitation led to the breach of hundreds of organizations and thousands of hosts,
including high-profile entities such as BBC, British Airways (BA), and Boots,
 Guy Waizel, Adriana Zaiț
46

among others, all falling victim to cyberattacks (BBC, 2023). Moreover, other
reputable news outlets have reported that the same CL0P ransomware group
previously employed a zero-day vulnerability in GoAnywhere, compromising over
130 organizations (Gatlan, S., 2023). Disturbingly, indications of the exploitation
of the MOVEit vulnerability were even evident as far back as two years ago (Scott
Downie, D., 2023).
The complex dynamics of these attacks highlight significant time gaps in the
cybersecurity landscape. Organizations get caught in a cycle involving attackers
experimenting with Proof-of-Concept (PoC), vendors revealing vulnerabilities,
exploits emerging in the wild, vendors eventually releasing patches, and the
patches being applied. This puts IT departments in a constant race against
cybercriminals, working to close the gap.
Managing patches becomes a crucial concern here, demanding substantial
time and careful attention. IT departments usually test patches in controlled settings
to ensure they don't disrupt essential processes before widespread use, protecting
productivity. However, vulnerabilities often persist even after patches are issued.
Previous research shows that a significant 42% of vulnerabilities continue to be
exploited after patches are released. The speed at which exploitation happens is
striking, with vulnerabilities targeted within just two days of PoC or exploit code
becoming publicly available. Also, the average time vulnerabilities remain critical,
from disclosure to patch availability, is around 9 days (Mandiant, 2023).
Considering these difficulties, the MOVEit attack incident stands as a clear
example. The discovery of signs of MOVEit vulnerability exploitation, stretching
over two years, vividly illustrates the proactive and persistent nature of cyber
adversaries (Scott Downie, D., 2023).

2.3. The Theory of Reasoned Action (TRA)

The Theory of Reasoned Action is a psychological model that explains the
relationship between attitudes, subjective norms, and behavioral intentions. It
suggests that people's behavioral intentions are influenced by their attitudes
towards a behavior and the subjective norms related to that behavior. (Fishbein, M.,
& Ajzen, I, 1977, 2011). By illuminating the dynamic connections between
attitudes, subjective norms, and behavioral intentions, this model provides a
comprehensive framework for understanding and predicting human actions in a
myriad of contexts.
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
47
Hartanti et al. (2021) utilized the TRA theory to explore users' behavioral
aspects in information system security, aiming to support organizational
accountability and budgeting. Although not focused on cybersecurity buyers, this
research highlights the significance of understanding behavioral aspects in
security-related decision-making processes.

2.4. The Theory of Planned Behavior (TPB)

The Theory of Planned Behavior is a psychological model that extends the
Theory of Reasoned Action (TRA). It suggests that behavioral intentions and
actions are influenced not only by attitudes and subjective norms but also by
perceived behavioral control or the perceived ease or difficulty of performing the
behavior. (Ajzen, I., 1985).
A clear study of how the TPB can be used in cybersecurity shows it can help
us understand complex situations better. For instance, Sulaiman et al. (2022) delved
into the domain of information security compliance violations, shedding light on
employees' behavioral tendencies. Similarly, George et al. (2021) unearthed
compelling insights by examining customers' intent to purchase IoT security devices.
Their findings revealed that fear of burglars emerged as a positive influence on
purchasing intentions, while privacy concerns negatively affected attitudes.
Further amplifying the TPB's relevance, Vafaei-Zadeh et al. (2019)
embarked on an investigation that elucidated the intricate nexus between perceived
price levels, information security awareness, attitudes, subjective norms, and
perceived behavioral control. Their research uncovered an interesting discovery:
subjective norms play a crucial role in predicting users' intentions to install anti-
malware software. Ansari (2021) unearthed a significant positive correlation
between the effectiveness of AI-Based Security Awareness Training programs and
employees' risk scores. Aderibigbe and Ocholla (2020) probed the challenges
surrounding cyber-ethics behavior in South African universities, adding a valuable
layer of understanding to the TPB's contextual application.
Addae, J.H. et al. (2019) conducted a study employing both TRA and TBP to
investigate the factors contributing to individual cybersecurity adaptive behavior.
Their findings indicated that security-related perceptions and general external
factors significantly impact individual cybersecurity adaptive behavior. In the
context of this review, it is evident that these behavioral factors may also influence
cybersecurity buyer decisions, as a more secure product or service may be
perceived as more appealing to potential buyers.
 Guy Waizel, Adriana Zaiț
48

Maalem Lahcen et al. (2020) focused on the behavioral aspects of

cybersecurity human factors in the context of TBP. While their primary emphasis
was on the prevention of cybercrime, it can be inferred that understanding human
factors could also be valuable in understanding cybersecurity buyer behavior.
Buyers may be more inclined to invest in products or services that align with their
perceptions of effective cybercrime prevention.
Pfleeger and Caputo (2012) explored how the application of behavioral
science aspects within the context of TRA and TBP can influence perceptions of
technology effectiveness among cybersecurity buyers. The study suggests that
incorporating behavioral science principles can impact cybersecurity product and
service perception, thereby influencing buying decisions.
Pham et al. (2017) examined the application of TBP in the context of
employees' security compliance. While their focus was on employees, The study is
related to cybersecurity buyer behavior, as both involve decision-making processes
influenced by perceptions of security.
Kim et al. (2014) utilized TPB and other theories to identify behavioral
factors influencing organization members' compliance with information security
policies. Although their focus was not on cybersecurity buyer behavior, it provides
insights into behavioral factors that may also affect buyers' choices when
considering cybersecurity products or services.
Fleischman et al. (2023) investigated how beliefs and trust affect
cybersecurity investments and buyer behavior using empirical studies. While not
directly incorporating marketing theories, their research offers valuable insights
into the psychological aspects of cybersecurity decision-making.
In sum, the Theory of Planned Behavior, through its incorporation of
perceived behavioral control, emerges as a versatile framework for comprehending
the complexities of human behavior within the dynamic landscape of
cybersecurity. As demonstrated by the studies highlighted, the TPB not only
extends theoretical understanding but also provides actionable insights for fostering
enhanced cybersecurity practices.

2.5. The Theory of Buyer Behavior (TOBB)

The Theory of Buyer Behavior is concerned with understanding the behavior
of buyers or consumers in the context of making purchasing decisions. It seeks to
analyze the factors that influence consumers' choices, such as personal preferences,
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
49
attitudes, perception of the product, social and cultural influences, and economic
factors. (Howard, J. A., & Sheth, J. N., 1969).

2.6. The Stakeholder Theory

The Stakeholder theory is a management and organizational theory that
suggests that an organization should consider the interests and needs of all its
stakeholders when making decisions. (Donaldson, T., & Preston, L. E. ,1995).
Within the realm of information security and cybersecurity, Washington (2023)
embarked on an exploratory journey to investigate the applicability of the
Stakeholder theory. The focus of the research was centered on discerning how this
theory informs perceptions of an organization's information security policy. By
analyzing stakeholders' perspectives, the study adds a layer of nuance to the
integration of this theory within the cybersecurity domain.
Interestingly, during the comprehensive literature search, no specific studies
were unearthed that delved into the intricate interplay between advanced cyber
attacks and cybersecurity buyer behavior while concurrently examining the
implications of pivotal theories, namely, the Theory of Reasoned Action (TRA),
Theory of Planned Behavior (TPB), Theory of Buyer Behavior (TOBB), and the
Stakeholder theory. This uncharted territory highlights a potential research gap,
indicating an interesting path that we are pursuing in this research paper.

2.7. Studies Examining Different Theoretical Frameworks

Fielder et al. (2016) conducted a highly structured empirical study with a
focus on game theory, combinatorial optimization, and a hybrid of the two. Their
research primarily addresses cybersecurity buyer decisions regarding investments.
Although it is computer science-oriented, it offers valuable insights into how
mathematical and strategic models can inform cybersecurity investment choices.
De Vries (2017) identified four distinct cybersecurity investment strategies
based on a survey. While not explicitly grounded in theoretical frameworks like
buyer behavior or stakeholder theory, this study provides practical insights into
real-world cybersecurity investment practices. It highlights the need for further
exploration within theoretical contexts.
Shaikh and Siponen (2023) examined cybersecurity investments through the
lens of Organization Learning Theory. Their findings indicate that cyberattacks
have a significant impact on cybersecurity investments, with higher breach costs
driving increased investment. This study emphasizes the importance of
organizational learning in adapting cybersecurity strategies.
 Guy Waizel, Adriana Zaiț
50

Kianpour et al. (2019) introduced the Protection Motivation Theory (PMT)

to explore the risks organizations face when collaborating with third-party vendors
in the cybersecurity context. This study focuses on social preferences, perceived
cybersecurity risk and value, and cyber attack experience. While not aligned with
marketing theories, it offers a theoretical model to explain willingness to cooperate
within third-party ecosystems, providing insights into the supplier and third-party
impact on cybersecurity decisions.

3. METHODS
Literature Review: An extensive literature review was conducted to identify
pertinent theories related to buyer behavior, with a specific focus on cybersecurity
buyers and the influence of cyberattacks on their behavior. Key theories selected
encompassed the Theory of Buyer Behavior, the Theory of Reasoned Action, the
Theory of Planned Behavior, and the Stakeholder Theory. The exploration
encompassed studies that delve into cybersecurity buyer behavior and the impacts
of cyberattacks on decision-making. Additionally, research linking the
aforementioned theories with cybersecurity was also included.
Theoretical Framework Identification: Drawing from the literature review,
crucial constructs and variables from each theory that pertained to cybersecurity buyer
behavior were identified. This process also revealed gaps and potential overlaps
among the theories, serving as a foundation for subsequent integration efforts.
Conceptual Integration: Construct comparison and analysis were undertaken
to uncover commonalities and interconnections among the identified constructs
from each theory. The aim was to explore how these constructs could
harmoniously blend to form a more comprehensive and cohesive model,
facilitating a deeper understanding of the ramifications of advanced cyberattacks
on cybersecurity buyer behavior.
Development of a New Proposed Model: Guided by insights derived from
the theoretical integration process, the Cybersecurity Buyer Behavior Effect Model
(CB2EM) was conceptualized. This model delineates the interrelationships and
interplays between key constructs, elucidating their impact on cybersecurity buyer
behavior in the face of sophisticated cyber threats.
Discussion and Implications: Subsequent discussions centered on the
ramifications of the newly proposed CB2EM model for cybersecurity marketers,
vendors, and organizations. The model's contributions to comprehending
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
51
cybersecurity buyer behavior were highlighted, alongside the strategic implications
for addressing buyer concerns within an evolving threat landscape.
Conclusion: The paper culminated with a concise summary of findings and
contributions. Emphasis was placed on the inherent value of integrating theories to
advance the comprehension of intricate phenomena such as cybersecurity buyer
behavior. Furthermore, the potential applications of CB2EM were underscored,
particularly its role in guiding marketing strategies and influencing cybersecurity
investments.
By deploying a methodical approach to theory integration, this research
paper aims to introduce an innovative model that sheds light on the interplay
between advanced cyberattacks and cybersecurity buyer behavior. In doing so, it
contributes to the expanding realm of knowledge within both cybersecurity and
marketing research domains.

4. RESULTS
4.1. Theory of Reasoned Action (TRA) and Theory of Planned Behavior (TPB)
in the Context of Advanced Cyber Threats on Cybersecurity Buyers
When applying the Theory of Planned Behavior (Ajzen, 1985) to understand
the impact of advanced cyberattacks on cybersecurity buyer behavior, we delineate
the following categories:
Attitudes: In the realm of cybersecurity, attitudes encompass a buyer's
beliefs and evaluations regarding the advantages and disadvantages of investing in
cybersecurity solutions. Advanced cyberattacks wield a considerable influence on
attitudes. Instances such as severe cyberattacks experienced by businesses or
organizations, or high-profile cyberattacks capturing media attention, heighten
awareness about the potential repercussions of inadequate cybersecurity measures.
Consequently, cybersecurity buyers may develop more favorable attitudes towards
investing in advanced cybersecurity solutions, recognizing the benefits of
safeguarding their assets and sensitive information.
Subjective Norms: Subjective norms within the cybersecurity context pertain
to the perceived social pressures and expectations concerning cybersecurity
investments. The occurrence of advanced cyberattacks can evoke a sense of
urgency and social pressure among cybersecurity buyers. Media coverage of
cyberattacks and public perception of organizations' data security practices hold the
potential to shape subjective norms. Positive subjective norms, such as peer
 Guy Waizel, Adriana Zaiț
52

organizations adopting robust cybersecurity measures, can serve as an impetus for

buyers to follow suit and make corresponding investments.
Perceived Behavioral Control: Perceived behavioral control denotes a
buyer's perception of their capability to enact a desired behavior, specifically
investing in advanced cybersecurity solutions. The impact of advanced
cyberattacks on this facet of the Theory of Planned Behavior is multi-faceted. For
instance, if buyers perceive their organization to lack the requisite resources or
expertise to effectively address cybersecurity challenges, it may diminish their
intention to invest in advanced solutions. Conversely, if they believe that
implementing advanced cybersecurity measures lies within their control and can
proficiently safeguard their assets, their intent to invest may be heightened.
Behavioral Intentions: Behavioral intentions encapsulate an individual's
motivation and willingness to engage in a specific behavior. In the context of
cybersecurity, advanced cyberattacks wield a substantial influence on behavioral
intentions. Buyers who perceive a substantial threat emanating from cyberattacks,
hold favorable attitudes towards cybersecurity investment, and possess a sense of
control over implementing advanced solutions, are more inclined to exhibit robust
behavioral intentions to procure and adopt such solutions.
To conclude, the Theory of Planned Behavior acts as a framework to clarify
how advanced cyberattacks can impact the behavior of cybersecurity buyers. This
occurs through their attitudes, the influence of others' opinions, and their perceived
control over their actions. Advanced cyberattacks affect attitudes by making
individuals more conscious of the advantages of investing in cybersecurity. They
shape subjective norms by creating social pressure and emphasizing the
significance of cybersecurity. Moreover, the perceived behavioral control is
influenced by how buyers assess their organization's ability to effectively handle
cybersecurity challenges. These combined elements shape the behavioral intentions
of cybersecurity buyers, motivating them to invest in advanced cybersecurity
solutions to protect their organizations against potential cyber threats. We employ a
visual representation (Fig. 4.1) to illustrate the core elements of the Theory of
Reasoned Action (TRA) and the Theory of Planned Behavior (TPB) within the
context of the effect of advanced cyber threats on cybersecurity buyers' behavior.
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
53

Figure 4.1 The effect of Advanced Cyberattacks on Cybersecurity Buyer Behavior -

Theory of Planned Behavior

4.2. The Theory of Buyer Behavior (TOBB) in the Context of Advanced Cyber
Threats on Cybersecurity Buyers' Behavior
When applying the TOBB Theory (Howard, J. A., & Sheth, J. N., 1969) to
Understand the Effect of Advanced Cyberattacks on Cybersecurity Buyer
Behavior, we define the following elements:
Perception and Motivation: Advanced cyberattacks can significantly
influence cybersecurity buyer behavior by shaping their perceptions and
motivations. Awareness of high-profile cyber incidents can create a perception of
vulnerability and a heightened sense of urgency to protect assets and data. The
motivation to invest in cybersecurity solutions increases as buyers aim to mitigate
potential risks and safeguard business interests.
Information Processing: Cybersecurity buyers engage in extensive
information processing when evaluating potential solutions. Advanced cyberattacks
can stimulate the search for more information about cybersecurity products and
services. Buyers may conduct thorough research, consult experts, and compare
various options to make informed decisions.
Attitudes and Preferences: The Theory of Buyer Behavior emphasizes
attitudes in shaping consumer decisions. Cybersecurity buyers' attitudes are
influenced by perceived effectiveness and reliability of different solutions.
Advanced cyberattacks can lead to more positive attitudes toward advanced and
comprehensive cybersecurity products, as buyers seek higher protection levels to
avoid breach consequences.
Personal and Situational Influences: Personal factors, like the buyer's needs,
experiences, and risk tolerance, play a role in decision-making. Advanced
cyberattacks can trigger emotional responses, impacting risk perceptions and
 Guy Waizel, Adriana Zaiț
54

aversion. Situational factors, such as recent attack severity or regulatory changes,

can also influence buyer behavior.
Social Influences: The Theory of Buyer Behavior acknowledges social
influences on purchasing decisions. In cybersecurity, this can manifest through
peer recommendations, testimonials from attacked organizations, or guidance from
experts. Positive experiences of other organizations investing in cybersecurity
solutions may drive buyers to follow.
Post-Purchase Evaluation: After investing in cybersecurity, buyers engage in
post-purchase evaluation. If they experience attacks despite efforts, it can lead to
reassessment. Organizations may seek advanced or tailored solutions to address gaps.
In Conclusion, the Theory of Buyer Behavior sheds light on how advanced
cyberattacks can affect cybersecurity buyer behavior. Cybersecurity buyers'
perceptions, motivations, information processing, attitudes, and social influences
are all impacted by these incidents. Understanding these influences helps marketers
tailor messaging and offerings to address specific cybersecurity buyer needs in a
changing threat landscape.
We Utilize a Visual Representation (Fig. 4.2) to illustrate the main elements
of the Theory of Buyer Behavior (TOBB) in the context of the effect of advanced
cyber threats on cybersecurity buyers' behavior.

Figure 4.2 The effect of Advanced Cyberattacks on Cybersecurity Buyer Behavior -

Theory of Buyer Behavior
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
55

4.3. The Stakeholder Theory in the Context of Advanced Cyber Threats on

Cybersecurity Buyers' Behavior
When Applying the Stakeholder Theory (Donaldson, T., & Preston, L. E.,
1995) to understand the effect of advanced cyberattacks on cybersecurity buyer
behavior, we define the following elements:
Perception of Risk: The occurrence of advanced cyberattacks increases the
perception of risk among different stakeholders, including potential buyers of
cybersecurity solutions. Customers grow concerned about the safety of their
personal information and might hesitate to engage with businesses that have a
history of cyber breaches. Employees worry about job security and question the
company's ability to safeguard their data. Shareholders become cautious about
potential financial losses and harm to the organization's reputation. These risk
perceptions can significantly influence cybersecurity buyer behavior.
Trust and Reputation: Advanced cyberattacks can severely harm an
organization's reputation and undermine trust with its stakeholders. Buyers are more
likely to trust and favor companies with a strong cybersecurity track record.
Conversely, organizations that have faced cyber incidents might experience negative
perceptions and reduced trust. As a result, cybersecurity buyers tend to seek out
trustworthy and reputable cybersecurity vendors to safeguard their interests.
Demand for Robust Solutions: Stakeholder Theory emphasizes the need for
organizations to prioritize stakeholders' interests and meet their needs. Advanced
cyberattacks elevate the demand for robust cybersecurity solutions from customers,
who expect businesses to prioritize data and privacy protection. This heightened
demand can drive a shift in cybersecurity buyer behavior, leading them to actively
seek out comprehensive and innovative solutions to counter cyber threats.
Regulatory Compliance: Stakeholders, particularly customers, often demand
that organizations adhere to relevant cybersecurity regulations to ensure data safety.
Advanced cyberattacks can prompt governments and regulatory bodies to tighten
cybersecurity requirements, impacting buyer behavior. Buyers may be more inclined
to invest in cybersecurity solutions that not only safeguard their interests but also aid
them in complying with standards and avoiding potential legal consequences.
Ethical Considerations: The Stakeholder Theory underscores the ethical
dimensions of business decisions. Cybersecurity buyers may be influenced by an
organization's commitment to ethical practices and data protection. Neglecting
cybersecurity responsibilities or inadequately addressing cyber threats may deter
potential buyers who prioritize ethical considerations in their purchasing choices.
 Guy Waizel, Adriana Zaiț
56

In Conclusion, the Stakeholder Theory underscores how advanced

cyberattacks affect cybersecurity buyer behavior by shaping stakeholders' risk
perceptions, trust, reputation, and ethical considerations. Cybersecurity buyers are
likelier to seek reliable and robust solutions from reputable vendors to protect their
interests and cater to the needs of various stakeholders, including customers,
employees, and regulatory authorities. Organizations that prioritize cybersecurity
and demonstrate a commitment to safeguarding stakeholders' interests are poised to
attract and retain cybersecurity buyers in an increasingly risk-aware and security-
conscious business landscape.
We offer a visual illustration (Fig. 4.3) that outlines the core components,
showcasing the impact of advanced cyberattacks on different stakeholders within
an organization. This representation aligns with the Stakeholder Theory and
showcases the dynamic relationship between stakeholders' concerns and the
decisions made by cybersecurity buyers in response to these concerns.

Figure 4.3 The effect of Advanced Cyberattacks on Cybersecurity Buyer Behavior –

The Stakeholder Theory
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
57

4.4. The Proposed Integrated Cybersecurity Buyer Behavior Effect Model

(CB2EM)
This proposed model aims to predict the potential effect of advanced
cyberattacks, Including zero-day supply chain attacks and stealth techniques
attacks, on Cybersecurity Buyer Behavior. Here's an Overview of the CB2EM
model’s elements:
Perceived Threat and Vulnerability: This forms the model's foundation,
influenced by the Theory of Buyer Behavior (Howard, J. A., & Sheth, J. N., 1969).
Perceived threat and vulnerability are based on cybersecurity buyers' awareness of
advanced cyberattacks, including incidents like zero-day supply chain attacks and
stealth technique attacks. This factor shapes the entire decision-making process.
Attitudes and Risk Perception: Drawing from the Theory of Reasoned
Action and the Theory of Planned Behavior (Ajzen, I. , 1985; Fishbein, M., &
Ajzen, I, 1977, 2011), this factor represents cybersecurity buyers' attitudes toward
cybersecurity investment. The perception of risk, influenced by the perceived threat
and vulnerability, affects buyers' attitudes toward the importance of investing in
advanced cybersecurity solutions.
Subjective Norms and Social Influences: Incorporating elements from the
Theory of Reasoned Action (Fishbein, M., & Ajzen, I, 1977, 2011) and the
Stakeholder Theory (Donaldson, T., & Preston, L. E., 1995), this factor considers
the impact of social influences on cybersecurity buyer behavior. Media coverage,
industry trends, and peer experiences play a significant role in shaping subjective
norms and the perceived importance of cybersecurity investment.
Perceived Behavioral Control and Resource Availability: Based on the Theory
of Planned Behavior (Ajzen, I., 1985), this factor examines buyers' perceived ability
to implement advanced cybersecurity solutions. It takes into account their resources,
expertise, and the feasibility of addressing potential cyber threats.
Trust and Reputation: This factor is influenced by the Stakeholder Theory
(Donaldson, T., & Preston, L. E., 1995) and reflects buyers' perceptions of
cybersecurity vendors and their trustworthiness. It considers how advanced
cyberattacks affect vendors' reputation and how it influences buyer decisions.
Organizational Stakeholders: This factor acknowledges the role of various
organizational stakeholders (e.g., customers, employees, shareholders) as
influenced by the Stakeholder Theory (Donaldson, T., & Preston, L. E., 1995). The
impact of cyberattacks on different stakeholders can drive cybersecurity buyer
behavior, as their interests and needs come into play.
 Guy Waizel, Adriana Zaiț
58

Buyer Decision Process: This represents the collective influence of all the
factors mentioned above on the buyer decision-making process. It predicts how
cybersecurity buyers' attitudes, subjective norms, perceived behavioral control, and
trust culminate in behavioral intentions to invest in advanced cybersecurity solutions.
By integrating insights from the Theory of Buyer Behavior, the Theory of
Reasoned Action, the Theory of Planned Behavior, the Stakeholder Theory, and the
potential effect of advanced cybersecurity attacks, the CB2EM provides a
comprehensive framework for understanding and predicting the potential effects of
cyber threats on cybersecurity buyer behavior. It considers both psychological and
social factors that influence buyer decisions, providing valuable insights for
marketers and cybersecurity vendors seeking to address the evolving challenges
posed by advanced cyberattacks.
We Use a Visual Representation (Fig. 4.4) to present the main elements of
the integrated model for understanding the potential effect of advanced
cybersecurity attacks on cybersecurity buyer behavior.

Figure 4.4 The proposed integrated Cybersecurity Buyer Behavior Effect Model (CB2EM)
 Potential Effects of Advanced Cyberattacks on Cybersecurity Software Buyers’ Behaviour
59

5. DISCUSSION
By employing a systematic approach to integrating theories, this research
paper offers the CB2EM model (Fig. 4.4), shedding light on the dynamics between
advanced cyberattacks and cybersecurity buyer behavior. This contribution adds to
the growing body of knowledge in the fields of cybersecurity and marketing
research. The proposed model holds value for cybersecurity marketers, vendors,
and organizations. Theory integration's significance lies in advancing the
comprehension of complex phenomena like cybersecurity buyer behavior. The
model serves as a guide for shaping marketing strategies and making informed
cybersecurity investments.
Future research is recommended to conduct a case study analysis using real-
world examples of organizations that have encountered advanced cyberattacks.
This analysis would examine how the CB2EM model aligns with observed buyer
behavior in these cases and the decision-making processes in response to the
incidents. Additionally, seeking expert opinions and feedback from cybersecurity
professionals and marketers to validate the CB2EM through qualitative data,
obtained via interviews and focus groups, can assess the model's practical
applicability and identify potential refinements.

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 Volume 17, Issue 1/2024, pp. 63-79
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0003

INTERCONNECTEDNESS OF BRICS FINANCIAL MARKETS: A

SPILLOVER ANALYSIS

PREMANANDA MEHERi, ROHITA KUMAR MISHRAi

Abstract: This study examines the spillover effects within the financial markets of Brazil,
Russia, India, China, and South Africa (BRICS countries) using market index, currency
conversion to USD, and 10-year government bond yield as key datasets. Through the
application of correlation analysis, Granger causality tests, and Vector Autoregression
(VAR) models, we investigate the interconnectedness and causal relationships among these
variables across the BRICS economies. Our findings reveal significant correlations and
causal linkages between market indices, currency conversions, and bond yields, indicating
the presence of spillover effects within the BRICS financial markets. Moreover, the VAR
models provide insights into the dynamic interactions and transmission mechanisms
shaping these spillover effects over time. Understanding these interconnections is crucial
for investors, policymakers, and stakeholders seeking to navigate and manage risks within
the BRICS financial landscape.
Keywords: BRICS; Financial markets; Spillover effects; Correlation analysis; VAR model
JEL Classification: G1

1. INTRODUCTION
The BRICS countries, which include Brazil, Russia, India, China, and South
Africa, have been gaining increasing importance in the global economy. These
emerging economies have become significant players in the international financial
market due to their rapid economic growth, large consumer markets, and abundant
natural resources (Chakraborty, 2018). As a group, the BRICS nations have also
established their own development bank, known as the New Development Bank, to
fund infrastructure and sustainable development projects in member countries and

i Dept. of Business Administration, Sambalpur University, Jyoti Vihar, Burla, Sambalpur- 768019,
Odisha, India, meher.premananda123@[Link]
i Dept. of Business Administration, Sambalpur University, Jyoti Vihar, Burla, Sambalpur- 768019,

Odisha, India, rkmishra@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Premananda Meheri, Rohita Kumar Mishra
64

other emerging economies. Their influence in the global economy is steadily

growing, making them a key focus for investors and policymakers worldwide
(Evaghorou, 2016). The increasing interconnectedness of financial markets
worldwide has meant that events and developments in the BRICS countries have an
impact beyond their borders. As their economies become more integrated with the
global financial system, the spillover effects of market movements in these
countries are felt in international markets. This interconnectedness has prompted
investors and policymakers to closely monitor and analyze the trends and
developments in the financial markets of BRICS countries, recognizing their
significance in the broader global economic landscape (Kang & Suh, 2015).
The spillover effect of financial markets in BRICS countries refers to the
transmission of shocks, changes, or trends from one country's financial market to
another country's financial market. This can occur through various channels, such
as trade linkages, capital flows, and investor sentiment (Syriopoulos et al., 2015).
Understanding and analyzing the spillover effect of financial markets in BRICS
countries is crucial for policymakers, investors, and market participants. The
spillover effect of financial markets in BRICS countries can have both positive and
negative impacts. For example, positive spillovers can include increased
investment and financial integration, which can contribute to economic growth and
stability. On the other hand, negative spillovers can lead to contagion, where
financial crises or instability in one country's market spread to other countries'
markets, causing disruptions and volatility (Zhang et al., 2024). This can result in a
loss of investor confidence, capital outflows, and economic downturns.
Despite the growing importance of the BRICS countries in the global
economy and financial markets, there is still a lack of comprehensive
understanding regarding the specific dynamics of spillover effects within BRICS
financial markets. While general concepts of spillover effects are well-recognized,
the specific mechanisms and channels through which these effects occur within the
BRICS context require further exploration and analysis. Understanding the
spillover effects of financial markets in BRICS countries is crucial for investors
and policymakers worldwide (Kang & Suh, 2015). It allows them to make
informed decisions and develop appropriate strategies in response to developments
in these markets.
Additionally, the potential asymmetries in the transmission of spillover
effects among BRICS countries, as well as the varying degrees of financial market
development and integration within the group, present an area that demands
research attention. These dynamics have significant implications for risk
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
65
management, portfolio diversification, and policy coordination among the BRICS
nations and the broader international financial community.
While existing research explores spillover effects in general, a
comprehensive understanding of their specific characteristics within BRICS
financial markets remains limited. This research aims to address this gap by
analyzing the types, sources, and strength of spillovers in BRICS markets. By
investigating return and volatility spillovers, this study seeks to contribute valuable
insights for investors, policymakers, and anyone interested in the economic
stability and future trajectory of the BRICS bloc.

2. REVIEW OF LITERATURE
Spillover effects, where events in one financial market impact others, have
become a crucial area of study in today's interconnected global financial landscape
(Calvo, 1999). Theoretical frameworks like financial contagion and information
transmission posit mechanisms through which these spillovers occur, highlighting the
importance of understanding their dynamics for market stability (Allen & Gale, 2001).
Empirical studies have extensively explored various aspects of spillover
effects. Researchers differentiate between return spillovers, where price
movements in one market influence others, and volatility spillovers, where
fluctuations (volatility) in one market are transmitted to others (Diebold & Sylla,
1999; Engle et al., 1990). Studies by Ang (1998) and Forbes and Rigobello (1999)
employ various techniques like correlation analysis and VAR models to measure
and analyze these spillovers. Existing research identifies potential sources of
spillovers such as economic policy changes, market sentiment, and global events
(Boyer et al., 2003; Ahearne et al., 2005). However, limitations exist in terms of
generalizability and the lack of consensus on the precise mechanisms driving
spillover transmission (Baig, 2012).
While extensive research exists on general spillover effects, focusing
specifically on BRICS markets reveals a growing, yet nuanced, body of knowledge.
Studies by Ghosh et al. (2020) and Sharma (2019) find evidence of both return and
volatility spillovers within the BRICS bloc, with varying degrees of strength and
directionality. Notably, China and Russia are often identified as potential sources of
spillovers for other BRICS markets, particularly in terms of volatility (Narayan &
Sharma, 2018; Masih & Masih, 2011). These findings are further supported by
Narayan and Sharma (2018) and Masih and Masih (2011), who highlight the
asymmetric nature of spillovers, where larger economies tend to exert greater
 Premananda Meheri, Rohita Kumar Mishra
66

influence on smaller ones. However, opposing viewpoints exist, with studies by

Caporale et al. (2006) and Bordo et al. (2015) reporting weaker spillover linkages
within BRICS compared to developed markets or other emerging market groupings.
Studies by Bordo et al. (2015) and Baek and Farooq (2012) highlight the
impact of economic policy uncertainty within individual BRICS countries on
triggering spillovers across the bloc. Additionally, studies by Aguiar and Wong
(2013) and Gupta et al. (2016) explore the role of specific events like global
financial crises and commodity price fluctuations in influencing spillover dynamics
within BRICS markets.
The choice of methodology plays a crucial role in investigating spillover
effects. Studies by Masih and Masih (2011) and Tiwari et al. (2018) employ
various econometric models like Vector Autoregressions (VAR) and BEKK-
GARCH models to capture both short-term and long-term spillover dynamics.
Additionally, studies by Kenourgios and Dimitriadis (2009) and Sharma (2020)
utilize techniques like wavelet analysis to examine spillover patterns across
different frequency domains.
The COVID-19 pandemic has presented a unique challenge to understanding
spillover effects in BRICS markets. While some studies by Arora et al. (2020) and
Narayan et al. (2021) suggest an amplification of spillover effects during the
pandemic, others like Aysan et al. (2021) report a decline in spillover linkages.
This ongoing research area highlights the need for further investigation into the
long-term consequences of the pandemic on BRICS financial market integration.
The literature review reveals a comprehensive understanding of spillover
effects in general, with established frameworks and methodologies for analysis.
However, focusing on BRICS markets, the research landscape is evolving. While
evidence suggests the presence of both return and volatility spillovers within the
bloc, their strength, direction, and specific sources remain open to further
investigation. This research aims to address these gaps by analyzing the types,
sources, and strength of spillovers within BRICS financial markets, specifically
considering the potential impact of the COVID-19 pandemic and employing a
robust methodological framework.

3. RESEARCH METHODOLOGY
This section details the research methodology employed to analyze spillover
effects within BRICS financial markets. The analysis utilizes publicly available
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
67
financial data from Yahoo Finance and [Link] for the period November
2013 to November 2023.

3.1. Data Collection and Preprocessing

The study collects three main data types for each BRICS country (Brazil,
Russia, India, China, and South Africa):
 Market Index Data: Monthly closing prices of the major stock market index
for each country.
 Bond Yield Data: Monthly yields of the 10-year government bond for each
country.
 Currency Exchange Rate Data: Monthly exchange rates of each BRICS
country's currency against the US dollar.
The following table represents the data set used for the analysis to satisfy the
objective the study:
Table 1: data collected for empirical Analysis
Sl. No. Variable Name Details of the Variable
01 Bovespa Brazil Market index
02 Moex Russian Market index
03 Nifty50 Indian Market index
04 Shanghai Composite Chinese Market index
05 FTSE South Africa South Africa Market index
06 USD/BRL US Dollar to Brazilian Currency
07 USD/RBL US Dollar to Russian Currency
08 USD/INR US Dollar to Indian Currency
09 USD/CNY US Dollar to Chinese Currency
10 USD/ZAR US Dollar to Siuth African Currency
11 Brazil Brazil 10 year govt bond yield
12 Russia Russia 10 year govt bond yield
13 India India 10 year govt bond yield
14 China Chinese 10 year govt bond yield
15 Southafrica South Africa 10 year govt bond yield
Missing values are addressed using linear interpolation, where missing data
points are estimated by fitting a straight line between existing data points.

3.2. Descriptive Statistics and Unit Root Testing

Descriptive statistics (mean, standard deviation, skewness, kurtosis) are
calculated for each data series to understand central tendency, dispersion, and
distribution characteristics.
 Premananda Meheri, Rohita Kumar Mishra
68

Unit root testing, specifically the Augmented Dickey-Fuller (ADF) test, is

conducted to assess data stationarity. Non-stationary data can lead to spurious
regressions. The ADF test ensures stationarity before further analysis. The
mathematical formulation for the ADF test is as follows:
ΔY_t = α + βt + δY_(t-1) + ∑γ_iΔY_(t-i) + ε_t
where:
 ΔY_t: Difference of the variable Y at time t (differencing)
 α: Intercept term
 β: Coefficient of the trend term (t)
 δ: Coefficient of the lagged dependent variable (Y_(t-1))
 γ_i: Coefficients of the lagged differenced terms (ΔY_(t-i))
 ε_t: Error term
The null hypothesis of the ADF test is that the data has a unit root (non-
stationary), and the alternative hypothesis is that the data is stationary. The
rejection of the null hypothesis suggests stationarity.

3.3. Correlation Analysis

Pairwise correlations are calculated between all data series to explore initial
relationships between stock market returns, bond yields, and exchange rates across
BRICS countries. Correlation analysis provides a preliminary understanding of
potential linkages.

3.4. Granger Causality Tests

Granger causality tests are conducted to investigate if past changes in one
variable (e.g., stock market returns in one BRICS country) can statistically predict
future changes in another variable (e.g., stock market returns in another BRICS
country). Granger causality does not imply causation, but suggests potential
predictive relationships.

3.5. Vector Autoregression (VAR) Model

A VAR model is employed to analyze the dynamic interactions between all
data series simultaneously. This provides a more comprehensive understanding of
spillover effects.
Lag Selection:
Appropriate lag length (p) for the VAR model is determined using
information criteria like AIC (Akaike Information Criterion) or BIC (Bayesian
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
69
Information Criterion). These criteria penalize model complexity while aiming to
capture the relevant dynamics. Lower AIC/BIC values indicate a better fit.
Cointegration Test:
A cointegration test is conducted to assess if a long-run equilibrium
relationship exists between the variables within the VAR model. Cointegration
implies that the variables, even if individually non-stationary, have a stable long-
run relationship. This is important for understanding spillover effects, as shocks in
one variable might have persistent effects on others in the cointegrated system.
A common cointegration test employed in VAR analysis is the Johansen test.
This test utilizes the eigenvalues of the estimated VAR model's lag order
representation to determine the number of cointegrating vectors (rank). The null
hypothesis of the Johansen test is that there are no cointegrating vectors (no long-
run equilibrium relationship), and the alternative hypothesis is that there are a
specific number of cointegrating vectors.
 Reliability Tests: The estimated VAR model undergoes various reliability tests
to ensure its statistical soundness and provide reliable estimates for spillover
analysis. These tests address potential issues like:
 Serial Correlation: LM tests are employed to check for serial correlation
(autocorrelation) in the model's residuals. Serial correlation violates the
assumption of independent errors and can lead to inefficient estimates and
unreliable standard errors.
 Heteroskedasticity: ARCH tests are conducted to assess the presence of
heteroskedasticity (unequal error variances). Heteroskedasticity can also affect
the efficiency and reliability of estimates.

4. ANALYSIS AND FINDINGS

4.1. Descriptive Statistics
Table 2 provide a preliminary overview of the closing prices for the five
stock market indices (Bovespa, FTSE/SOUTHAFRICA, MOEX, NIFTY 50, and
Shanghai Stock Exchange Composite Index) over the sample period.
Table 2: Descriptive Statistics of BRICS market index
BOV FTSE_SOUT MOEX NIFTY_50 SHANGHAI_
ESPA
Mean 83306.04 3405.441 2371.028 11686.31 3088.859
Median 85741.00 3369.595 2292.970 10765.93 3135.610
Maximum 126802.0 4174.410 4150.000 19753.80 4611.740
 Premananda Meheri, Rohita Kumar Mishra
70
BOV FTSE_SOUT MOEX NIFTY_50 SHANGHAI_
ESPA
Minimum 40406.00 2582.750 1306.010 6089.500 2026.360
Std. Dev. 26095.62 336.1200 680.2899 3867.608 451.6006
Skewness -0.069644 0.030561 0.637549 0.633987 -0.150279
Kurtosis 1.516861 2.687653 2.825409 2.094328 4.604839
Jarque-Bera 11.09551 0.506481 8.281795 12.14001 13.32922
Probability 0.003896 0.776281 0.015909 0.002311 0.001275
Sum 9996725. 408652.9 284523.4 1402357. 370663.1
Sum Sq. Dev. 8.10E+10 13444222 55072521 1.78E+09 24269233
Observations 120 120 120 120 120

Table 3 provide a preliminary overview of the closing prices for the currency
conversion of BRICS USD/BRL, USD/RBL, USD/INR, USD/CNY, USD/ZAR)
over the sample period.
Table 3: Descriptive Statistics of BRICS currency conversion to USD
USD/B USD/RBL USD/INR USD/CNY USD/ZAR
RL
Mean 4.036873 6.637293 70.22552 64.49044 14.43751
Median 3.900550 6.641500 69.37750 64.64575 14.39760
Maximum 5.744600 7.315800 83.25600 97.96750 19.72480
Minimum 2.213700 6.053700 59.19500 32.89500 10.15500
Std. Dev. 1.046286 0.328765 6.526546 13.24707 2.244099
Skewness -0.002719 0.108540 0.404636 -0.343263 0.163297
Kurtosis 1.776591 2.015710 2.227655 3.798313 2.495400
Jarque-Bera 7.483792 5.079753 6.257188 5.543115 1.806425
Probability 0.023709 0.078876 0.043779 0.062564 0.405266
Sum 484.4247 796.4752 8427.062 7738.852 1732.502
Sum Sq. Dev. 130.2711 12.86232 5068.901 20882.69 599.2819
Observations 120 120 120 120 120

Table 4 provide a preliminary overview of the rate for the10 year govt bond
yield over the sample period.
Table 4: Descriptive Statistics of BRICS 10 year bond yield data
BRAZI CHINA INDIA RUSSIA SOUTH_AFR
L
Mean 10.86391 3.264042 7.181000 8.706583 8.981000
Median 11.24000 3.179500 7.245000 8.385000 8.837500
Maximum 16.49000 4.630000 9.044000 14.09000 11.30000
Minimum 6.300000 2.510000 5.837000 5.570000 6.875000
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
71
BRAZI CHINA INDIA RUSSIA SOUTH_AFR
L
Std. Dev. 2.334049 0.486917 0.793838 1.866067 0.834794
Skewness -0.08589 0.857663 0.267626 0.691279 0.563276
Kurtosis 2.639304 3.101819 2.471798 3.085864 3.146237
Jarque-Bera 0.798071 14.76354 2.827459 9.594186 6.452527
Probability 0.670967 0.000622 0.243234 0.008254 0.039706
Sum 1303.669 391.6850 861.7200 1044.790 1077.720
Sum Sq. Dev. 648.2864 28.21349 74.99125 414.3823 82.92893
Observations 120 120 120 120 120

4.2. Correlation Test

Table 5: correlation matrix of all variable
d(Moex)
d(Nifty50)

d(India)
d(China)
d(Bovespa)

Shanghai Composite

d(Southafrica)
d(Brazil)
d(Russia)
FTSE South Africa
d(USD/BRL)
d(USD/RBL)
d(USD/INR)
d(USD/CNY)

Bovespa 1.00 d(USD/ZAR)

Moex 0.33 1.00
Nifty50 0.55 0.46 1.00
Shanghai Composite 0.01 0.02 0.05 1.00
FTSE South Africa 0.14 0.03 0.15 0.52 1.00
USD/BRL 0.68 0.29 0.45 -0.03 0.03 1.00
USD/RBL 0.30 0.70 0.39 -0.01 0.05 0.43 1.00
USD/INR 0.38 0.24 0.71 0.01 0.02 0.59 0.45 1.00
USD/CNY 0.19 0.05 0.17 0.17 0.02 0.07 0.02 0.14 1.00
USD/ZAR 0.51 0.23 0.57 0.00 0.17 0.45 0.28 0.45 0.26 1.00
Brazil -0.53 -0.14 -0.15 0.15 0.09 -0.33 -0.13 -0.17 -0.07 -0.15 1.00
Russia -0.15 -0.44 -0.11 -0.06 0.05 -0.19 -0.42 -0.20 -0.05 -0.03 0.19 1.00
India 0.03 -0.07 0.03 0.22 0.33 -0.01 -0.04 -0.04 -0.05 0.15 0.15 -0.04 1.00
China 0.04 -0.07 0.07 0.14 0.08 -0.13 -0.14 -0.10 0.12 0.17 0.10 0.14 0.11 1.00
Southafrica -0.50 -0.24 -0.36 0.09 -0.09 -0.39 -0.22 -0.26 -0.03 -0.48 0.39 0.17 0.02 -0.03 1.00

The provided correlation matrix displays the pairwise correlation

coefficients between various financial data series for the BRICS countries (Brazil,
Russia, India, China, and South Africa) over a ten-year period (November 2013 to
November 2023). Here are some key findings based on significant correlations
(positive or negative exceeding 0.25):
 Premananda Meheri, Rohita Kumar Mishra
72

Positive Correlations:
 Within Country: A striking observation is the presence of strong positive
correlations between bond yields and stock market indices within each BRICS
nation. Brazil (0.76), Russia (0.70), India (0.71), and South Africa (0.57) all
exhibit this relationship, suggesting potential alignment between rising bond
yields and stock market performance. Additionally, all BRICS countries, except
India (0.33), display a moderate positive correlation between their currency
exchange rate and stock market index. This could indicate that a weakening
domestic currency might coincide with a rise in the stock market, potentially
due to increased attractiveness of domestic assets for foreign investors.
 Cross Country: Weaker but positive correlations exist between bond yields of
different BRICS countries. Brazil-Russia (0.34), Brazil-India (0.38), and
Russia-India (0.33) exhibit this linkage, suggesting some degree of co-
movement in their bond markets. Similarly, currency exchange rates of Brazil
and Russia (0.29), Brazil and India (0.24), and Russia and India (0.24) show a
weak positive correlation, hinting at potential interdependence influenced by
global factors affecting these currencies.
Negative Correlations:
 Within Country: Interestingly, a strong negative correlation emerges between
bond yields and stock market indices within each BRICS country, except India.
Brazil (-0.53), Russia (-0.44), and South Africa (-0.36) all display this inverse
relationship. This is the opposite of the positive correlation observed within
countries, suggesting a more complex dynamic. It's possible that rising bond
yields might signal higher risk perceptions or tightening monetary policy,
potentially leading to stock market downturns. However, India's weak negative
correlation between bond yields and currency (-0.11) is less conclusive.
 Cross Country: No significant negative correlations exceeding +- 0.25 were
observed in the heatmap shared above.

4.3. Granger Causality Test

Table 6: Granger causality test of selected pairs (+-0.25 correlation)
Lag: 1; Obs: 118 Lag: 2; Obs: 117
Null Hypothesis F- Prob. F- Prob.
Statistic Statistic
the Country

USD/BRL does not 1.06509 0.3042 051990 0.5960

Granger Cause Brazil
Variables (>
Correlated
Positively

Brazil does not 2.87651 0.0926 4.77135 0.0102*

Brazil
0.25)

Granger Cause
Within

USD/BRL
Bovespa does not 67.9287 0.0000* NA NA
Granger Cause
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
73
USD/BRL
USD/BRL does not 1.99254 0.1608 NA NA
Granger Cause
Bovespa

USD/RBL does not 0.64505 0.4235 2.41244 0.0942

Granger Cause
Russia
Russia does not 4.08293 0.0456* 0.67130 0.5131
Granger Cause
Russia

USD/RBL
Moex does not 48.4789 0.0000* NA NA
Granger Cause
USD/RBL
USD/RBL does not 0.69245 0.4071 NA NA
Granger Cause Moex

Nifty50 does not 1.04704 0.3083 0.88708 0.4147

Granger Cause India
India does not 0.06564 0.7983 0.04400 0.9570
Granger Cause
Nifty50
India

Nifty50 does not 70.4006 0.0000* NA NA

Granger Cause
USD/INR
USD/INR does not 1.11555 0.2931 NA NA
Granger Cause
Nifty50

FTSE South Africa 1.22427 0.2708 2.72625 0.0698

does not Granger
Cause Southafrica
Southafrica does not 0.33934 0.5614 0.09607 0.9085
South Africa

Granger Cause FTSE

South Africa
FTSE South Africa 7.42590 0.0074* NA NA
does not Granger
Cause USD/ZAR
USD/ZAR does not 0.35046 0.5550 NA NA
Granger Cause FTSE
South Africa

Russia does not 0.18588 0.6672 1.36136 0.2605

Granger Cause Brazil
Cross Countries

Brazil does not 0.81074 0.3698 1.18512 0.3095

Bond Yield

Granger Cause
Russia
Brazil does not 0.80976 0.3701 0.31154 0.7329
Granger Cause India
India does not 2.73459 0.1009 1.87551 0.1581
Granger Cause Brazil
 Premananda Meheri, Rohita Kumar Mishra
74
Russia does not 0.83477 0.3628 0.06035 0.3498
Granger Cause India
India does not 0.01804 0.8934 0.01040 0.9897
Granger Cause
Russia

USD/RBL does not 3.25968 0.0736 2.74600 0.0685

Granger Cause
USD/BRL
USD/BRL does not 0.01341 0.9080 0.27982 0.7564
Granger Cause
USD/RBL
USD/INR does not 0.01557 0.9009 0.32880 0.7205
Currencies

Granger Cause
rrencies

USD/BRL
USD/BRL does not 0.92818 0.3374 0.85505 0.4280
Granger Cause
USD/INR
USD/INR does not 7.92963 0.0057* 3.73689 0.0268*
Granger Cause
USD/RBL
USD/RBL does not 1.22373 0.2709 1.39504 0.2521
Granger Cause
USD/INR

Brazil Bovespa does not 0.04717 0.8285 0.97797 0.3793

Granger Cause Brazil
Brazil does not 2.64724 0.1065 1.57527 0.2115
Granger Cause
Bovespa

Russia Moex does not 7.28259 0.0080* 4.40456 0.0144*

Negatively Correlated Variables

Granger Cause
Russia
Russia does not 0.96851 0.3271 0.49876 0.6086
Within Country

Granger Cause Moex

(> -0.25)

India India does not 0.59588 0.4417 0.65702 0.5204

Granger Cause
USD/INR
USD/INR does not 0.01518 0.9021 0.35587 0.7014
Granger Cause India

South Africa USD/ZAR does not 1.97587 0.1625 1.28008 0.2820

Granger Cause
Southafrica
Southafrica does not 0.11638 0.7336 0.05797 0.9437
Granger Cause
USD/ZAR
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
75
To make the study more focused, those variable pairs which are having a
correlation of +- 0.25 have considered for the granger causality test. The following
are the significant findings of the test, the positive correlations between bond and
currency, currency and index within the BRICS countries are shown. The
correlation coefficients for Brazil, Russia, India, and South Africa are 0.76, 0.7,
0.71, and 0.57, respectively. The Granger causality test results show that in Brazil,
Brazil bond Granger causes USD/BRL at lag 2, and Brazil market index Granger
causes USD/BRL at lag 1. In Russia, Russian bond Granger causes USD/RBL at
lag 1, and Russian market index Granger causes USD/RBL at lag 1. In India, no
significant causal relationship was found between bond and index, but Indian
market index Granger causes USD/INR at lag 1. In South Africa, no significant
causal relationship was found between bond and index, but South Africa market
index Granger causes d(USD/ZAR) at lag [Link] cross-country analysis shows that
no significant positive correlations exceeding 0.25 were observed in the heatmap
for bond yields and currencies. However, the Granger causality test results for
cross-countries show that USD/INR Granger causes USD/RBL at lag 1.
the negative correlations between bond yield and index in Brazil, Russia,
India, and South Africa are shown. The correlation coefficients for Brazil, Russia,
India, and South Africa are -0.53, -0.44, -0.11, and -0.36, respectively. The
Granger causality test results show that no significant causal relationship was
found between bond yield and index in Brazil, India, and South Africa. However,
in Russia, the test results indicate that Moex Granger causes Russian bond at lag
[Link] cross-country analysis shows that no significant negative correlations
exceeding -0.25 were observed in the heatmap. The Granger causality test results
for cross-countries show that no significant causal relationship was found between
bond yields and exchange rates in the BRICS countries.
In summary, the Granger Causality Test results suggest that there is a
significant causal relationship between bond and currency, and currency and index
within the BRICS countries, except for India where no significant causal
relationship was found between bond and index. Additionally, the cross-country
analysis shows that there is no significant positive correlation between bond yields
and currencies, but USD/INR Granger causes USD/RBL at lag 1. The Granger
Causality Test results suggest that there is no significant causal relationship
between bond yields and indices in the BRICS countries, except for Russia where
Moex Granger causes Russian bond at lag 1. Additionally, no significant negative
correlations exceeding -0.25 were observed in the heatmap for cross-countries.
 Premananda Meheri, Rohita Kumar Mishra
76

4.4. VAR Test

The analysis employs a lag length of 1 based on the optimal lag selection
criteria. Johansen Co-integration tests have conducted. Trace test and max-
eigenvalue test confirms the absence of co-integration at the 0.05 significance
level, indicating that the variables are not necessarily trending together in the long
run. However, the VAR model results reveal significant causal relationships within
 Interconnectedness of BRICS Financial Markets: A Spillover Analysis
77
each BRICS country, suggesting short-term dynamic interactions between these
financial variables.
Stock Market Indices and Exchange Rates:
A key finding emerges from the VAR model: a strong causal link between
domestic stock market indices and their corresponding exchange rates in each
BRICS nation. Here's a breakdown of these relationships:
 Brazil: A coefficient of 0.933668 (p-value < 0.05) indicates that positive
performance in the Bovespa (Brazilian stock market index) is likely followed by
an appreciation of the USD/BRL. This suggests that strong stock market
performance might attract foreign investment inflows, leading to a higher
demand for BRL.
 Russia: Similarly, the model reveals a significant causal effect with a coefficient
of 0.845437 (p-value < 0.05). Positive movements in the Moex (Russian stock
market index) tend to precede an appreciation of the USD/RUB. This potential
link can be attributed to similar mechanisms observed in Brazil, where
improved stock market performance potentially attracts foreign capital inflows,
strengthening the RUB.
 India: The VAR model highlights a significant causal relationship between the
Nifty50 (Indian stock market index) and the USD/INR exchange rate. The
coefficient of 0.756463 (p-value < 0.05) suggests that a strong Indian stock
market might predict a stronger USD/INR. This potential connection could be
explained by factors like increased foreign investment in Indian equities,
leading to a higher demand for INR.
 South Africa: The model reveals a significant causal effect of the FTSE/JSE All
Share (South African stock market index) on the USD/ZAR exchange rate. The
coefficient of 0.725500 (p-value < 0.05) implies that positive movements in the
South African stock market might precede an appreciation of the USD/ZAR.
This potential link could be attributed to similar mechanisms observed in other
BRICS countries, where strong stock market performance might attract foreign
capital inflows, strengthening the ZAR.
Diagnostic tests were conducted to ensure the model's reliability. These tests
included checking for serial autocorrelation and heteroskedasticity in the model
residuals. The results of these tests confirmed the absence of serial autocorrelation
and heteroskedasticity, implying that the model residuals are not serially correlated
and have constant variance, leading to more reliable estimates and inferences.
 Premananda Meheri, Rohita Kumar Mishra
78

5. CONCLUSION
The comprehensive analysis of BRICS financial markets reveals intricate
relationships between stock market indices and exchange rates. Correlation
analysis highlights initial linkages, while Granger causality tests suggest predictive
relationships between variables. The strong causal links identified in the VAR
model emphasize the role of foreign investment inflows in shaping currency
valuations. These results contribute to a deeper understanding of the
interconnectedness of financial markets within the BRICS bloc and the influence of
global capital flows on exchange rate dynamics. The VAR model uncovers
significant short-term causal links, indicating that positive stock market
performance in Brazil, Russia, India, and South Africa influences their respective
exchange rates. These findings underscore the interconnectedness of financial
markets within BRICS nations, emphasizing the impact of foreign investment
flows on exchange rate dynamics. The absence of cointegration suggests short-term
interactions rather than long-run trends. Overall, the study provides valuable
insights into the dynamic interactions within BRICS economies, this research sets
the stage for further exploration of the mechanisms driving financial market
interactions in emerging economies and underscores the significance of
considering stock market behavior in predicting exchange rate movements within
the BRICS nations

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 Volume 17, Issue 1/2024, pp. 81-102
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0004

EVALUATING THE ELASTICITY OF SUBSTITUTION BETWEEN

CAPITAL AND LABOUR (BOTH SKILLED AND UNSKILLED) IN THE
INDIAN MANUFACTURING SECTOR

ARPIT GUPTAi, KASHIKA ARORA ii

Abstract: This study investigates the dynamics of the elasticity of substitution between
capital and labour, both skilled and unskilled, across sixteen key industries in India's
manufacturing sector. Employing a Constant Elasticity of Substitution (CES) production
function and utilizing panel data spanning from 2001 to 2017, the research employs panel
cointegration techniques to establish a long-term relationship between the variables. The
study calculates long-run elasticity through FMOLS and DOLS estimators, revealing that
in India's manufacturing sector, the elasticity of substitution between capital and skilled
labour is higher compared to that between capital and unskilled labour, as consistently
indicated by both estimators. These findings bear significant implications for industry-level
resource allocation and labour market policies, suggesting a need for targeted strategies to
enhance the integration and efficiency of skilled labour within the manufacturing sector.
Keywords: Elasticity of substitution, Factor mobility, CES production function
JEL Classification: F10, F14, L60, O14

1. INTRODUCTION
The Indian manufacturing sector has emerged as a crucial cornerstone of the
country's economic growth, contributing significantly to employment generation and
gross domestic product (GDP) expansion (Ghani, 2022). However, it thrives on the
intricate relationship between capital and labour, both skilled and unskilled.
Understanding the dynamics of substitution possibilities between capital and these
distinct labour categories holds paramount importance in optimizing production
processes and resource allocation (Das & Marjit, 2017; Basu & Maertens, 2007). The
concept of elasticity of substitution between these factors lies at the heart of

i PhD Research Scholar, Department of Economics, Indian Institute of Foreign Trade, New Delhi,
India, arpit_phd2019@[Link]
ii Senior Research Fellow at the Centre for WTO Studies, Indian Institute of Foreign Trade New

Delhi, 10kashika@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Arpit Gupta, Kashika Arora
82

understanding the industry's efficiency in utilizing resources (Acemoglu & Restrepo

2020), while playing an integral role in economic growth, labour market and public
finance (Klump, et al., 2012). This could be understood in the context of the
production function. The elasticity of substitution serves as a parameter, either
explicit or implicit, and it defines the range of all technically possible combinations
of input factors capable of generating a specific output quantity. Essentially, the
elasticity of substitution reflects how effectively a production system can convert
inputs into output. In simpler terms, it measures the efficiency of the system in this
conversion process (de La Grandville, 1989, p. 479). Put differently, when two inputs
in production are more easily replaceable, indicated by a higher elasticity of
substitution, the economy is better equipped to translate an increase in the relative
abundance of one input factor into additional output. Therefore, its impact can be
seen on business investments (Chirinko, 2002), returns of productive factors (Jones
and Ruffin, 2008), relationship between technology shocks and work hours (Cantore
et al., 2014, 2015), sectoral transformation by affecting the extent of transformation
within different sectors of the economy (Alvarez-Cuadrado et al., 2017). Recent
explanations, such as Piketty's (2014) work, on the decrease in the share of labour
income over the past two decades, heavily rely on the assumption that 𝜎 is greater
than one. Moreover, in economic growth theory, models like Solow (1956) and
Pitchford (1960) show that if 𝜎 is sufficiently high, even without technological
advancements, perpetual growth is possible, also, 𝜎 influences various aspects of
economic growth such as the level of per capita income (Klump and de La
Grandville, 2000), the rate of convergence to a steady state (Turnovsky, 2002;
Turnovsky & García-Peñalosa 2008; Klump and Saam, 2008), the differences in
income among countries (Caselli, 2005), and the direction of technological change
(Acemoglu, 2003). The elasticity of substitution between capital and labour is a
crucial factor influencing a wide array of economic phenomena and theories across
both macroeconomics and economic growth studies.
Although global studies have shed light on these dynamics (Baldwin &
Lopez-Gonzalez, 2015), the unique characteristics and challenges inherent in the
Indian context necessitate a focused investigation (Nagaraj, 2018) as developing
country such as India uses more of capital-oriented techniques of production in
manufacturing sector that complements skilled labour more, as compared to
unskilled labour employed in the same sector (Mishra 2020; Nayak, 2020). This
exploration aims to delve into this nuanced relationship, unveiling the extent to
which capital can effectively replace or complement skilled and unskilled labour in
India's multifaceted manufacturing landscape. By uncovering the elasticity of
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
83
substitution's implications, this research endeavours to shed light on optimal
resource utilization, labour market dynamics, and policy formulation tailored to
India's manufacturing sector by considering data from Annual Survey of Industries
published by Central Statistical Organization (CSO) for the period 2001-2017. The
estimation begins by developing long run cointegration relationship between the
variables. Once the cointegration relationship has been established between the
dependent and independent variables then the model is estimated using FMOLS
and DOLS method. Using the DOLS and FMOLS estimators, we find that the long
run elasticity estimates of capital and skilled labour is greater than that of capital
and unskilled labour both for FMOLS and DOLS estimators in the manufacturing
sector of India. To the best of our knowledge, there is no such study present in the
Indian context that have analysed the elasticity of substitution between capital and
skilled labour compared to capital and unskilled labour using panel data following
a panel cointegration approach.
The paper is structured as follows; the second section provides the literature
supporting the notion of elasticity of substitution between capital and different
forms of labour. Third section focuses materials and methods. The fourth section
discusses the results. Fifth section presents the conclusion and finally, section six
provides managerial implications.

2. LITERATURE REVIEW
The necessity for estimating production functions at the industry level within
macroeconomics has emerged due to the successful integration of human capital
into macroeconomic analyses. Pioneering contributions by Romer (1987, 1990)
and Lucas (1988) initiated this shift, emphasizing the pivotal role of human capital
in growth and development. As the significance of human capital became widely
acknowledged, macroeconomists expanded the paradigm to differentiate between
various types of labour inputs and production capacities across industries. Notably,
attention has been directed towards two prominent trends in the overall economy
regarding labour types. Firstly, there has been a consistent increase in the
proportion of the population classified as skilled, measured through various
criteria. Secondly, there has been a continual rise in the wage disparity favouring
skilled workers over time. To comprehensively address the causes and implications
of these trends, it becomes imperative to dissect labour into skilled and unskilled
categories. Recent studies pursuing this line of inquiry include the works of Krusell
et al. (2000), Acemoglu (2002), and Blankenau and Cassou (2006). However, it is
 Arpit Gupta, Kashika Arora
84

the elasticity of substitution between labour and capital that acts as a key factor in
supply-side economics, significantly influencing economic growth, labour markets,
and public finance, (Borjas, 1980, 2003; Bound et al., 2004; Borjas & Katz, 2007;
Klump, 2012) noted. A nation's economic expansion is heavily reliant on the rapid
development of its principal sectors, particularly manufacturing, which employs a
substantial number of both skilled and unskilled workers, as well as capital. The
growth of the manufacturing sector is dependent not only on the expansion of its
production factors but also on the interplay between capital and skills within the
sector. In developing countries like India, manufacturing often favours capital-
intensive production methods that are more complementary to skilled labour than
to unskilled labour (Kapoor, 2015). This capital-skill complementarity raises
important questions. Early research by Fallon & Layard (1975) indicated that
physical capital is more complementary to skilled than unskilled labour. Knoblach,
et al., (2000) found similar results, showing a higher elasticity of substitution
between capital equipment and unskilled labour compared to skilled labour. This is
attributed to the fact that as capital stock increases, the marginal productivity of
skilled labour rises (due to capital-skill complementarity), while that of unskilled
labour falls. Therefore, a country's economic growth can be enhanced by increasing
skilled labour, which has a higher degree of substitutability with capital compared
to unskilled labour. These conclusions were supported by using a two-level CES
production function and analyzing time series data.
Several empirical studies have been conducted to estimate the elasticity of
substitution between capital and labour in Indian manufacturing industries, with
notable contributions by researchers like Asif Banarji (1975), Gujarati (1966), Kazi
(1980), Upender (2009), and Pohit et al., (1995), Chadha et al., (1998).
Elabourately, in 1966, Gujarati found that the substitution elasticity index was
close to one for the period from 1946-1958, based on his CES (Constant Elasticity
of Substitution) formulations. Shankar, in his 1970 study, estimated this elasticity
and returns to scale across fifteen manufacturing industries using the CES
production function. He discovered that five of these industries exhibited elasticity
greater than one. Kazmi, in his 1981 study, opted for a Variable Elasticity of
Substitution (VES) production function instead of the CES model, critiquing the
latter for assuming constant elasticity along an isoquant. He noted that the elasticity
estimates were overestimated when using the CES function. Chadha and Pohit in
their 1995 study aimed to measure the substitution elasticity in Indian
manufacturing using the CES production function. They found that the estimates
varied between 0.58 to 1.62 across 23 sectors at the three-digit level. Additionally,
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
85
studies by Virmani and Hashim (2009) also focused on gauging these elasticity
estimates in the manufacturing sector in the Indian context, employing time-series
data for their analysis. More recently, Goldar in 2014 conducted a study to measure
the substitution elasticity between capital and labour in the broader context of the
Indian economy, not just limited to the manufacturing sector. In this sector, he
observed a high degree of substitution elasticity between capital and labour.
However, it's noteworthy that there appears to be a lack of studies measuring the
elasticity of substitution between capital and skilled labour versus capital and
unskilled labour in the Indian context, particularly using panel data and following a
panel cointegration approach. This suggests an area for potential future research. In
similar vein, we proceed by building a theoretical model to find out elasticity of
substitution estimates between capital and skilled - unskilled labour in the Indian
manufacturing sector.

3. MATERIAL AND METHODS

3.1. Empirical Framework
The mathematical equation of CES production function can be depicted as:
𝜎
𝜎−1 𝜎−1 𝜎−1
𝑌 = (𝛼𝐾 𝜎 + (1 − 𝛼)𝐿 𝜎 )

Where 𝑌 is the output, 𝐾 is the stock of capital and 𝐿 is labour employed.

𝛼, 𝜎, 𝜌 are the parameters. 𝜎 is the CES estimates between the factors of production
and 𝛼 is the distribution parameter. The value of 𝛼 ∈ (0,1). 𝜎 and 𝜌 are related by
1
equation: 𝜎 = ( ); here the value of 𝜌 ≤ 1.
1−𝜌

We can separately write the above CES production function equation in terms
of unskilled labour and skilled labour respectively with same amount of capital:
𝜎
𝜎−1 𝜎−1 𝜎−1
𝑌= (𝛼𝐾 𝜎 + (1 − 𝛼)𝐿𝑢𝜎 )
𝜎
𝜎−1 𝜎−1 𝜎−1
𝑌= (𝛼𝐾 𝜎 + (1 − 𝛼)𝐿𝑠 𝜎 )

Where 𝑌 is the real output of industries, 𝐾 is the real net fixed capital stock,
𝐿𝑠 represents skilled labour and 𝐿𝑢 represents unskilled labour respectively.
 Arpit Gupta, Kashika Arora
86

The ratios of computed marginal productivity of labour and capital can be

shown as;
1
𝑀𝑃𝑙 𝛿𝑌 𝛿𝑌 1 − 𝛼 𝐾 𝜎
= = ( )
𝑀𝑃𝑘 𝛿𝐿 𝛿𝐾 𝛼 𝐿

At equilibrium:
𝑀𝑃𝑙 = 𝑤
𝑀𝑃𝑘 = 𝑟

where, 𝑤 is the wage rate of labour and 𝑟 is the rent rate for the capital. At
equilibrium, marginal productivity of labour is equal to the wage rate (𝑀𝑃𝑙 = 𝑤) and
the marginal productivity of capital is equal to the rental cost of capital(𝑀𝑃𝑘 = 𝑟).
Solving the above equilibrium condition, we get:
1
1−𝛼 𝐾 𝜌 𝑤
⟹ =( ) =
𝛼 𝐿 𝑟

Taking log on both the sides, we get a log linear equation represented by:
𝐾 𝛼 𝑤
log ( ) = 𝜎log ( ) + 𝜎log ( )
𝐿 1−𝛼 𝑟
𝐾 𝑤
Where, 𝐿
is the capital-labour ratio, 𝑟
is the wage-rental ratio and
𝛼 𝑤
𝜎log (1−𝛼) is the constant term. The coefficient of 𝑟 , which is 𝜎 is the elasticity of
substitution.

3.2. Empirical Strategy

As can be seen from the theoretical model, we can write the equilibrium
condition in the following econometric form to estimate our model:
𝐾𝑗 𝛼 𝑤𝑗
log ( ) = 𝜎log ( ) + 𝜎log ( ) + 𝜂𝑖𝑡
𝐿 𝑖𝑡 1−𝛼 𝑟 𝑖𝑡

𝐾𝑗
The dependent variable log ( ) is the capital-labour ratio in the logarithm
𝐿 𝑖𝑡
form where 𝑗 = U (unskilled labour), S (skilled labour); subscript 𝑖 denotes the 𝑖 th
industry (𝑖 = 1, … . ,16) and 𝑡 denotes the 𝑡 th year (𝑡 = 2001 − 02, … ,2017 −
𝑤𝑗
18). The independent variable is log ( 𝑟 ) which is the ratio of labour wage-rental
𝑖𝑡
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
87

rate of capital stock (in logarithm form) at time-period 𝑡 for 𝑖 manufacturing

industries. 𝜎 is the elasticity of substitution between capital and labour (unskilled).
𝛼
𝜎log (1−𝛼) is the constant term and 𝜂𝑖𝑡 is the idiosyncratic error term.
To assess the model, we have employed the panel cointegration estimation
technique to derive estimates of the long-run elasticity of substitution. Initially,
panel unit root tests were utilized to ascertain the stationarity of variables involved
in the estimation process. Various unit root tests, namely Levin, Lin & Chu (LLC),
Breitung, Im, Pesaran and Shin (IPS), and Hadri, were applied to identify the
characteristics of the variables. A series is considered non-stationary if it possesses
a unit root. To test for non-stationarity, four distinct tests were employed: Levin,
Lin & Chu (LLC), Breitung, Im, Pesaran and Shin (IPS), and Hadri unit root tests.
Following the confirmation of unit root presence and the stationarity of
variables at first difference I(1), indicating they are stationary, a cointegration test
was performed to explore the long-run relationship between dependent and
independent variables. The Pedroni cointegration test, introduced by Pedroni (1999),
comprises seven tests categorized into within dimension statistics (panel
cointegration statistics) and between dimension statistics (group mean cointegration
statistics). The within dimension statistics involve pooling autoregressive coefficients
across heterogeneous cross-sectional units, while the between dimension statistics
entail averaging individual estimated coefficients for each cross-sectional unit.
Out of the seven Pedroni tests, three are between dimension statistics (group-
rho, group non-parametric-t, and parametric test similar to the ADF statistic), and
four are within dimension statistics (parametric variance ratio test, Philips-Perron
rho-statistic, Philips and Perron t statistics test, and ADF statistics). All these tests
assume the null hypothesis of no cointegration, with the alternative being the
presence of cointegration.
Once cointegration is established, the model is estimated using Fully
Modified OLS (FMOLS) and Dynamic OLS (DOLS) methods. Conventional OLS
method is avoided due to non-stationarity in the model of order 1, as it may yield
consistent but inefficient estimates, potentially leading to erroneous inferences.
FMOLS and DOLS tests, on the other hand, provide more accurate results for
panel cointegrated models, accommodating heterogeneity in cointegrating vectors
and elucidating the long-run relationship among regressors.
he Group Mean Fully Modified OLS (GFMOLS) approach, introduced by
Pedroni in 2001, averages individual FMOLS estimations for each cross-section
(industries, in this case), effectively addressing the endogeneity issue in
 Arpit Gupta, Kashika Arora
88

independent variables and correcting for serial correlation. This leads to more
reliable coefficient estimates, particularly in small sample scenarios. The FMOLS
group mean panel estimator is more versatile in its hypothesis testing compared to
the pooled FMOLS panel estimator because it relies on between dimension
estimation, unlike the within dimension approach. As a result, group mean
estimators (FMOLS) are more likely to yield consistent estimates of the sample
mean of the cointegrating vector, whereas pooled within dimension estimators
often fall short in this regard.
The DOLS estimator, developed by Stock and Watson in 1993, offers an
improvement over FMOLS by addressing model endogeneity more effectively. In
finite sample situations, DOLS has demonstrated superior performance to both
OLS and FMOLS in Monte Carlo experiments, providing unbiased estimations.
Additionally, DOLS includes robust adjustments to correct for endogeneity in
regressors, further enhancing its efficacy in empirical analysis.

3.3. Data Sources and Construction of Variables

Current study employs data from the Annual Survey of Industries published
by Central Statistical Organization (CSO), which is the principal source of data for
industrial statistics. In ASI database, National Industrial Classification (NIC) had
been revised many times in the past for example- NIC 1987, NIC-1998, NIC-2004
and NIC 2008. In our analysis, since we have used data from the time-period 2001-
2017, comparable data is required at 2-digit level of industries. Therefore, we have
used data from the EPWRF Database where concordance exercise has already been
worked out at the 2-digit level. The fixed capital variable is deflated by using
Wholesale Price Index (Machinery and machine tools) which is provided by the
office of Economic advisor, Ministry of Commerce and Industry. To deflate the
value of wages of skilled and unskilled workers, consumer price index for
industrial workers (CPI-IW) has been employed which was obtained from Labour
Bureau (Ministry of Labour and Employment).

3.3.1. Labour
The present study required data of both skilled labour and unskilled labour
employed by the Indian manufacturing industries. The data ASI provides is on
‘worker’ and ‘total persons engaged’ in a manufacturing industry. Since separate
data on skilled labour and unskilled labour employed in the Indian manufacturing
sector is not available in ASI database and no such information is available on the
education level and skill set of the workforce.
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
89
Therefore, available information in the ASI database is used. The data
provides information on number of workers and total employees engaged in a
particular industry. The number of workers is the ‘production workers’ (which is
also subcategorized into directly employed workers and contract workers) and the
‘non production workers’ which are managerial staff and supervisors. Thus, to
calculate the no. of unskilled workers employed, these two categories are clubbed to
represent ‘production workers’ as unskilled workers and non -production workers as
skilled workers. The production workers include all those who were employed in
production activities and non-production workers includes staff such as supervisors,
clerks, administrative and managerial staff. Therefore, the data of number of
workers’ will be used as a proxy for unskilled workers in the estimation and
remaining data will be treated as proxy for skilled workers. Since ASI database does
not provide any type of information regarding education or skill set of the employees
therefore, we had to rely upon this type of method to distinguish between skilled and
unskilled labour. Previous literature suggests proximity between the production
workers and their level of education Goldberg and Pavcnik (2007).
Similarly, to get data for wages of skilled workers and unskilled workers,
information on wages of workers and total emoluments has been utilized. ‘Wages
to Workers’ have been used as proxy for wages of unskilled workers and this data
is then subtracted from ‘Total Emoluments’ to get data for wages of skilled labour.

3.3.2. Capital
Real net fixed capital has been used as a proxy for capital. For this perpetual
inventory method has been employed to calculate the value of real net fixed capital stock.
ASI database provides data for fixed capital which cannot be used for the
stock of capital, so the variable has been transformed to real net fixed capital stock
through perpetual inventory method.
𝐾𝑡 = 𝐼𝑡 + (1 − 𝛿𝑡 )𝐾𝑡−1
Where 𝐼𝑡 is the gross investment and 𝛿𝑡 is the depreciation rate at time period 𝑡
First to construct real fixed capital stock, fixed capital book value at current
year is being subtracted from the previous year and depreciation of the current year
is added to it to get the value of gross investment in the current year.
Real gross investment value is created by deflating gross investment by WPI
(Machinery and machine tools) index. The book value of fixed capital is deflated
by WPI (Machinery and machine tools) index.
 Arpit Gupta, Kashika Arora
90

Finally, to create a series for real fixed capital stock for the current year, real
fixed capital from previous year is added to real gross investment of current year
and subtracted to depreciation of current period to arrive at the final series.

4. RESULTS AND DISCUSSIONS

The analysis begins with the application of panel unit root test LLC,
Breitung, Im-Pesaran Shin, Hadri to check the order of integration of the variables.
There are total four sets of variables specified in table 1 for whom these tests are
run. Total four test are run on these specified variables to check the order of
integration. The null hypothesis in each case assume that the process is non
stationary except Hadri LM test whose null hypothesis assumes that the process is
stationary against the alternative hypothesis of non-stationary.
Table 1: Panel Unit Root Tests (Variables in Levels)
Variables LLC Breitung IPS Hadri
log(capital/labour(US) -2.05 -1.34 -1.60 21.28*
log(capital/labour(US)) -2.55 -0.77 - 1.30 23.21*
log(wage(S)/rent) -1.70 -2.42* -1.86 16.40*
log(wage(US)/rent) -1.65 -2.63* -2.01 13.89*
Note:
1. All variables are specified in natural log
2. Automatic selection of maximum lags is based on SIC: 0 to 3
3. Automatic bandwidth selection is based on Newey-west using Kernel-Bartlett
4. * indicates null hypothesis rejection of non-stationary process for Levin,Lin&Chu, Breitung, Im,
Pesaran and Shin or Stationary process (Hadri) at the 5% level of significance.
5. Individual intercept included and no. of observation NT=272.
From the table 1 we can clearly see that almost all of the test fail to reject the
null hypothesis that is presence of unit root (LLC, Breitung, IPS) and reject the null
hypothesis (Hadri) that is presence of stationary process. However, for the
(Breitung unit root test), variable log(wage(S)/rent) and log(wage(US)/rent) reject
the null hypothesis that is the process is stationary. Since three of the four tests
confirm that the process is non stationary at level that means present of unit root
therefore from the above table, we conclude that the above four variables are non–
stationary at level.
Table 2: Panel Unit Root Tests (Variables in 1st Differences)
Variables LLC Breitung IPS Hadri
log(capital/labour(S) -13.38* -5.77* -5.30* -1.73
log(capital/labour(US)) -13.72* -3.76* -5.13* -2.37
log(wage(S)/rent) -13.70* -4.39* -5.36* -2.07
log (wage(US)/rent) -12.87* -3.22* -5.23* -2.01
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
91
Note:
1. All variables are specified in natural log
2. Automatic selection of maximum lags is based on SIC: 0 to 3
3. Automatic bandwidth selection is based on Newey-west using Kernel-Bartlett
4. * indicates null hypothesis rejection of non-stationary process for Levin,Lin&Chu, Breitung, Im,
Pesaran and Shin or Stationary process (Hadri) at the 5% level of significance.
5. Individual intercept included and no. of observation NT=272.
From the table 2, we can clearly infer that the all three tests (LLC, Breitung,
IPS) reject the null hypothesis of non-stationary process which means that the
variables are stationary at first difference. Similarly, Hadri (LM) test fail to reject
the null hypothesis which also confirms the above three tests. Now since we know
that all the variables are integrated of order one then we can go for panel
cointegration tests to identify the long run relationship among the variable. If there
is cointegration then we can estimate the non-stationary variables at level form that
are consistent and avoids spurious regression which we usually get in case of non-
stationary variables.
Table 3: Seven different Pedroni panel cointegration tests

Group panel
Variables Panel statistics
statistics
Dependent variable Panel V--Statistics 1.03
(0.149)
log(capital/ labour(S) -3.56*** -1.75**
Panel Rho--Statistics
(0.000) (0.039)
-4.47*** -4.52***
Panel PP--Statistics
explanatory Variable (0.000) (0.000)
log(wage(S)/rent) Panel ADF--Statistics -2.96*** -4.503***
(0.001) (0.000)
Dependent variable Panel V--Statistics -0.018
(0.574)
log(capital/labour (US) -1.18** -0.78
Panel Rho--Statistics
(0.034) (0.216)
-2.69*** -3.04***
Panel PP--Statistics
explanatory Variable (0.003) (0.001)
log(wage(US)/rent) Panel ADF--Statistics -2.57*** -2.58***
(0.005) (0.004)
NOTE: *** Indicates level of significance at 1%, 5%, 10% respectively

In the above table 3, Pedroni (2004) cointegration test has been applied to
check for the presence of long run relationship among the variables of interest. In
our study we have two models: Model 1 that examines the long run elasticity
between capital and skilled Labour and Model 2 that examines the long run
elasticity between capital and unskilled labour. Thus, separate tests have been
conducted for both the models to check for their cointegration. Test have been
 Arpit Gupta, Kashika Arora
92

conducted with individual intercept without trend. Optimal lag selection used is
Schwarz Info criterion for both the cases.
From the table 3, we can infer that in model 1, six out of seven tests (both
within and between dimension estimation) points out that there is presence of long
run relationship among the variables. Six out of seven tests reject the null
hypothesis of no cointegration thus proves strong cointegrating relationship when
the dependent variable is log (capital/labour(S)). Similarly, from the above table in
model 2, we can infer that Five out of seven test (both within and between
dimension estimation) points out that there is presence of long run cointegrating
relationship between the variables when the dependent variable is
log(capital/labour(US)). All the tests are performed at their level form.
Table 4: Cross Sectional Dependence Estimation Results
Variable CD-test P valueless
log(wage(S)/rent) 24.868*** 0.0000***
log(wage(US)/rent) 23.857*** 0.0000***
log(wage(S)/rent) 10.388*** 0.0000***
log(wage(US)/rent) 4.149*** 0.0000***
Note: *** Indicates level of significance at 1%, 5%, 10% respectively
From the above table 4, we can clearly see that cross-sectional dependence
there is present in the model since CD-test statistic is significant. The p value is
also very small (equal to zero) and significant at all levels. This means that Indian
industries are cross-sectionally dependent on each other. This can be due to
unobserved factor like technological spillover or observed factors like business
cycle, geopolitical factors.

Table 5: Panel FMOLS and DOLS Results

Dependent variable: log (capital/labour(S)
Std.
Coefficient Coefficient
Error Std. Error
Method Variables (pooled (group P-value
(pooled (group mean)
mean) mean)
mean)
FMOLS log(wage(S)/rent) 0.788 0.744
0.043 0.038 0.000***
(17.93) (19.47)
log(wage(S)/rent) 0.866 0.746
DOLS 0.061 0.051 0.000***
(14.012) (14.63)
NOTE:
1. *** Indicates level of significance at 1%, 5%, 10% respectively
2. t-statistics are in parenthesis ().
3. p value indicates both for pooled mean and group mean
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
93
Table 6: Panel FMOLS and DOLS Results
Dependent variable: log (capital/labour (US)
Coefficient Std. Error Coefficient Std. Error
Method Variables (Pooled (pooled (group (group P-value
mean) mean) mean) mean)
log(wage(US)/rent) 0.518 0.67
FMOLS 0.058 0.066 0.000***
(8.814) (10.11)
log(wage(US)/rent) 0.548 0.80
DOLS 0.088 0.122 0.000***
(6.216) (6.54)
NOTE:
1. *** Indicates level of significance at 1%, 5%, 10% respectively
2. t-statistics are in parenthesis ().
3. p value indicates both for pooled mean and group mean

Table 5 presents the outcomes of Panel Fully Modified OLS (FMOLS) and
Dynamic OLS (DOLS) estimations for the elasticity of substitution between capital
and skilled labour. The long-run elasticity is 0.788 (FMOLS) and 0.866 (DOLS)
for the pooled mean, and these results are statistically significant. In contrast, Table
6 illustrates the long-run elasticity estimates between capital and unskilled labour,
which are 0.518 (FMOLS) and 0.548 (DOLS) for the pooled mean. Notably, these
estimates are lower than the long-run estimates for the relationship between capital
and skilled labour.
Furthermore, when examining Table 5 for the group mean estimates, the
long-run elasticity between capital and skilled labour is 0.744 (FMOLS) and 0.746
(DOLS), surpassing the elasticity estimates for the capital and unskilled labour,
which is 0.67 (FMOLS). This suggests a notable difference in the substitution
elasticity patterns between capital and skilled labour compared to capital and
unskilled labour, with the former exhibiting higher long-run elasticity in both
pooled mean and group mean estimations.
Our findings contrast with those of Hamermesh (1994), who indicated a lower
degree of substitution between capital and skilled labour compared to capital and
unskilled labour. However, it is important to note that Hamermesh's research focused
on Latin American and Caribbean countries. Similarly, our results diverge from those
of Grilliches (1969) and Bergstrom and Panas (1992), who also found that the
elasticity estimates between capital and skilled labour were lower than those between
capital and unskilled labour. A crucial difference in our approach is the use of panel
data, unlike the time series data employed in these studies, which did not account for
variations in technology and assumed constant returns to scale and neutral
technological progress. Panel data offers the advantage of controlling for time-specific
or industry-specific fixed effects, which can be a significant factor in such analyses.
 Arpit Gupta, Kashika Arora
94

To date, there appears to be no similar study in the Indian context that has
calculated the long-run elasticity estimates between capital and skilled labour
versus capital and unskilled labour using panel data. This highlights the novelty
and significance of our research in this area.
Table 7 provides individual FMOLS results for the long-run elasticity
estimates across sixteen manufacturing industries for the period 2001-2017. The
coefficients of the log of wages (s)/rent ratios are mostly significant, with the
notable exceptions being the wearing apparel and consumer electronics industries,
where the coefficients are not significant. In the case of unskilled labour, the
coefficients of the log of wages (us)/rent ratio are significant across most
industries, except for three: wearing apparel, non-electrical machinery, and
consumer electronics industries. This indicates that while the relationship between
wages and capital rent ratios is generally significant in determining elasticity, there
are industry-specific variations that merit further investigation.
When analysing the elasticity estimates between capital-skilled and capital-
unskilled labour using individual FMOLS results, we find that in 8 out of 14
industries, the elasticity between capital and unskilled labour is higher than that
between capital and skilled labour. This pattern aligns with the findings of
Grilliches (1969) and Bergstrom and Panas (1992), who also utilized time series
data to demonstrate similar results.
In certain industries, such as food products and beverages, tobacco products,
rubber and plastics products, basic metals, non-electrical machinery (in the case of
skilled labour), and textiles (in the case of unskilled labour), the substitution
elasticity is reported to be greater than one and is statistically significant. This high
elasticity indicates that the relative demand for factors of production adjusts
effectively in response to changes in their relative supply, a concept highlighted by
Chiswick in 1985. It's important to note that the substitution elasticity is influenced
not only by technology and innovation but also by the organizational structure of
the economy and how firms respond to change and uncertainty in the market.
An interesting case is seen in the medical optical and communication
industry, where a negative elasticity of substitution (-0.32) between capital and
unskilled labour is reported (Individual FMOLS), with significant results. This
negative elasticity suggests that in this industry, capital and unskilled labour
function as complements rather than substitutes. This distinction is crucial for
understanding the dynamics of labour and capital in different sectors and how they
adapt to economic and technological changes.
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
95
Table 7: Long run Elasticity Estimates over the Period 2001-2017 in sixteen selected Industries of
Indian Manufacturing (Individual FMOLS Results)
Dependent variable: Dependent variable:
log(capital/labour(S)) log(capital/labour(US))
2-Digit Industries log(wages/rent(S)) P-value log(wages/rent(US)) P-value
ID
14 Mining and 0.82*** 0.0004*** 0.77*** 0.003***
Quarrying (4.62) (3.52)
15 Food Products 1.07*** 0.000*** 1.32*** 0.000***
Beverages (11.38) (7.73)
16 Tobacco 0.89*** 0.000*** 1.11*** 0.000***
Products (10.20) (4.97)
17 Textiles 0.76*** 0.000*** 1.02*** 0.000***
(10.53) (11.40)
18 Wearing 0.07 0.77 -0.26 0.251
Apparel (0.29) (-1.19)
21 Paper 0.79*** 0.001*** 0.85** 0.042**
and Paper (3.97) (2.23)
Products
23 Coke, Refined 0.73*** 0.000*** 0.84*** 0.000***
&Petroleum (7.19) ( 4.34)
Products
24 Chemicals and 0.54*** 0.002*** 0.88*** 0.001***
Products (3.74) (4.13)
25 Rubber and 1.10*** 0.000*** 1.37*** 0.003***
Plastics (5.18) (3.46)
Products
26 Non-metallic 0.72*** 0.000*** 0.84*** 0.000***
Mineral Products (14.06) (6.87)
27 Basic 1.08*** 0.000*** 1.22*** 0.000***
Metals (8.97) (7.88)
29 Non- 1.43*** 0.000*** 0.24 0.755
Electrical (8.60) (1.31)
Machinery
30 Office & 0.43*** 0.002*** 0.19*** 0.002***
Computer (3.76) (3.67)
Machinery
31 Electrical 0.80*** 0.000*** 0.36* 0.067*
Machinery (4.23) (1.98)
32 Consumer 0.01 0.951 0.22 0.127
Electronics (0.06) (1.62)
33 Medical 0.59** 0.024** -0.32*** 0.003***
optical & (2.51) (-3.45)
Communication
NOTE:
1. ‘***’ indicates 1% ‘**’ at 5% and ‘*’ at 10% statistically different from zero respectively
2. All the variables are in log form
3. Bartlett Kernel, Newey-west fixed bandwidth=3, DOLS estimation lag =1&leads=1
4. t-statistics are in parenthesis ()
 Arpit Gupta, Kashika Arora
96
Table 8: Long run Elasticity Estimates over the Period 2001-2017 in sixteen selected Industries of
Indian Manufacturing (Individual DOLS Results)
Dependent variable: Dependent variable:
log(capital/labour(S)) log(capital/labour (US))
2-Digit
Industries log(wages/rent(S)) P-value log(wages/rent(US)) P-value
ID
Mining And 1.24*** 1.27**
14 0.000*** 0.012**
Quarrying (8.19) (3.13)
Food Products 1.03*** 0.000*** 1.24***
15 0.000***
Beverages (11.98) (7.77)
Tobacco 0.92*** 1.20***
16 0.000*** 0.002***
Products (9.16) (4.26)
0.76*** 0.94***
17 Textiles 0.000*** 0.000***
(9.34) (7.33)
Wearing -0.31 -0.53
18 0.33 0.1003
Apparel (-1.01) (-1.83)
Paper
1.02*** 1.30*
21 and Paper 0.001*** 0.083*
(4.44) (1.94)
Products
Coke, Refined
0.74*** 0.91***
23 &Petroleum 0.001*** 0.000***
(6.27) (5.16)
Products
0.53** 0.86*
24 Chemicals and Products 0.017** 0.065*
(2.89) (2.09)
Rubber and Plastics 1.19*** 1.59***
25 0.000*** 0.008***
Products (5.13) (3.37)
Non-metallic 0.75*** 0.92***
26 0.000*** 0.000***
Mineral Products (13.99) (8.93)
1.12*** 1.30***
27 Basic Metals 0.000*** 0.000***
(9.01) (8.13)
Non- Electrical 1.44*** 1.28*
29 0.000*** 0.437*
Machinery (8.82) (0.81)
Office & Computer 0.58** 0.037** 0.19**
30 0.014**
Machinery (2.43) (3.00)
Electrical 0.76*** 0.49***
31 0.003*** 0.008***
Machinery (5.70) (3.33)
Consumer -0.11 0.19
32 0.681 0.315
Electronics (-0.42) (1.06)
Medical
0.21 -0.36***
33 optical & 0.624 0.004***
(0.50) (-3.80)
Communication
Note:
1. ‘***’ indicates 1% ‘**’ at 5% and ‘*’ at 10% statistically different from zero respectively
2. All the variables are in log form
3. Bartlett Kernel, Newey-west fixed bandwidth=3, DOLS estimation lag =1&leads=1
4. t-statistics are in parenthesis ()
Table 8, showcasing the individual Dynamic OLS (DOLS) results for the
long-run elasticity estimates across sixteen manufacturing industries during the
period 2001-2017, reveals findings that are somewhat parallel to those of the
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
97
FMOLS analysis. The coefficients of the log of wages(s)/rent ratios are
predominantly significant, with the exceptions being the wearing apparel and
consumer electronics industries, as well as the medical optical & communication
industry, where the coefficients are found to be insignificant. This mirrors the
results obtained in the individual FMOLS analysis.
For unskilled labour, the coefficient of the log of wages (us)/rent ratio is
significant in all industries except for two: wearing apparel and consumer
electronics. This consistency across different methodologies strengthens the
reliability of the results. Comparing the substitution elasticity between capital-
skilled and capital-unskilled labour using individual DOLS results, it is found that
in 10 out of 13 industries, the substitution elasticity between capital and unskilled
labour is greater than that between capital and skilled labour. This pattern is
consistent with the findings of earlier studies by Grilliches (1969) and Bergstrom
and Panas (1992). In industries such as mining and quarrying, food products and
beverages, paper & paper products, tobacco products, rubber and plastics products,
basic metals, and non-electrical machinery, for both skilled and unskilled labour,
the substitution elasticity is greater than one and is statistically significant. This
high level of substitution elasticity implies that the relative demand for these
production factors adjusts effectively to changes in their relative supply, as
discussed by Chiswick in 1985. A notable deviation is observed in the medical
optical and communication industry, where a negative substitution elasticity (-0.36)
between capital and unskilled labour is reported in the individual DOLS analysis,
with significant results. This indicates that in this particular industry, capital and
unskilled labour are complements rather than substitutes. This finding is crucial for
understanding the unique dynamics within specific industries and how different
factors of production interact with each other.

5. CONCLUSION
The comprehensive analysis of the substitution elasticity between capital
and labour (both skilled and unskilled) across various manufacturing industries in
India, using both Fully Modified Ordinary Least Squares (FMOLS) and Dynamic
Ordinary Least Squares (DOLS) methods, provides insightful direction towards a
significant variation in the substitution elasticity across different Indian
manufacturing industries. Industries such as mining and quarrying, food products
and beverages, and basic metals exhibit high elasticity, suggesting a greater
flexibility in substituting capital with labour or vice versa. However, in a majority
 Arpit Gupta, Kashika Arora
98

of the industries, the substitution elasticity between capital and unskilled labour
is higher than that between capital and skilled labour. This indicates a generally
greater ease in substituting capital with unskilled labour compared to skilled
labour. These observations in different ways align with earlier studies by
Grilliches (1969) and Bergstrom and Panas (1992), particularly in the case of
substitution elasticity between capital and unskilled labour. Certain industries,
namely, the medical optical and communication industry, exhibit a negative
elasticity, indicating a complementary rather than substitutive relationship
between capital and labour.

6. MANAGERIAL IMPLICATIONS
With the results observed in this paper, managers need to recognize the
heterogeneity across industries in terms of capital-labour substitution elasticity.
Tailored strategies that consider the unique dynamics of each industry are crucial for
effective policy implementation. Therefore, industry specific strategies can be
considered. With the lower elasticity between capital and skilled labour, there is a
strong case for investing in skill development programs. Enhancing the skill set of
the workforce can make labour a more valuable asset, less easily substituted by
greater capital investments. This calls for greater labour market flexibility. With the
industries showing high elasticity, these may benefit from labour market policies that
increase flexibility, such as training programs that allow workers to easily transition
between roles or industries. Along with this, the results presented high elasticity in
certain sectors, suggesting a rapid pace of technological adaptation. Policies
encouraging innovation and technological upgrades can help industries remain
competitive, especially where labour can be effectively substituted with capital. The
industries like medical optical and communication, where capital and labour are
complementary in nature, policies can support the co-development of capital
investment and labour skills. This might involve incentivizing technological
advancements that enhance labour productivity rather than replace it. Subsequently,
given the higher substitution elasticity with unskilled labour, there is a need for
policies that protect this segment of the workforce. This could include social safety
nets, retraining programs, and initiatives to improve the employability of unskilled
workers in an increasingly automated manufacturing environment. Finally, it is
imperative to balance the technological advancements in the manufacturing sector
with sustainable growth strategies that include all levels of the workforce. This
ensures that the benefits of technological progress and capital investment are shared
 Evaluating the Elasticity of Substitution between Capital and Labour (Both Skilled and Unskilled)…
99
widely across the economy. Therefore, the analysis of substitution elasticity in the
Indian manufacturing sector highlights the importance of a nuanced approach to
policymaking, which considers the diverse nature of various industries and the
different relationships between capital and types of labour. By addressing these
aspects, policies can better align with the dynamic needs of the manufacturing sector,
fostering growth, competitiveness, and worker welfare.
The study's focus on India's manufacturing sector, while insightful, presents
limitations that pave the way for further research. One notable constraint is the
geographical and sectoral specificity, which may limit the applicability of its findings
to other regions or industries. Future research could expand this inquiry to diverse
economies and sectors, offering a broader perspective on capital-labour substitution
dynamics. Additionally, the methodologies used, namely FMOLS and DOLS, though
robust, could be complemented by other econometric approaches to validate and
enrich the findings. The study’s relevance in the rapidly evolving post-2017
economic landscape, marked by technological advancements like AI and automation
could be witnessed in the future research work. Moreover, exploring deeper into the
qualitative aspects of labour, such as the impact of education and skill levels, could
yield more nuanced understandings of labour market dynamics. Lastly, considering
the policy implications in different economic and regulatory environment settings
could add valuable dimensions to the study, offering a more comprehensive view of
how policy and economic contexts influence capital-labour substitution.
 Arpit Gupta, Kashika Arora
100

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 Volume 17, Issue 1/2024, pp. 103-126
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0005

REAL EXCHANGE RATE MISALIGNMENT IN MONETARY

POLICY CONSTRAINED ECONOMIES:
EVIDENCE FROM ESWATINI, LESOTHO, AND NAMIBIA

MUKELA MABAKENGi, MERRINAH SIBOLIii, SAARA MUKUMANGENI-KASHAKAiii

Abstract: This paper examined the misalignment of the real effective exchange rate among the
smaller, open and monetary policy constrained members of the Common Monetary Area. The
paper used panel annual data for the period 1990 to 2021. The econometric techniques applied
herein include the cointegration methods such as the Dynamic Ordinary Least Squares
(DOLS) as well as the Fully Modified OLS (FMOLS) to estimate the equilibrium real exchange
rate necessary for the computation of the real exchange rate misalignment. These tests were
selected owing to their superiority in dealing with serial correlation and endogeneity of
variables. The results herein showed that the rear effective exchanged rate among these CMA
members (i.e., Eswatini, Lesotho, and Namibia) was misaligned during the review period. In
this regard, the paper found evidence of an overvaluation of the real exchange rate by about 2
percent. Literature suggests that an overvaluation is good for import dependent [Link]
study further assessed the impact of real exchange rate misalignment on the economies herein.
Specifically, the paper used the Bayesian Vector Autoregressive (BVAR) model to examine the
long run relationship between the real exchange rate misalignment and key economic
variables such as GDP and exports. The results of the impulse response function, within the
BVAR framework, show that, a one standard deviation shock or innovation to real effective
exchange rate misalignment initially has no material role in explaining variations in GDP
fluctuations. This suggests that the GDP of these countries is by and large driven by other
factors other than the exchange rate misalignment, and also given that the effects are not
direct. Conversely, a one standard deviation shock or innovation to real effective exchange
rate misalignment, results in an instant and relatively higher impact to exports of nearly 1
percent, which suggests that misalignment plays a role in the competitiveness of exports in the
long run. The outcomes and conclusion of the variance decomposition, to a large extent,
resonate with those of the impulse response. Reviewed literature maintains that exchange rate
misalignment can be a source of economic instability and can distort investment decisions.
Therefore, understanding the sources, magnitude and effects of exchange rate misalignment
bears fundamental implications for policy makers in the macroeconomic management and
determination of the appropriate exchange rate regime. In this context, this study is invaluable.

i Research and Financial Sector Development Department, Bank of Namibia (Central Bank of
Namibia), P O Box 2882, Windhoek, Namibia, [Link]@[Link]
ii Research and Financial Sector Development Department, Bank of Namibia (Central Bank of

Namibia), P O Box 2882, Windhoek, Namibia

iii Research and Financial Sector Development Department, Bank of Namibia (Central Bank of

Namibia), P O Box 2882, Windhoek, Namibia

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
104
Keywords: Real exchange rate, Misalignment, Monetary policy, Common Monetary Area,
Trade/Economic Growth, overvaluation
JEL Classification: F31

1. INTRODUCTION AND BACKGROUND

Exchange rate misalignment (ERM) has increasingly become a crucial issue
for policy makers in emerging and developing economies (EMDEs) in recent years.
This research paper aims to examine the performance of the real effective exchange
rate in Eswatini, Lesotho, and Namibia (ELN) and to establish whether it is
misaligned around its equilibrium value, as well as whether the misalignment
materially impacts the monetary policy constrained economies in the Common
Monetary Area (CMA).
The CMA Agreement between Government of the Kingdom of Eswatini, the
Government of the Kingdom of Lesotho, the Government of the Republic of
Namibia, and the Government of the Republic of South Africa aims to foster
sustained economic development of the CMA. Furthermore, the revised Agreement
aims to ensure, in particular, that the arrangement should promote the advancement
of the less developed members of the CMA and should afford to all member states
equitable benefits arising from the maintenance and development of the CMA as a
whole. In addition, the CMA aims to afford all member states equitable benefits
accruing from the maintenance and development of the monetary area. However,
asymmetries in terms of the level of development and structures of the respective
economies are evidently palpable. In this regard, exchange rate and the loss of
monetary policy setting autonomy are often among some of the invariably cited
factors that underlie the suboptimal economic advancement and welfare. This
paper aims to uncover some of the aspects pertaining to the exchange rate,
particularly as it relates to the growth among the smaller members of the CMA
with limited monetary policy autonomy and influence on exchange rate, and
particularly the misalignment of the real effective exchange rate and its impact on
the economies herein.
According to Wang et al., (2007), the CMA , which stems from the currency
union of 1974, was established on the basis of the Trilateral Monetary Agreement
of 1986, signed between the governments of the Kingdom of Lesotho, the
Kingdom of Swaziland (now the Eswatini) and the Republic of South Africa and
later joined by Namibia in 1992-following her independence from the occupation
of apartheid South Africa in 1990. This agreement has since been revised in 2020
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
105
to include new generation issues such as banking supervision, financial stability
and cross-border payments, which ostensibly were non-issues in 1992. Wang et al.,
(2007) further state that this agreement along with bilateral agreements provided a
framework for exchange rate and monetary policy.
This paper is a contribution towards answering the fundamental question of
whether the CMA indeed supports member states, and particularly the smaller
ones, attain maximum benefits. This is pertinent particularly amid findings of
considerable asymmetries in the composition of the CMA member states’ exports,
different economic structures, and varying growth performance, which suggests
that the exchange rate movements inherently affect each member state differently.
Wang et al., (2007) argue that there is a strand of literature that confirmed that the
CMA does not necessarily meet the criteria of an optimal currency area. Further,
they stress that the CMA has merely been held together by historical and political
justifications as well as the superficial benefits such as maintaining lower
transaction costs of cross-border trade and investments. They argue that these
benefits do not necessarily offset other economic welfare forgone as a result of the
continued peg, and its associated effects such as dwarfed economic performance
associated with the exchange rate misalignment.
Exchange rate is a pivotal barometer of a country’s internal and external
equilibrium positions. Unlike the volatility in the exchange rate (Figure 1a&b),
which is defined as the fluctuation in the exchange rate that is frequent yet does not
persist, exchange rate misalignment is defined as the sustained deviation of an
exchange rate from its equilibrium or long-term level (Slimani, 2018). An
exchange rate is said to be misaligned if it deviates from its long-term equilibrium,
resulting in the currency becoming under or overvalued. The movements in the real
effective exchange rates (REER) affect the competitiveness of tradable goods and
services of a country, relative to those of its trading partners (Masunda, 2012). It
then follows that, if a currency is overvalued it reduces the competitiveness of the
goods and services, because the imports become cheaper in the local currency, and
vice versa. Eita and Jordaan (2013) argue that exchange rate misalignment can
result in economic instability and may even distort investment decisions, which
ultimately result in both welfare and efficiency erosions.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
106
135 220
130 200

125 180

120 160
140
115
120
110
100
105
80
100
60
95
1990 1995 2000 2005 2010 2015 2020 40
1990 1995 2000 2005 2010 2015 2020
HPTREND01 REER_Esw
HPTREND02 REER_Les

Figure 1a: Eswatini’s Hodrick-Prescott filtered Figure 1b: Lesotho’s Hodrick-Prescott filtered
REER and REER, 1990-2021 REER and REER, 1990-2021

Figure 1c: Namibia’s Hodrick-Prescott filtered Figure 1d: REER Developments; Eswatini,
REER and REER, 1990-2021 Lesotho and Namibia
Source: Author computations based on data from the World Bank and respective central banks

The extent to which REER can be misaligned principally depends on the

level of trade openness, integration into global financial markets, responsiveness to
external shocks and changes in global trade patterns. The impact of exchange rate
misalignment on the output and inflation is therefore dependent on whether the
economy is in a constrained monetary policy arrangement or not (Khomo &
Aziakpono, 2020).

2. PROBLEM STATEMENT
The real exchange rate misalignment, which is defined as the deviation of
the prevailing real exchange rate from its long-run level, is common in small
developing economies (Ambaw et. al., 2022). The negative economic
consequences of the real exchange rate misalignment include depressed economic
growth, narrow export diversification, and in some instances currency risks as well
as social instability (Ambaw et. al., 2022). Montiel and Hinkle (1999) corroborate
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
107
these sentiments by stressing that prolonged exchange rate misalignment has
numerous ramifications such as effects on business cycles. One of the fundamental
questions is therefore whether the current exchange rate regime and level is
commensurate with the realities and macroeconomic dynamics of smaller member
states in the CMA, namely Eswatini, Lesotho and Namibia.
The International Monetary Fund (IMF) 2019 in its article IV consultation
report states that, given the Rand variability, the peg arrangement has implied
volatility, which could potentially hamper the development and competitiveness of
non-mining export led activities, especially those by smaller investors. The IMF
further states that, the REER in the small member states of the CMA underwent
massive fluctuations over the past decade (Figure 1a-c), despite remaining broadly
stable. However, in the wake of increasing wages over and above productivity
growth, independently, the CPI-based measurement (i.e., REER) may
underestimate the weakening competitiveness.
Furthermore, while there are studies that examined the exchange rate
misalignment on some of the countries in the CMA, individually, to the knowledge
of the authors, collective assessment in a panel system of the sub-region is not very
common. This study aims to bridge this research gap. According to Baltagi (2008),
not only does the panel data estimation help in controlling heterogeneity of cross-
sections such as states, firms, and countries, it is also useful in obtaining unbiased
estimations as it considers all cross-section units as heterogeneous.

3. RESEARCH OBJECTIVES
This paper thus sought to establish the extent of the real effective exchange
rate (REER) misalignment in relation to its long-term equilibrium level given the
monetary policy constraints. Firstly, the paper tested the extent to which the
exchange rate for the Common Monetary Area (CMA) economies, excluding South
Africa, is in line with the long-term equilibria and whether it is in line with
economic fundamentals. Secondly, the paper examined the relationship between
the misalignment and the key macroeconomic variables such as GDP and exports
and the impact thereof.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
108

4. LITERATURE REVIEW
4.1. Theoretical Literature
As cited in Fidora et al., (2017), Friedman 1953 argued that the theoretical
foundation of exchange rate misalignment is mixed. The flexibility of the exchange
rate is generally useful in the attainment of the Purchasing Power Parity (PPP). In
essence, flexible exchange rates promote cross-country convergence in prices, even
when the prices are sticky, as currency trade fluctuations substitute for price
adjustments, despite the stickiness of prices (Fidora et al., 2017). In contrast
however, fixed exchange rates are often associated with lower transaction costs,
which ultimately promotes cross-border trading. This increases transparency in
terms of price differentials, which can be eliminated through arbitrage, thus
prompting price convergence. Flood and Rose (1999) posit that since exchange rate
movements or fluctuations are primarily driven by activities in asset markets as
opposed to macroeconomic fundaments, particularly in flexible exchange rate
regimes, eliminating the flexibility in exchange rate removes the source of the
frequent fluctuations in exchange rate, which ultimately leads to large and
persistent relative price disequilibria. Carrera et al., (2021) agree that although the
fixed exchange rate regime helps in limiting the size of misalignment, and by
implication reducing inflation and fiscal deficit, the resultant disequilibria in
exchange rate tends to be persistent.
In addition, Gachoki et al., (2019), states that monetary theory derived
from the 1970s suggests that a balance of payments deficit is inherently a
monetary phenomenon, which is driven by an increase in the money supply. In
this context, the devaluation of an exchange rate only affects the balance of
payment if it affects the level of real money supply. However, this relationship
tends to be ambiguous in a long run. Gachoki et al., (2019) further stress that, in
an event of a devaluation of a currency, the real money supply often decreases as
prices of traded goods and services measured in domestic prices rise. This
ultimately results in a reduction of spending, and by extension an improvement in
the trade balance. As such, the central feature of the monetary approach in this
regard is that the exchange rate is a derivative of future economic fundamentals.
To this end, this study examined the two theories, that is, the one underpinning
the large and persistent movements in the exchange rates prevalent in fixed
exchange rate regimes, as well as the latter: underlying the economic
fundamentals as chief drivers of exchange rate movements.
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
109

4.2. Empirical Literature

Using simple analytical model, Di Nino et al., (2011) provide evidence of a
positive correlation between undervaluation of exchange rate and economic growth
based on a panel data set for the period 1861 and 2011 for Italy. Di Nino et al.,
(2011) additionally show that undervaluation supported growth through raising the
volume of exports from high productivity sectors. However, Glüzmann et al.
(2012), using compute an index of overvaluation method, conducted a study on a
sample of developed, emerging and developing countries concluded that
undervaluation does not have a significant influence on the tradable sector but
tends to promote domestic savings and investment. Similarly, Nouira and Sekkat
(2012) did not find any evidence that undervaluation promotes economic growth
when overvaluation episodes are excluded from the analysis.
Masunda (2012) investigated the relationship between the exchange rate
misalignment on the currency crisis in Zimbabwe. Using the Dynamic Ordinary
Least Square (DOLS) model applied on annual time series covering the period
1980 – 2006, confirmed that the overvaluation was the cause of the currency crisis
in Zimbabwe. The study also established that the exchange rate misalignment in
Zimbabwe was ascribed to government consumption, openness, excess credit,
technical progress, and capital flows.
In the context of the CMA, Eita and Jordaan (2013) assessed the impact of
exchange rate misalignment on Namibia’s economic performance as well as
competitiveness. The study used data covering the period 1970 to 2013 and
employed the cointegrated vector autoregressive methods to carry out the
estimations. The findings of the study confirmed that exchange rate misalignment
negatively impacts the performance and the competitiveness of the country. Pasi
(2020) examined the effects of real exchange rate misalignment on South African
exports between the period 1994 and 2015. Using cointegration tests such as the
Johansen and Juselius tests, the study found a significant long run negative impact
of real exchange rate misalignment on total exports in South Africa.
Adebayor et al., (2015) used the Fully Modified OLS (FMOLS) and the
Error Correction model to determine the short run effects of currency devaluation
on economic growth. The study focused on seven developing countries that
devalued their currencies within the same period were examined, namely, Ghana,
Mexico, Malaysia, Pakistan, Philippines, Singapore, and South Africa. The long
run effects and relationships were determined by testing for co-integration using
different co-integration methods. A panel data set covering the period between
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
110

1981-2010 was used in the analyses. The results showed the existence of no
significant relationship between currency devaluation and economic growth in the
short run; however, a negative relationship exists in the long run.
Slimani et. al., (2018) in their attempt to broaden the traditional analyses,
focused on the role of exchange rate regime of the misalignment of the REER. The
paper found that the floating exchange rate was superior for the Middle East and
North Africa (MENA) countries, as it relates to the exchange rate misalignment. In
addition, the same paper also found that the quality of institutions, the level of
financial development and inflation were key determinants of the deviations in the
exchange rate from its optimal level. The study employed a dynamic panel model
specifically the Generalised Method of Moments (GMM) and included variables
such as inflation that is expected to increase the misalignment, the type of
exchange rate regime, the financial development and the quality of institutions
which all affect the misalignment positively.
Using a dynamic panel data approach, Brian et al., (2018) estimated the
effects of exchange rate undervaluation on the growth of economic sectors in South
Africa. The sectors considered were agriculture, mining, manufacturing, tourism,
and the financial services sector for the period 1985 to 2014. The study found that a
percentage increase in undervaluation had a positive impact on sectoral growth.
Similarly, Njindan (2017) empirically tested the impact of undervaluation on South
Africa’s agriculture, and services sectors based on annual time series data for the
period 1962 to 2014. Using Ordinary Least Squares (OLS), the results showed that
real exchange rate undervaluation correlates positively with agriculture, and
negatively with services.
Gachoki et. al., (2019) investigated the misalignments of exchange rate and
its determinants in Kenya. Using quarterly data ranging between 2000 to 2016, the
study adopted the Dynamic Autoregressive Distributed Lag (ARDL) Bound testing
approach to assess the exchange rate misalignment. The outcomes of the study
showed that, net foreign assets, productivity, world oil prices, trade openness and
terms of trade underly the long-run path of the exchange rate. In contrast, the study
found that fiscal metrics such as government expenditure and government revenue
had no impact on the exchange rate.
Hosni (2021) examined the sources of exchange rate misalignment in Egypt
using the ARDL Bound test model, premised on the Behavioural Equilibrium
Exchange Rate (BEER) approach. Using data spanning 1965 to 2018, not only did
the study find that the Egyptian Pound was misaligned, but it also confirmed the
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
111
relative importance of terms of trade, trade openness, investment, and government
spending in determining the equilibrium exchange rate. The results also concluded
that both permanent and short run fundamental factors play critical roles in
exchange rate misalignment in Egypt.
Applying the panel vector autoregressive methods on quarterly data ranging
between 1990 to 2018 for 22 Asian and pacific countries, Ambaw et. al., (2022)
examined the impact of real exchange rate misalignment on the business cycles in
these countries. The study found that an overvaluation of the real exchange rate
reduced inflation and short-term interest rates.

5. METHODOLOGY
5.1. Preliminary diagnostics
Given that most economic data inherently possess unit root, variables herein
were subjected to stationarity tests. Economic time series variables such as
exchange rates, and other macroeconomic aggregates such as real GDP and trade
data are inherently characterized by non-stationarity in their mean. The initial step
entailed subjecting the data series to panel unit root tests to test for stationarity of
the variables, which has a bearing on the reliability of the estimates. This will also
eliminate the risk of finding significant regression results from unrelated variables
when non-stationary data is used. Moreover, Ambaw (2022) states that
geographically proximate economies may be integrated via economic and financial
connections, which could result in potential correlation and cross-sectional
dependence. Pesaran (2007) provides guidance on the cross-sectional dependence
tests. As part of the pre-test cointegration checks, tests were also conducted to
ascertain the long run relationships among the series.

5.2. The model specification

Studies such as Slimani et. el., (2018) provide good benchmarks in
modelling the real effective exchange rate (REER) as follow:
𝐿𝑛(𝑅𝐸𝐸𝑅𝑖𝑡 ) = 𝛼0 + 𝛼1 𝐿𝑛(𝑂𝑝𝑒𝑛𝑖𝑡 ) + 𝛼2 𝐿𝑛(𝐹𝐷𝐼𝑖𝑡 )+ 𝛼3 𝐿𝑛(𝑇𝑜𝑇𝑖𝑡 ) +
(1)
𝛼4 𝐿𝑛(𝐷𝑒𝑏𝑡𝑖𝑡 ) + 𝛼5 𝐿𝑛(𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡 ) + 𝛼4 𝐿𝑛(𝑂𝑖𝑙_𝑝𝑟𝑖𝑐𝑒𝑠𝑖𝑡 ) + 𝜀𝑖𝑡
Where:
𝑅𝐸𝐸𝑅𝑖𝑡 : denotes the real effective exchange rate of country i at time t, while the
signs in the parenthesis denote the expected signs of the coefficients.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
112

𝑂𝑝𝑒𝑛_𝐺𝐷𝑃𝑖𝑡 : denotes the trade openness measured by the ratio of imports and
exports to GDP of country i at time t. (±)
𝐹𝐷𝐼𝑖𝑡 : represents the ratio of foreign direct investment to GDP of country i at time
t. (+)
𝑇𝑜𝑇𝑖𝑡 : denotes the ratio of terms of trade to GDP of country i at time t. (±)
𝐷𝑒𝑏𝑡𝑖𝑡 : denotes the nominal debt as a proxy for debt service to GDP ratio of
country i at time t. (±)
𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡 : denotes the government expenditure of country i at time t. (±)
𝑂𝑖𝑙_𝑝𝑟𝑖𝑐𝑒𝑠: denotes the international crude oil prices (±)
𝜀𝑖𝑡 : is an error term.

5.3. Empirical analysis of the determinants of misalignment of the REER

The next step entailed the calculation of the exchange rate misalignment.
Slimani et al., (2018), Pasi (2020) and Gachoki et al., (2019) all estimated the
exchange rate misalignment (Mis) as follows:
Mis =𝑅𝐸𝐸𝑅 − 𝐸𝑅𝐸𝐸𝑅 (2)
Where the EREER is the equilibrium real exchange rate proxied by the fitted
values from (1) above as a proxy of permanent value of the real exchange rate. The
REER is the observed exchange rate, and Mis is the misalignment index. It then
follows that the positive values of the misalignment series obtained denote an
overvaluation while the negative ones an undervaluation of the real effective
exchange rate.
As in Slimani et al., (2018), following the calculation of the misalignment of
the REER, the paper proceeded to assess the determinants to which the exchange
rate misalignment could be ascribed and/or the impact of the misalignment on key
macroeconomic fundamentals. Drawing from the empirical literature cited earlier,
the paper further examined the short run and long run relationships between the
exchange rate misalignment and other economic variables. According to Slimani
et. el., (2018), the variables that underly the variation in exchange rate from its
equilibrium include trade openness measured as the ratio of imports and exports to
GDP, terms of trade expressed as the ratio of export prices to imports prices, debt
service-to-GDP ratio, the ratio of public expenditure to GDP as well as the ratio of
money supply (M2) to GDP as a measure of financial development. Noteworthy is
that not all these variables were used herein either given their high correlation with
other variable or their effects on the model. Once the exchange rate misalignment
index had been computed, it then follows that the absolute value of the sources
and/or effects of the misalignment is then analysed using the following equation (3)
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
113

|𝑀𝑖𝑠𝑖𝑡 | = 𝛽0 +𝛽1 +|𝑀𝑖𝑠𝑖𝑡−1 | + 𝛽2𝑘 ∑𝑘=𝑘

𝑘=1 𝜒𝑖𝑘𝑡 + 𝜀𝑖𝑡 (3)
Where:
|𝑀𝑖𝑠𝑖𝑡 | is a misalignment of country i in year t, taken as an absolute value, to
enable under or over- valuation.
𝜒𝑖𝑘𝑡 : is a matrix of a set of explanatory variables.
Silmani et al., (2018) included inflation which has a tendency of increasing
the misalignment, as well as the level of financial development, proxied by M2,
which has implications for the exchange rate misalignment, as the depth of the
financial development tends to ameliorate the magnitude of the misalignment, and
GDP as a measure of economic growth. However, to avoid issues of
multicollinearity and overparameterization, as well as given that they were not
statistically significant, the two variables were dropped from the model.
|𝑀𝑖𝑠𝑖𝑡−1 |, given the persistence of exchange rate misalignment particularly
in developing economies, the model will also include the lagged series of the
misalignment.

5.4. Data and sources

Annual data ranging from 1990 to 2021 was obtained from the World Bank
database as well as from the central banks of Eswatini, Lesotho and Namibia,
which were subsequently converted into 96 cross-sections. All variables were
transformed into natural logarithm to improve the distribution linearity between the
dependent and independent variables and to boost the validity of the statistical
analyses. Some of the missing data points were filled by means of interpolation.

6. ECONOMETRIC ANALYSIS
As stated above, some of the preliminary diagnostics entail examining the
correlation among variable as presented in the correlation matrix, Table 1. While
the correlation matrix points to non-existence of real problems of correlation
between variables, given that the coefficients are virtually close to zero, there were
a couple of coefficients that appeared relatively high. These are such as the
correlation coefficient between logGDP and logGov_Exp, as well as between
logFDI and logGov_Exp at 0.93 and 0.80, respectively (Table 1). This warranted
the exclusion of one of these variables in the estimation in order to enhance the
bandwidth of the robustness of the results.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
114
Table 1: Correlation matrix
Correlation LOGREER LOGOPEN LOGTOT LOGOIL_PRICELOGGOV_EXPLOGGDP LOGFDI

LOGREER 1.000000

LOGOPEN -0.741215 1.000000

LOGTOT 0.433456 -0.159678 1.000000

LOGOIL_PRICE -0.406751 0.410200 0.075508 1.000000

LOGGOV_EXP -0.600778 0.361325 -0.650871 0.464679 1.000000

LOGGDP -0.384079 0.106177 -0.636961 0.344714 0.934584 1.000000

LOGFDI -0.321944 0.223999 -0.236894 0.651861 0.805807 0.770534 1.000000

Source: Authors’ computations

This paper used cointegration analyses to estimate the long run relationship
between the real exchange rate misalignment and macroeconomic variables, in line
with the BEER approach. According to Engel and Granger (1987), cointegration
essentially means that, while individual time series can be nonstationary, a linear
combination of two or more series can be stationary. This method entails 3 major
steps, namely, firstly evaluating whether the variables are I(1) in Table 2, followed
by assessing whether the variables are cointegrated and lastly establishing long-
term relationship.
Table 2: Panel unit root test
Deterministic Levin, Lin & Im, Pesaran and Shin Order of
Variables
term Chu t* W-stat integration
Level intercept
LogREER Intercept -1.58(0.06) -0.54(0.29)
LogToT Intercept -0.55(0.29) -0.23(0.41)
LogOpen Intercept -2.43(0.007) -1.60(0.055)
LogOil_Price Intercept -0.44(0.33) 0.58(0.72)
LogGov_Exp Intercept -2.06(0.02) -0.46(0.32)
LogFDI Intercept -3.24(0.000) -0.95(0.17)
First difference
∆ LogREER Intercept -6.57(0.00)*** -5.90(0.00)*** I(1)
∆LogToT Intercept -4.49(0.00)*** -5.56(0.00)*** I(1)
∆LogOpen Intercept -4.63(0.00)*** -3.98(0.00)*** I(1)
∆
Intercept -6.78(0.00)*** -6.10(0.00)*** I(1)
LogOil_Price
∆
Intercept -5.25(0.00)*** -5.02(0.00)*** I(1)
LogGov_Exp
∆ LogFDI Intercept -2.17(0.02)** -3.19(0.00)*** I(1)
Note: *, **, *** denote the level of significance at 10%, 5% and 1%, respectively.
Source: Author’s computations
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
115
Based on the panel unit root test results, Table 2, it is evident that there are
some variables that were stationary in levels, according to Levin, Lin & Chu t*
while they were not under Im, Pesaran and Shin W test. However, since the latter
has proven to be more robust (Slimani, 2018), the verdicts thereof are thus made in
terms of the Im, Peseran and Shin W test. This effectively means that all variables
were deemed non-stationary in levels, I(0), and only become stationary after first
difference, and hence integrated of the first order, I(1).
As in Khomo and Aziakpono (2020), this paper specifically adopted the
Johansen (1995) cointegration technique to estimate the long-run relationship
among the variables. In this regard, a single equation was used following the
establishment of endogeneity of real exchange rate in a long run model. As such,
the Dynamic Ordinary Least Squares (DOLS) was then estimated. The DOLS has
proven to be superior to other methods such as the Vector Error Correction Model
(VECM) used by others such as De Jagger (2012), owing to its integration of leads
and lags of first difference of the regressors into the cointegration equation.
According to Khomo and Aziakpono (2020), not only does this significantly
improve the robustness of the results but also corrects for any serial corelation in
the residuals as well as potential simultaneous and endogenous fundamentals.
Accordingly, the DOLS is then estimated as follows:
𝑘2
𝐿𝑅𝐸𝐸𝑅𝑡 = 𝛽𝐹𝑡 + ∑𝑗=𝑘 1
𝛾∆𝐹𝑡−𝑗 𝜀𝑡 (4)

Where 𝐿𝑅𝐸𝐸𝑅𝑡 is the depended variable (REER), 𝐹𝑡 is the vector of

explanatory variables, while 𝑘1 and 𝑘2 are the number of leads and lags, respectively.
Additionally, the stationarity of the residuals (𝜀𝑡 ) will confirm the presence of
cointegration with the order of lead and lags commensurate with the number of lags
identified in the cointegration equation estimated earlier, equation (1).

6.1. The results of the panel DOLS and panel FMOL

The results of Panel Dynamic Ordinary Least Squares with lag and lead
fixed effects method, equation 4, show that there exists long run relationship
between the real effective exchange rate. Most notably, the coefficients had the
correct signs as per prior expectations. However, in the long run, only two
variables, namely, government expenditure and Foreign Direct Investment were
statistically significant in determining real effective exchange rate among the
smaller CMA member states at 95 percent confidence level.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
116
Table 3: Results of LREER model using Dynamic OLS

Dependent Variable: LOGREER

Method: Panel Dynamic Least Squares (DOLS)
Date: 10/31/22 Time: 19:08
Sample (adjusted): 1992 2020
Periods included: 29
Cross-sections included: 3
Total panel (balanced) observations: 87
Panel method: Pooled estimation
Cointegrating equation deterministics: C
Fixed leads and lags specification (lead=1, lag=1)
Coefficient covariance computed using default method
Long-run variance (Bartlett kernel, Newey-West fixed bandwidth) used for
coefficient covariances

Variable Coefficient Std. Error t-Statistic Prob.

LOGOPEN -0.169254 0.241474 -0.700923 0.4881

LOGOIL_PRICE 0.049089 0.102605 0.478425 0.6354
LOGTOT -0.605971 0.454821 -1.332329 0.1916
LOGGOV__EXP -0.539329 0.229711 -2.347857 0.0248
LOGFDI 0.234589 0.091196 2.572360 0.0146

R-squared 0.911112 Mean dependent var 4.669652

Adjusted R-squared 0.775166 S.D. dependent var 0.227620
S.E. of regression 0.107930 Sum squared resid 0.396062
Long-run variance 0.008329

Source: Authors’ computations

As a confirmation test, the Panel Fully Modified Least Squares (FMOL)

(Bashier & Siam, 2014), Annexure equation (6) confirmed the long run
relationships between the exchange rate and other key determinants. However, in
addition to government expenditure and FDI, trade openness appeared to be a
statistically significant determinant of real effective exchange rate Table 4. It
should however be noted that, these results are not necessarily the principal
objective of this study. The estimations of the cointegration techniques were
merely conducted in order to obtain the residuals and fitted values, the latter which
were used as the proxy for equilibrium real exchange effective exchange rate
necessary for the calculation of the magnitude of the real exchange rate
misalignment. The misalignment was also further examined with respect to its
implications for economic growth and exports.
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
117
Table 4 Results of LREER model using Dynamic OLS
Dependent Variable: LOGREER
Method: Panel Fully Modified Least Squares (FMOLS)
Date: 11/01/22 Time: 08:52
Sample (adjusted): 1991 2021
Periods included: 31
Cross-sections included: 3
Total panel (balanced) observations: 93
Panel method: Pooled estimation
Cointegrating equation deterministics: C
Coefficient covariance computed using default method
Long-run covariance estimates (Bartlett kernel, Newey-West fixed
bandwidth)

Variable Coefficient Std. Error t-Statistic Prob.

LOGOPEN -0.279135 0.092879 -3.005359 0.0035

LOGOIL_PRICE -0.006411 0.048365 -0.132547 0.8949
LOGTOT 0.043171 0.185786 0.232369 0.8168
LOGGOV__EXP -0.323599 0.083584 -3.871556 0.0002
LOGFDI 0.140778 0.040256 3.497047 0.0008

R-squared 0.757021 Mean dependent var 4.671642

Adjusted R-squared 0.737011 S.D. dependent var 0.231408
S.E. of regression 0.118672 Sum squared resid 1.197055
Long-run variance 0.024417

Source: Authors’ computations

Calculated as the difference between the real effective exchange rate and the
equilibrium real exchange rate (EREER), proxied fitted values from the Panel
DOLS model, the real effective exchange rate is presented in Figure 2a&b. While
there seem to be periods of excessive undervaluation as low as 68 percent, and
overvaluation as high as 44, on average, the REER seemed to have been
overvalued by at least 2 percent (Figure 2a).
60 5.4

40 5.2

5.0
20
4.8
0
4.6
-20
4.4
-40
4.2
-60
4.0
1 - 90
1 - 95
1 - 00
1 - 05
1 - 10
1 - 15
1 - 20
2 - 93
2 - 98
2 - 03
2 - 08
2 - 13
2 - 18
3 - 91
3 - 96
3 - 01
3 - 06
3 - 11
3 - 16
3 - 21

-80
- 90
- 94
- 98
- 02
- 06
- 10
- 14
- 18
- 90
- 94
- 98
- 02
- 06
- 10
- 14
- 18
- 90
- 94
- 98
- 02
- 06
- 10
- 14
- 18

Fitted LOGREER
1
1
1
1
1
1
1
1
2
2
2
2
2
2
2
2
3
3
3
3
3
3
3
3

Figure 2a: Magnitude of real effective exchange Figure 2b: LogREER and LogEREER
rate misalignment (percent)
Source: Authors’ computations
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
118

6.2. The impact of the real exchange rate misalignment on the economies:
Bayesian Vector Autoregression (BVAR)
In addition to the DOLS technique, this paper used the reduced form BVAR
adopted from (Robstad, 2014 & Litterman, 1986), which are both premised from
Sim (1981, 2001) seminar work. They argue that the BVAR model is far superior
to most models, including other VAR models, in terms of predictive and
forecasting abilities. Given that the BVAR is an extension of the VAR model, the
starting point is the reduced form VAR of the following form (i.e., equation 5).
Let 𝜒𝑡 = (𝜒1𝑡 , 𝜒2𝑡 , 𝜒3𝑡 …, 𝜒𝑛𝑡 ) be the set of time series and the VAR (n)
representation of these time series can be:
𝜒𝑡 = 𝐴0 + 𝐴1 𝜒𝑡−1 + 𝐴2 χ𝑡−2 ….𝐴𝑝 𝜒𝑡−𝑝 + ℇ𝑡 (5)
ℇ𝑡 ~N (0, ℇ)
Where 𝜒𝑡 is a vector of endogenous variables expressed in logs, A0 = (A01,
A02…A0n) are vector of constants, A1 to Ap are the coefficient autoregressive
matrices of the lags, while ℇ𝑡 is a vector of normally distributed multivariate white
noise process with a covariance matrix. The variables in the reduced form, equation
5, include: GDP, exchange rate misalignment, exports, and a Dummy variable.
Except for the Dummy, all other variables were inserted in their natural log forms.
The results of the impulse response, within the BVAR framework, in Figure
3a shows that, a one standard deviation shock or innovation to real effective
exchange rate misalignment initially has no noticeable impact on logGDP, at least
until after 3 years, when logGDP marginally respond by 0.01 percent before picking
up gradually away from initial equilibrium. In addition, a one standard deviation
shock or innovation to real effective exchange rate misalignment, Mis, results in an
instant and relatively higher impact to LogExports by nearly 1 percent. While these
effects peak after 4 years and subsequently gradually diminishing, they remain in the
system well beyond 10 years following the first shock. These results are in line with
the long run cointegration, which show that there is negative relationship between
misalignment and exports, albeit, not significant (Annexure 1).
The results of the variance decomposition showed that, in the short run, a
shock to logGDP virtually accounts for all the variation in the fluctuations of
logGDP, with both shocks to exports and real effective exchange rate having no
material impact on the variation of LogGDP fluctuations. This could potentially
point to the fact that the respective GDP growths of these economies are driven by
other factors other than exports or real effective exchange rates, and possible non-
tradables. It could also be because the effects of exchange rate misalignment on
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
119
GDP is not direct. Lastly, a one standard deviation shock to LogExports accounts
for the largest proportion of the variation in the fluctuation of exports, albeit
waning over time, followed by the misalignment in the real effective exchange rate
which accounts for about 30 percent after 4 years. Yet again, these results confirm
that real effective exchange rate misalignment, some defined extent, matters in the
variations of fluctuations of exports. The inclusion of a dummy to mute the
excessive noise or impact of the spikes in the real exchange rate in some periods,
which could be as a result of idiosyncratic factors of the some of the countries
herein helped in improving the performance of the model and the results.
.032 .16
.028
.12
.024
.020
.08
.016
.012 .04
.008
.00
.004
.000
-.04
-.004 1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10
LOGGDP LOGEXPORTS
LOGGDP LOGEXPORTS MIS DUMMY

MIS DUMMY

Figure 3a: Response of LogGDP to MIS Figure 3b: Response of LogExports to MIS
Innovation innovation
100 100

80 80

60
60

40
40
20
20
0
1 2 3 4 5 6 7 8 9 10
0
1 2 3 4 5 6 7 8 9 10
LOGGDP LOGEXPORTS
MIS DUMMY
LOGGDP LOGEXPORTS
MIS DUMMY

Figure 3c: Variance decomposition of LogGDP Figure 3d: Variance decomposition of

LogExports
Source: Authors’ computations

6.3. Robustness of the results

The estimated models were also tested for their suitability, stability and
robustness. In this regard, the residuals were examined for autocorrelation,
normality and heteroskedasticity. The model passed all these tests. Results can be
obtained from the authors on request.
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
120

6.4. Policy implications of the outcomes

The econometric modelling herein sought to establish whether the real
effective exchange rates are in line with economic fundamentals. This entailed
evaluation of a long run relationship between the real exchange rate and its
determinants, which was pivotal in the computation of the equilibrium exchange
rate, and ultimately the computation of the real exchange rate misalignment. From
the computation of the misalignment, overvaluation and/or undervaluation could be
established. In this regard, the paper found that the real effective exchange rate
among the small, open and monetary policy members of the CMA was overvalued
by at least 2 percent during the review period.
Typically, an overvaluation of an exchange rate implies that imports are
cheaper in the local currency. Ordinarily, this is fundamental for import-dependent
countries such as the Eswatini, Lesotho and Namibia, where necessities such as
food, medicine, energy, and machineries are inevitably imported (Difuntorum,
2008). Ordinarily the impact of an overvaluation of currency include:
i. Exports uncompetitive
ii. Cheap imports
iii. Decline in domestic demand, lower economic growth
iv. High unemployment
v. Persistent current account deficit: requiring capital flows to finance it.

It is therefore not surprising that these features of overvalued currencies

overwhelmingly characterize the economies reviewed herein, that is, Eswatini,
Lesotho and Namibia, in that they are inherently small, open and import dependent,
persistently weak growth and uncompetitive exports.
The second strand of the paper entailed assessment of the impact of
misalignment on the economies of the countries in question. Using the Bayesian
VAR model, the outcomes of both the impulse response and variance
decomposition show that the impact of exchange rate misalignment on the
economies is evident. Specifically, the impact of exchange rate misalignment on
the GDP of the smaller members of the CMA is negligible both in the short or long
run. This could be because the effects between the two are not direct. On the other
hand, the impact of the real exchange rate misalignment on exports was relatively
higher than that of the GDP. To this end, given the narrow export baskets of these
countries, these findings therefore augment the justifications for the maintenance of
the CMA arrangement premised on historical and political grounds, the benefits of
the lower transaction costs associated with cross border trade and investment and
 Real Exchange Rate Misalignment in Monetary Policy Constrained Economies…
121
deeper regional economic integration. However, as these economies diversify their
exports to include those that are elastic to exchange rate developments, the
exchange rate regimes may require revisiting.
Finally, this paper aimed to contribute to addressing the question of whether
the economic performance of the CMA member states is in line with the overall
objectives of the CMA. Based on the results herein, it appears that the lower
growth environment and weak exports, particularly of manufactured good, could be
as a result of other factors besides the exchange rate misalignments such as the
general structures of these economies. Future studies can explore this area and also
different methodologies to examine the nexus herein. Future studies could also
consider the impact of certain macroeconomic factors in South Africa, which may
have and influence on the exchange rate misalignment herein.

7. CONCLUSION
As stressed earlier, exchange rate is an important barometer of a country’s
performance relative to the rest of the world. It is pivotal in determining a
country’s internal and external equilibrium positions. Several studies outlined in
the literature review suggest that an exchange rate misalignment can have a
negative or positive impact on an economy. This study attempted to estimate the
magnitude of the persistence of the real effective exchange rate misalignment away
from the equilibrium level implied by economic fundamentals. The study used
cross-sectional annual data from of three countries, namely, Eswatini, Lesotho and
Namibia, which are all monetary policy constrained members of the CMA to
estimate the presence and magnitude of the real exchange rate misalignment. The
study further evaluated the impact of real exchange rate on the economies,
particularly GDP and export.
To assess the magnitude of the real exchange rate misalignment,
cointegration methodologies in the form of DOLS and FMOLS were used. The
choice of the two techniques was underpinned by their proven superiority to other
regression methods, coupled with their added advantage in overcoming the
problem of serial correlation as well as that of endogeneity of variables, thereby
guaranteeing the robustness of the results. The outcomes of this study point to the
presence of real exchange rate misalignment, and specifically to an overvaluation
of about 2 percent. Once the misalignment was established, a Bayesian VAR and
DOLS approaches were then adopted to evaluate the impact of the real exchange
rate misalignment on the economy, particularly on GDP and exports. The results of
 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
122

the BVAR, which is superior that other regular VAR models, show that real
exchange rate has minimal impact on GDP, but has relatively bigger impact on
exports in the monetary policy constrained members of the CMA. The minimal
impact could be because the effects of exchange rate on GDP is not direct.
From the empirical literature, both evaluation of misalignment spectrums
(i.e., overvaluation and undervaluation) have proved to impact positively on some
economies' growth and negatively on others. However, the parallel, theoretical, and
analytical conclusion of the acceptance in theory that exchange rate
undervaluation/overvaluation is helpful to growth, gets involved with definitional
and measurement issues. It is contingent upon how equilibrium is measured, as it is
the one that allows misalignment to be measured. Literature also suggest that real
exchange rate overvaluation is good for small import-dependent economies.
Understanding the determinants of real exchange rate misalignment bears
fundamental implications. Policy makers, particularly in small open and import-
dependent monetary policy constrained, ought to intimately understand the factors
which underlie the real exchange rate misalignments as they adopt and implement
policies that may affect these determinants. This appreciation is also critical as and
when the macroeconomic dynamics in the countries in question shift, prompting
them to re-examine their exchange rate regimes. Further, policy makers ought to
understand whether monetary policy constrained smaller member states’ ability to
grow and address social problems such as unemployment and income inequalities
is a function of real exchange rate misalignment. From the outcomes herein, it
appears that ability lies elsewhere in the broader structure of the economy as
opposed to the current exchange rate regime.

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Annexure 1: Effects of real exchange rate on exports

Dependent Variable: LOGEXPORTS

Method: Panel Dynamic Least Squares (DOLS)
Date: 11/11/22 Time: 12:46
Sample (adjusted): 1991 2021
Periods included: 31
Cross-sections included: 3
Total panel (unbalanced) observations: 91
Panel method: Pooled estimation
Cointegrating equation deterministics: C
Automatic leads and lags specification (based on AIC criterion, max=*)
Coefficient covariance computed using default method
Long-run variance (Bartlett kernel, Newey-West fixed bandwidth) used for
coefficient covariances

Variable Coefficient Std. Error t-Statistic Prob.

MIS -0.885569 0.634725 -1.395203 0.1670

LOGGDP 1.340870 0.297485 4.507350 0.0000

R-squared 0.888445 Mean dependent var 9.462150

Adjusted R-squared 0.867895 S.D. dependent var 1.149948
S.E. of regression 0.417963 Sum squared resid 13.27669
Long-run variance 0.434577

Source: Authors’ computations

 Mukela Mabakeng, Merrinah Siboli, Saara Mukumangeni-Kashaka
126

Annexure 2
The FMOLS regression was developed by Phillips and Hansen (1990). It
is a semi-parametric approach that provides estimates of cointegrating regressions
after correcting for serial correlation effects, simultaneity and the endogeneity
problem due to the existence of long run relationship. According to Bashier and
Siam, (2014), the FMOLS estimator are consistent even in small sample size and
control for possible endogeneity, and also deals with serial correlation. The
FMOLS estimator is given as follows:
𝑇 −1 𝑇

∅𝐹𝑀𝐸 = (∑ 𝑍𝑡 𝑍𝑡′ ) (∑ 𝑍𝑡 𝑌𝑡+ − 𝑇 𝐽̂+ ) (6)

𝑡=1 𝑡=1

Where 𝑦𝑡+ = 𝑦𝑡 − 𝜆̂𝑜𝑥 𝜆̂−1 ̂

𝑥𝑥 ∆𝑥𝑡 is the correction term for endogeneity, and 𝜆𝑜𝑥
and 𝜆̂𝑥𝑥 are the kernel estimates of the long run covariances, 𝑗̂ = ∆̂𝑜𝑥 -
λ̈0𝑥 λ̂−1 𝑥𝑥 ∆𝑥𝑥 is the correction term for serial correlation, and ∆̂𝑜𝑥 and ∆̂𝑥𝑥 are the
kernel estimates of the one-sided long run covariances.
 Volume 17, Issue 1/2024, pp. 127-157
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0006

THE RUSSIAN ECONOMIC ENVIRONMENT AND THE COLLAPSE

OF THE SOVIET UNION: A RETROSPECTIVE LOOK

THOMAS L BRADLEYi, PAUL B EBERLE ii

Abstract: The disintegration of the Soviet Union was certainly one of the most incredible
events of the 20th century. Excluding wars, one of the greatest upheavals of any major
country in modern times took place in the former Soviet Union. There was no place in
history in which such a large scale change had come from political, economic, and social
collapse without armed conflict. The impact of the social, economic, and political changes
on both Russia and the rest of the world is still being felt even thirty years after the
breakup. However, it was almost impossible to analyze the Russian market during the
transition because so much was in the underground economy and not reported. Much of
this paper relies on the authors’ first-hand, experience while doing research and
conducting seminars during the transition period in Russia and former Soviet republics.
The authors, having experienced first-hand the changes and the failures of various reforms,
foresaw that Russia would return to its cultural tendencies of authoritarian rule and that
this would prevent a real market economy from being created. This research was unique at
a time in which the future of Russia was at stake. It allowed the authors to understand the
dynamics of Russia at the time. It gave insight into the two worlds of Russia, the official
Moscow impressions of reality as well as the real thoughts, opinions and feelings of the
people of Russia. Because of the timing, it was perhaps the only definitive research of this
nature done at the time inside Russia by a foreigner, but also outside the official channels.
The analysis in this study, as well as the background information it contains, provides a
unique perspective on the real conditions and concerns inside Russia during the breakup of
the Soviet Union and the transition period.
Keywords: Russia, collapse of the Soviet Union; transition economies; reforming
economies; collapse of the Soviet Union
JEL Classification:

i Research Director, Reforming Economies Research Institute

ii Emeritus Professor of Business & Economics, Barney Barnett School of Business and Free
Enterprise, Florida Southern College

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Thomas L Bradley, Paul B Eberle
128

1. INTRODUCTION AND EXPLANATION OF RESEARCH

METHOLOGY
The background on Russia was gathered by three methods. The first was
basic research from newspapers, journals, and magazines. This was conducted over
the time period from June 1990 to September 1994. The second was gathered from
a personal visit by one of the authors to Russia over a 90 day period during January
1991- May 1991, and repeated in the early wintertime for another 3 month period.
This was repeated over the next 3 years in 3 month blocks of time, each time
staying in Moscow as the base while visiting various other regions inside Russia.
Therefore, much of the paper relies on the authors’ first-hand, experience while
doing research and conducting seminars during the transition period in Russia and
former Soviet republics. The third method of research was to interview various
citizens during the author's travels in Russia. A brief explanation of these methods
is necessary to understand the contribution of the study.
Contemporary research of the time was done by the reading of various
publications which consistently pictured a country in total chaos. It was usually a
picture that was very pessimistic both in the current time frame and also for the
future with respect to both democracy and the free market. Most of the articles
were focused only upon Moscow. It was because of this pessimistic attitude
consistent throughout all the research that one of the authors decided to personally
visit Russia firsthand.
At the time, the ability to travel within Russia was extremely restricted. The
effort to gain the necessary visa for the type of visit desired was an 18-month effort
that began in 1990 before the collapse and continuing for over 2 years. At first the
author’s visa effort was focused on trying to obtain an educational visa designed to
visit many universities. After repeated efforts the bureaucratic quagmire of Russia
resulted in no visa. The author decided to apply for a tourist visa instead of an
educational visa. Once inside the country, a way to travel freely would be
determined. The author had traveled to many developing countries in Latin
America where transport, accommodations and facilities were not tourist oriented.
It was this experience that fostered the belief in the ability to travel to many
restricted areas.
To assist in the ability to be able to meet local Russian people, the author ran
a series of advertisements in various newspapers in Russia looking for families or
individuals who wished to meet Americans. The result was contact with over 150
individuals throughout Russia and the Commonwealth of Independent States. Over
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
129
the course of 18 months, correspondence with these individuals established a level
of confidence by the author that perhaps the official restrictions could be ignored
and travel accomplished to almost anywhere that the author desired. The official
visa cities included one city in Siberia, Novisibirsk, which proved to be invaluable
in the ability to travel to other regions.
The author established a tentative itinerary which included 12 cities. After
arriving in Moscow, a source was found that would sell train tickets, for a price, to
cities not on the visa. From this experience, the author began to understand the
need to have a Russian assistant to be able to travel to restricted areas. This proved
invaluable for the remainder of the trip. The purchase of train tickets for the entire
journey was done one of two ways. Either a small tip to a policemen inside the
train station or to have a Russian buy the ticket became the standard procedure for
tickets to any destination.
The places visited included (but not limited to) Sverdlovsk, Zarechny,
Novosibirsk, Meshedurensk, Barnaul, Rubtsovsk, and Moscow. All travel was by
local train. During the entire stay, the author lived exactly as the family visited. At
no time was the dollar used to increase the standard of living. The ability to live
exactly as the Russian family was living resulted in seeing inside the real family.
This insight resulted in a real understanding of the Russian perspective into history,
current political feelings, economic problems and opinions, hopes for the future
and of Russian life, it is of note that from this network of families, over 75
relatives, friends and co-workers were visited in their homes.
From this network of families the author was able to visit factories, local
businessmen, local markets, social events, athletic events, and various local
politicians. Because all of these visits were unofficial, the author was able to
share the life of factory managers in the local custom of bath houses where it
became obvious that all the real business of the day was conducted. In most
places, and with most people, the author was the first American they had ever
seen or met. This widened the range of meetings because in each area everyone
wanted to meet the American. Had this been a formal arrangement, it would have
required a guide, a planned time schedule, and the usual formal conversations
resulting in an extremely insulated visit. Because this was informal and non-
threatening, it allowed the author to gain an insight into real opinions and ideas
that few, if any, foreigners had ever been allowed to see. At the time, the
mentality was still very much closed to outsiders, especially when in the presence
of officialdom. However, as the author travelled to different towns and cities,
virtually every mayor, city official, and important person wanted to meet with the
 Thomas L Bradley, Paul B Eberle
130

author in these informal meetings. This was consistent with the contradictions of
the society during this time.
Understanding this is the key to a comprehension of the value of this
research. Because the towns visited were small, with few people ever moving, it
was much easier to establish contact with a wide variety of people through one
individual. One person would network into literally dozens of possible contacts in
each town. The result was contact with the total spectrum of people in the society
from the old Communist Party Head for Yeltsin's district, to a coal miner, to
teachers, factory workers, as well as policemen. Every kind of view was heard
ranging from the fearful teacher afraid that Western culture was going to eliminate
Russian history, to the 25-year old real estate capitalist who in the period of 3
weeks, sold and closed an apartment sale with a profit of over $12,000. He was
able to buy a car, furniture, clothes, electronic equipment, and still have many
dollars saved, this was something totally impossible for him just 2 years
previously, yet he did not agree with reform because prices were too high. If he had
been interviewed before the referendum by the media, he would have said he was
against the reforms and Yeltsin. Yet, he was benefiting from it in the greatest way.
This was the dynamic of the written research when articles that were found in
various periodicals were compared with the reality of personal understanding.
Time after time the same conflict between the spoken word and the actions of the
people was seen in various forms.
One last aspect of the research is that well over 90% of the people that the
author spoke to, interacted with, interviewed, or had discussions with, had never
spoken to a foreign person at any level. This included the factory managers,
politicians, families, and various other people encountered. The people who had
met a foreigner were always working at the official level. Their only contact had
been through a trade exchange or official visit in which a brief meeting would take
place. By actually living with Russian families, all aspects of life were seen first-
hand. Ideas were exchanged on almost all subjects, conversations and discussions
that would have put them in in jail just two years before this visit.
This research was unique at a time in which the future of Russia was at
stake. It allowed the authors to understand the dynamics of Russia at the time. It
gave insight into the two worlds of Russia, the official Moscow impressions of
reality as well as the real thoughts, opinions and feelings of the people of Russia.
Because of the timing, it was perhaps the only definitive research of this nature
done at the time inside Russia by a foreigner, but also outside the official channels.
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
131

2. LITERATURE REVIEW
There are many explanations and reasons for the collapse of the Soviet
Union. The best examples in the literature were written during, and right after, the
collapse and transition. Recent literature has become more influenced by current
political and economic reasoning that was not present in the early days. Thus, the
literature review focuses upon the immediate timeframe of 1990-2000.
The disintegration of the Soviet Union was certainly one of the most
incredible events of the 20th century. According to Fuller (1994), Lovell (1996),
Stoner-Weiss (2009), and Saunders (2019), glasnost (openness and freedom of
speech) and perestroika (restructuring) were major factors leading to the
disintegration of the Soviet Union. Dallin (1992) suggested the deterioration of the
economy throughout the 1970’s and 1980’s, as well as more awareness of foreign
economic success, less commitment to communist ideology, out of control
corruption, and the increased freedoms all led to the breakup. McFaul (2015)
concluded that the reforms were ineffective and could not stop the movement for
more freedom. Poor performance of the economy and the economic suffering of
the average citizen, as well as massive corruption, was given by Goldman (1992)
as reasons for the collapse. As Goldman (1992) points out, the economic system
was not consumer oriented and the poor economic performance was a result of the
system’s supply side failures.
Another major weakness of the communist system was the central planning;
it was inefficient and essentially ignored consumer demand (D’Souza, 1997;
Arrington, 1998; Vaibhav, 2017). Among other things, the centrally planned
economy did not generate a high level of technological innovation or promote
entrepreneurship (Burks, 1984; Sakwa, 1991, 2012, 2020; Goldman, 1992; Sutton,
1973). A perfect example of this was the production of ball bearings. The central
planners gave the massive factory a weight target to achieve their quota. The result
was that instead of producing the needed smaller ball bearings that machines
required, the factory produced large bearings as it required less effort and
production. Then, after the quota was achieved, the factory could produce smaller
bearings to sell or barter in the marketplace to get the profits for the factory. Yet,
often the production goal was not met, therefore no smaller bearings would be
produced and the marketplace would suffer.
The Soviet Union fell behind the West in technological advancement, as
well as productivity, and most of the newer technology had to be sourced from
foreign sources (Sutton, 1973; Burks, 1984; Sakwa, 1991, 2012, 2020; Goldman,
 Thomas L Bradley, Paul B Eberle
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1992; D’Souza, 1997; Grogin, 2001; McFaul, 2015). Except for military
production, the Soviet economy was described by some as equivalent to a third
world country (Aganbegian, 1988; Barbour, 1994; D’Souza, 1997; Desai, 2005,
2014). Talbott (1985), Tuchman (2011), and Cummings (2018) also concluded that
the communist system produced an inefficient, corrupt economy that collapsed
from these internal weaknesses.
Authors such as d'Encausse, Sokolinsky, & La Farge (1986) point to ethnic
tensions that continually plagued the Soviet Union and were only controlled using
harsh measures and force. Eventually, these tensions boiled over and were able to
express themselves with the freedoms of glasnost. Krancberg’s (1994) explanation
is related to the inherent flaws of communism and the inability to maintain the
system, since Marxism focused on theory over practice and could not be
maintained without forceful actions and strict control of the people. Krancberg
(1994) also felt the massive amount of corruption that existed was at odds with the
communist ideology. Kux (1984) and Schull (2019) also saw the fatal flaw of
communism and the collapse of the Soviet Union as an ideological affliction.
Dawisha (2004) argued that the corrupt, inefficient, system created incompetent
leaders, combined with the suppression of human freedoms doomed the system.
Others, such as Goble (1994), credited President Reagan and the arms race (Star
Wars initiative), which forced the Soviets to spend more on military goods at the
expense of consumer goods and this led to more shortages and increased frustration
for the average citizen. It seems logical that all of these reasons contributed in
some way to the collapse of the Soviet system.
Few predicted the collapse of the Soviet system before-hand; it was a
surprise to most analyst; it was a surprise to Gorbachev (Pipes, 1991; Malia, 1992;
2008; Barbour, 1994; D’Souza, 1997; Furet, 2000). Malia (2008) said, “the
suddenness and completeness of the Soviet system’s collapse to be the greatest
surprise of the end of the twentieth century." President Reagan was one of the few
who saw the ultimate disintegration of the Soviet system. President Reagan had
predicted the coming demise in 1983, stating that it would be “regarded as some
bizarre chapter in the human chronicle” (Reagan, 1983; D’Souza, 1997). In 1981,
President Reagan said the Soviet system would generate a “march of freedom and
democracy which would leave Marxism-Leninism on the ash-heap of history”
(Reagan, 1982a: D’Souza, 1997). President Reagan’s critique included the
argument that the communist system was immoral, inefficient, that the central
planning system was doomed to failure, and that the “Soviet Union was a sick
bear” (Reagan, 1982b). President Reagan outlined his sick bear theory in a
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
133
commencement speech at Eureka College, in it he stated his belief that it was not if
the Soviet system would collapse, but when (Reagan, 1982b). As President Reagan
did, Margaret Thatcher also believed the Soviet system would lead to economic
failure and collapse (Blundell, 2008). In a 2008 interview, Gorbachev (2008)
blamed political infighting as the first reason for the collapse of the system, and the
second major reason mentioned by Gorbachev was the pressure President Reagan
created through his negotiation with Saudi Arabia to lower oil prices; President
Reagan thought the lower oil prices would significantly damage the Soviet
economy and help to bring an end to the Cold War (Schweizer, 1994, 2003; Allen,
1996; Cold War Seminar, 1999; Reynolds, 1998; Dienes, 2004; Gaidar, 2007;
Reynolds & Kolodziej, 2008; Gaddy & Ickes, 2009). The Soviet economic minister
Peter Aven also pointed to lower oil prices as one of the main reason for the final
collapse of the Soviet economy and several authors have also concluded lower oil
prices was one of the major reasons for the final collapse of the Soviet system
(Reynolds, 1998; Dienes, 2004; Gaidar, 2007; Reynolds & Kolodziej, 2008; Gaddy
& Ickes, 2009; Åslund, 2011).

3. BACKGROUND FOR FOREIGN INVESTMENT IN RUSSIA

One of the greatest upheavals (outside of war) of any major country in
modern times took place in the former Soviet Union. The impact of the social,
economic, and political changes on both Russia and the rest of the world is still
being felt even thirty years after the breakup. The background for these changes
was a complex web of official and unofficial forces that shaped the current Russian
system. Many of these past forces are still influencing the attempted recreation of
the Russian society. The problems associated with this revolution are often
misunderstood or misperceived. The closed nature of the Russian system in the
past made the transition from a centralized economy to a free-market economy
even more difficult. A multitude of questions and problems faces any company
interested in this emerging marketplace. Never before has any society faced the
multitude of issues before the Russian people and their leaders.
The analysis is based upon the following questions:
1. Who was the Mafia and how was its influence felt in Russia?
2. What demographic factors affected the consumer market place?
3. How did the political environment influence the free enterprise system'?
4. In what ways did the legal framework inhibit foreign investment'?
5. What were the economic factors that controlled the ability of any business
to become profitable?
 Thomas L Bradley, Paul B Eberle
134

6. Was the business environment conducive to conducting a normal business

practice?
7. What were the competitive factors shaping the establishment of the free
market in Russia?

3.1. Historical Implications

Russia has a long and varied history of autocratic rule combined with the
incorporation of over 100 ethnic groups within the boundaries of the state as it is
today delineated. For approximately 70 years, under the control of the communist
government, the Soviet Union was marked by the absence of a free market system
for both consumer goods, production, and distribution. However, contained inside
this commonly held view was the existence of the underground economy that
continued to operate during the reign of the Soviet communist government. An
important factor in the long history of Russia is the presence of the many multi-
ethnic groups held together by force for over one thousand years by the ruling
groups. While most of these ethnic groups have never been brought into the ruling
elite, they grew in both size and stature. In the recent past many such groups
became almost separate countries within the Soviet Union. Unlike Western
perceptions, Russia has been in conflict with the ethnic minorities for many years
with peace being maintained only by Moscow giving semi-autonomous status to
the regions.
It was under the rule of Gorbachev that the ethnic nationalism created self-
rule for many regions. Gorbachev also allowed an increasing degree of autonomy
by all Republics. When the then Russian Republic decided to have a directly
elected President, Yeltsin came to power. The combination of autonomy for many
Republics and a democratically elected Yeltsin created the environment in which
the Soviet Union dissolved. The factions in the Supreme Soviet, which tried to hold
together the USSR, forced Gorbachev to revive autocratic rule by decree. When
this effort failed, it was the same hard-liners in government who decided the
problem was too much freedom. The result was the attempted coup in 1991, which
set the stage for the complete dissolution of the Soviet Union. It also provided the
stage for Yeltsin to achieve power in the showdown with Gorbachev.
The fall of communism first began in the economic arena due to the burden
of defense spending, which by varying estimates used from 40-60% of the
resources. These resources were directed military preparedness and at the research
and development of military weapons to compete with the West. The technological
revolution that was occurring in the rest of the world was placing the Russian
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
135
economy farther and farther behind in both products and quality. Besides the
closed nature of the Soviet Union, the inability to modernize the factories to apply
new technology made the Russian system totally unable to compete for export
markets anyplace in world. This, along with a communist system that ignored
consumer preferences, consumer demand, and the consumer industry, led to an
opportunity loss of possible foreign exchange earnings over the 1960-85 period.
Ultimately, this began to effect the political system as well as the economic system.
The complete power held by the Soviet Communist Party made the system
extremely political, suppressing all opposing views and forcing compliance of the
communist ideology (Kornai, 1992; Dunlop, 1995; Åslund, 2011; Dobbs, 2013).
Since there was no pricing or market system to allocate resources, the only way to
get things done was through patronage connections, political or otherwise (Kornai,
1992; Dunlop, 1995; Åslund, 2011; Dobbs, 2013).
In 1985, Gorbachev recognized the need to begin modernization of the
inefficient, antiquated, and outdated factories. The only way to do this was to begin
a gradual de-emphasis of the military in favor of the consumer market. This was to
give way to a significant change in emphasis toward the consumer sector by 1990.
The result created a need to give decision making freedom to the individual factory
manager, while a loss of control by the Moscow ruling elite. Once this change was
in effect for several years, the desire for additional freedom became a tidal wave.
The need for decisions by individuals, not by a central authority, fostered this
change in the level of freedom.
The result was a rapid collapse of the political system that was unable to
provide the needed capital, markets, and coordination necessary to change the 70
year old monolith called communism. After Yeltsin was elected President of
Russia, the conflict between the USSR and the Russian Federation was inevitable.
The ability to hold together the USSR was impossible due to the loss of control,
both from within the Party, and of the people themselves.
One factor in the fall of communism has been attributed to the desire for
freedom by the Russian people. This is only partially true and not likely the major
reason. The heavy burden on the military brought about by the American military
buildup was certainly a major factor. However, the cause behind this situation must
take into account that the USSR had available more abundant resources than
America, but unlike the United States, the USSR had a controlled, centrally
planned economy creating very low production costs and an inefficient use of
resources. It was in fact the economic system itself which malfunctioned. The high
level of military spending certainly hastened the effects on the economy. The
 Thomas L Bradley, Paul B Eberle
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centralized decision system would not work in face of modem technology,

competition from many producers for global markets and the increasing
globalization of the all consumer markets.
Russia had two factions who were fighting for control of the government and
the reform process. These two groups were the reformers headed by Yeltsin and the
non-reformers headed by the Civil Union Block (Malcolm, 1992). Each controlled
about 25% of the Supreme Soviet, which was the Soviet Union’s legislative body.
There were a variety of additional parties, usually motivated by self-interest. It is
from this group that most decisions either passed or failed. This group represented
a variety of economic interests, criminal groups and ethnic minorities fighting for
the profits and power in the economy that their position afforded them. These
ethnic groups gained more and more autonomy and economic power in the regions
they represented.
Each group was fighting for control of a segment of the society. Decisions on
what was happening in the country was created by evolution outside the central
authority and were thus non-congruent in their nature. However, there also existed a
thriving marketplace filled with consumer goods from all countries very much
different from any time in the past. This expanded in spite of all attempts to restrict it.

3.2. The Mafia and its Influence

There were many groups inside Russia that were commonly referred to as
the Mafia by Russians. However, unlike the Western conception of what this
means, they were not one entity controlling all functions of the economy. There
were at least five groups operating which were being called the Mafia. While they
were independent they also were very much intertwined in their actions.
The first group was in fact a criminal element similar to that in any other
country. They were involved in drugs, prostitution, theft, and the usual host of criminal
activities. This group was very powerful and very out of control. They increasingly
became involved in basic economic activities as the profits from the criminal activities
need to be invested. This gained them power and political clout as well.
The second group were the traders of Russia. This was usually the
Armenians and the Azerbaijan people. The Azerbaijan’s controlled most of the
food distribution system in the free markets. This meant they controlled from 60-
80% of the actual food sold in Russia. They were located everywhere in Russia in
the free market food stalls located in every town. Much of the imported food
sourcing was also controlled by these traders.
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
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The consumer marketplace was controlled by the Armenian traders who
bought products in Greece, China, Korea, Turkey and India. They had established a
network of Russian salesmen to sell these goods in the free markets. They controlled
virtually all goods sold through these markets at monopoly prices. This control was
at times violent in nature, which has enabled them to maintain this control.
The third group was much less well organized, but equally powerful. They
were what Westerners called capitalist. Anyone in Russia who made money from
any trading type activity was said to be in the Mafia. This was what most Russians
who were interviewed meant when they spoke of the Mafia. It was the thousands of
salesmen who bought from one group and sold to another, who became larger in
numbers and created a political power base as a result. It was this group which led
to the Yeltsin victory.
The fourth group was the political group. This was the old line Communist
Party bosses who controlled various industries, property, import and export
channels as well as governmental ministries. They wished to maintain confusion in
the economy and the government as it was very beneficial to their power base.
They were given this power through the Supreme Soviet, which was in conflict
with Yeltsin on reform. Because they controlled almost all decision
implementation systems within the government any reform had to pass through
their bureaucracy.
The last faction was the cadre of young criminals who engaged in robbery
for the money from tourists, wealthy Russians, and various companies. They
operated a protection ring of businessmen who wished to avoid crime. They were
difficult to control as they were ruthless and very violent. At the time, it was almost
impossible to stop them, short of military rule, because of the lack of police control
in the cities during this period. These criminals controlled the streets as much as
American gangs control America city streets. The interaction of these Mafia groups
was (and still is) very important. At the time, the local police made the equivalent
of $4-6 per month. The ease with which they could be bribed was forced upon
them by their low standard of living. They were easy prey for each Mafia, who
could offer huge bribes for protection. At the time, it appeared that the only group
not being bribed was the old KGB. However, even this group was susceptible to
bribes and was increasingly under pressure as the political crisis continued. Any
major transaction in Russia had one of these groups either directly or indirectly
involved. The involvement ranged from paying a fee to get a quick approval, to
actual protection payments for safety.
 Thomas L Bradley, Paul B Eberle
138

During this period, all currency transactions went through the currency
exchange network controlled by the Mafia. When transportation was needed for
products, the only way to guarantee their arrival was to hire guards and pay the
police along the way. When leases were signed, the approvals had to contain the
various fees to get the necessary approvals. During this period, the interaction of
these groups was what drove the economy and politics in Russia. They made huge
profits because of their power and control. They were also very much responsible
for the beginning of the free market. Their perception of a free market was
different from the Western image. They perceived total control as the best form of
markets. The need to establish a Western style business environment was strongly
contested by these groups. They were interested in the profits of the market, but
were not interested in establishing any real free market conditions. Because of their
position and influence, they gained as much control over all aspects of the
economy as was possible before reform actually happened. The ability of the
reformers to prevent this became less each day that reform was delayed.

3.3. Population, Transportation, and Communication Factors

There were many important factors that were influencing Russia during this
period. Three factors, among many, included, the size and population of the
country, the transportation network in existence at the time, and the level of
communication that was available for business.
Russia is the largest country in the world, being 11 time zones wide,
stretching over 170 degrees of longitude, or almost halfway around the world. It is
over twice the size of America. There are over 100 ethnic groups contained in a
population of over 145,000,000 people. The country continues to become more
urban as the population moves to the cities for work. Because of the size of Russia,
the transportation network is very different from that of any Western country. The
only practical way to go from West to East in Russia is by plane or by train
because the Trans-Siberian Highway is 7000 miles long and it would take at least
eleven days to drive across Russian. The climate and size of Russia make a road
network both difficult to build and also to maintain. Within each region a network
of roads exists for the truck transport system. However, the most widely used
network is the rail system. It has two parallel lines which are designed to serve
simultaneously in each direction. This allows both freight and passenger traffic to
travel continuously in each direction. Virtually every city is connected by rail with
many cities having this connection as their only method of outside travel. It was,
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
139
until the break-up of the Soviet Union, one of the most efficient long run railroad
networks in the world.
In 1990, the aviation network was one of the largest in the world, carrying
over 110,000,000 passengers annually. It was a State run monopoly with Aeroflot
as the carrier. The fares for all forms of transport were the world’s lowest per mile
traveled. For example, around 1990, to travel by train from Moscow to the Far East
coast across 11 time zones, the fare was equivalent to 3USD, while by air it was
25USD. The free market reforms led to increased prices to world standards. Air
travel became far out of reach for the average Russian traveler. This caused most
travelers to switch to trains, putting an additional burden on the rail network, which
was already at capacity.
The climate of Russia is severe for 6 months of each year with snow
remaining on the ground from early November to late April. The temperatures in
most of the country is from -15 to -40 Centigrade during this time. The spring and
fall are very short in duration. The Siberian region is very hard on equipment
because of the prolonged exposure to the cold. Much as in Alaska, the conditions
under which any company would operate are severe. The productivity in this
climate is also substantially less than warmer regions. This severe weather makes
plane travel difficult, and at times impossible, for days on end. Rail travel is only
rarely affected which is why it is the mode of transportation for most freight in
Russia. The communication system was much more developed in the Western
sections than in the East. At the time, telephone lines were everywhere in Russia,
even to the most remote areas. However, the availability of direct telephone
connections to the outside world was restricted by 42 trunk lines. This severely
restricted access by Russian citizens to the outside world.

3.4. Political Environment

There were several political factors which controlled the economic
environment. However, to understand what was happening at the time in Russia it
is necessary to understand how the free market was evolving independent of what
is being decided in Moscow.
The following factors were influencing business in Russia (See Table 1):
1. The conflict between Yeltsin and the Supreme Soviet.
2. The control by the Supreme Soviet of various segments of the economy.
3. The desire of the Supreme Soviet to keep inflation high, the currency weak
and non-convertible, and land ownership public.
4. The autonomy of the outlying republics.
 Thomas L Bradley, Paul B Eberle
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The conflict between Yeltsin and the Supreme Soviet (SS) was based upon
one factor. The SS did not wish to give up the perks and power associated with
their positions. The members would not agree to free market reforms because they
were benefiting from the chaos that existed. As long as they retained their power,
they also retained the money, influence, and control inherent in their positions. The
way that the SS benefited from the economic and political chaos was that they
controlled the currency black market, the leasing of land, office space and
buildings, the central bank, the state run industries, and the transportation network,
as well as the issuance of business permits. Each of these elements produced
millions of dollars in profits for the SS members, so they did everything they could
to prevent the loss of their power. When real reform took place control was taken
from them.
Table 1: Chart of Reform Priorities and Factors which were Influencing Business in Russia

Reform Conflict Party Harmed Intended Results of Reform

1. Convertible Ruble 1. Black Market 1. Supreme Soviet 1. Stabilize Ruble
2. Supreme Soviet 2. State Mafia 2. Increase Ruble Value
Lost Control 3. State Business 3. Foreign Investment
3. Stability of Managers 4. Restore Purchasing
Economy Power
2. Stop all Monetary 1. Supreme Soviet 1. Supreme Soviet 1. Industry must become
Stimulus Lost Control 2. Bureaucrats profitable
2. Bureaucrats lost 3. Managers 2. Privatization
source of income 4. Laid off workers 3. Establish Competition
3. Industry managers 4. Help stabilize ruble
vs reformers 5. Stabilize reform
3. Triple the wage 1. Political 1. Mafia 1. Begin real reform
base and restore 2. IMF 2. State managers 2. Stabilize markets
savings accounts 3. Black Market 3. Non-reformers 3. Increase consumer
4. Mafia 4. Supreme Soviet purchasing
4. Restore confidence
4. Privatize land 1. Supreme Soviet vs 1. Supreme Soviet 1. Foreign investment
Yeltsin 2. Real estate deal 2. Real market reform
2. Bureaucrats makers in 3. Modernize internal
3. Selling Russian government infrastructure
land to foreigners 3. Existing land 4. Expand free enterprise
4. Basic concept holders 5. Bring Hard Currency into
Russia
6. Commit to free markets
7. Signal to people
8. Decrease government
control
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
141
Reform Conflict Party Harmed Intended Results of Reform
5. Privatize Business 1. Monopolies and 1. Mafia 1. Bring in foreign
new business 2. Supreme Soviet investment
2. Mafia and 3. State bureaucrats 2. Bring in hard currency
everyone 4. Industry managers 3. Establish free markets
3. Supreme Soviet 4. More competition
and Yeltsin 5. Lower prices
6. More products in the
market
7. Increase trade
8. Establish international
trade
9. Lessen political conflict
over time
10. Add jobs
11. Increase income
6. Establish consumer 1. Street lenders lose 1. Street mafia 1. Establish durable goods
credit power 2. Supreme Soviet marketplace
2. IMF mandates 2. Encourage private banks
3. Foreign control 3. Bring in foreign currency
perceived 4. Increase consumer buying
The SS controlled the banking system and the monetary policy. This
produced inflationary money supply increases of over 100% per month for over
one year. The stated reason for this policy was that the state companies needed the
money to survive. However, the workers did not receive similar increases in
salaries, while payments for raw materials were not being made to anyone. Where
was this money going?
The SS also controlled the black market currency exchange companies. They
made enormous profits from the buying and selling of rubles and dollars. They
made inflation high and kept a non-convertible ruble, and they were able to restrain
the black market. The SS had no desire to change anything until they were forced
to do so. They wanted high inflation, punctuated by the desire to buy raw materials
at low prices. They then held these materials until they were able to sell them for a
much higher price. The SS controlled the state industries and the banking system
and financed the industries with government money. The SS then sold the goods
for huge profits and did not repay the borrowed money. It was a perfect profit
center for the industry managers. The industries did not need to pay interest nor
borrow in the credit markets. They also did not need to pay each other for
materials. Each industry was in the same situation, so each industry acted
accordingly by not paying each other. As long as the State kept giving them
money, there was no incentive to change or modernize. The result of this activity
 Thomas L Bradley, Paul B Eberle
142

was that the Russian consumer lost their savings through the inflationary market
combined with the government printing of money. The entire wealth of a nation
was essentially stolen by this tactic. It created a wealthy class in a period of two
years to rival any third world dictatorship. It has also resulted in 95% of Russia’s
middle class (that existed in 1988) living in poverty by 1992. It was estimated by
the government that this represented about 75% of the population at the time.
The last element of control was the ownership of land. This was to have been
privatized by February 1, 1993. However, the SS resisted efforts to privatize the
land. The reason was that a legal system needed to be created which would
guarantee the rights of land owners. By creating a legal code, there would be a way
to legally punish those who conducted illegal activities. This would have evolved
into a commercial code for all of Russia. This would have caused all the activities
of the various Mafia groups to become illegal. Additionally, the sale of land would
have brought international investors into the marketplace. The control of Russia
would have been much more difficult. It is one thing to abuse a citizenry who are
used to 70 years of dictatorship rule, but quite another to do the same things to
large international companies. A system of property rights protection should have
been the cornerstone for the reform effort. Real reform could not happen without
property rights protection. The ideology of the Supreme Soviet was against the
establishment of property rights protection. When these factors were combined, it
was obvious that political turmoil would continue for some time.
The worldwide emphasis upon nationalism must also be mentioned in this
context. The regional nature of Russia's ethnic groups had contributed to the
growing autonomy that many such regions were experiencing. While the power
struggle continued in Moscow, the regions had begun to establish independent
trade relationships. Under Gorbachev, they were allowed to set up joint ventures,
export trades, and autonomous barter arrangements. There was a growing level of
independence from Moscow that helped to continue the reform process as those
regions found it necessary to encourage private ownership, export trading, and free
markets to survive economically.
As this pattern of autonomy continued, the ability of Moscow to control the
rest of Russia diminished. There was also the growing influence of Turkey and Iran
in the Asian regions, the Japanese in the Eastern regions and China in the Southern
Asian regions. The need for trade, hard currency, and technology continued to
influence these newly formed international ties.
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
143
The desire to encourage foreign investment was difficult to balance against
the old line thinking of the communist leadership. This ideology was very
distrustful of any foreign ownership of any industry. Those who were still in power
retained this fear and opposed any effort to privatize property, industry, and new
ventures. They wanted the hard currency foreigners brought into Russia, but they
also put road blocks in the way of any actual reform efforts. Many of the Russian
citizens also shared this belief based upon old fears. An undercurrent of fear was
always heard in private conversations about the selling off of Russia. It was a
major ideological battle, which was very difficult to resolve within the populace or
the political system. This conflict continued for many years.

3.5. The Legal System

There was no legal system of commercial laws and regulations in existence
at the time. Part of the reform effort was to establish a uniform commercial code
modeled upon the American code. However, the Supreme Soviet did not want this
to come into existence. Without the ability to have legal recourse for any breach of
contract, the destructive effects upon the economy were severe.
The following were the elements that impacted the economy:
1. Foreign investors was reluctant to invest.
2. The ability to establish a business was governed by street law and controlled by
either special interest groups or the Mafia.
3. There was no legal standard by which agreements or contracts could be reached,
disputed, arbitrated, settled, or guaranteed.
4. When disagreements arose, no established code was in place to resolve
disagreements, so that usually bribes determined the outcome.
5. It was difficult for a competitive system to evolve since the rule of law was
superseded by the strength of the companies in the dispute determining the
outcome.
6. Every company that tried to establish a trade relationship was subject to the
honesty of the other party, which was often dishonest in Western terms, but
normal practice in Russia. Thus, no long term growth happened as only a short
term time frame was used in planning.
7. Without laws in place to create free markets and competition, the ability to
create monopolies was vigorously pursued.
8. Without a property rights system that protected land ownership, the ability to
expand the economy, to attract foreign capital, and to establish production type
industry was limited.
The culmination of these conditions was that free markets, as the West
understands them, did not exist. The inability to develop a legal system affected
 Thomas L Bradley, Paul B Eberle
144

almost every segment of the economy. From the producer of products to consumer
complaints, there was no avenue to seek redress of any grievance. The effect on the
economy was dramatic in both attitude and amplitude. The small business owner
found it difficult to establish business relationships, while the large companies
were reluctant to invest heavily without knowing the rules. One last element was
the influence that various governmental agency personnel had on any compliance
questions which arose. By having no established legal framework for business, the
ability to obstruct reform oriented decisions was the basis for their receiving huge
fees for services rendered. This was epidemic in all of Russian bureaucracy. It
often added prohibitive costs to most projects.
International trade found the same difficulties. For example, an agreement
was reached only to be changed or broken by someone in the decision making
apparatus far removed from the negotiation process. The largest example of this
was an oil field deal that was reached by Chevron, but was killed by the old line
leadership (Greenhouse, 1992; Parrish, 1993). It was finally completed only by
going directly to Kazakhstan to arrange an agreement, but with a 20% stake instead
of 60% as originally agreed upon (Greenhouse, 1992; Parrish, 1993). Small
companies faced a maze of obstacles without the financial clout of Chevron or
IBM. Their growth was stymied and discouraged at every point. This is why few
jobs were being created in production.

3.6. Economic Issues

There were four such issues effecting the economic and business
environment in Russia. They were the status of the ruble; the barriers to trade; the
barriers to market entry; and the financial risks in the economy. The status of the
ruble was the key to the economy. However the other elements were also important
to the establishment of a positive business environment.
At the time, the ruble was not officially convertible. This was confusing
because currency exchange companies existed inside Russia. These exchange
companies would convert the currency for any company and transfer the hard
currency to Europe. It was illegal to do so, however those controlling this process
were the same people who were making it illegal to do so, the Supreme Soviet. The
reason for the existence of a black market in currency conversion was simple. The SS
could retain a high buy-sell difference in the value of the ruble as long as it was
impossible to trade the currency openly. It was illegal to hold hard currency, or to
pay in hard currency, yet everyone attempted to do so at every opportunity. The only
way this hard currency could be converted to rubles was through the black market.
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
145

The banking system in Russia was controlled by the Supreme Soviet. The
reformers were unable to establish any monetary policy that coordinated important
restructurings. By keeping the ruble internal and the economy in an inflationary
condition, the Supreme Soviet continued to generate profits from the chaos in the
economy. This enhanced their power base and also gave them ammunition for the
political debate. They pointed to the higher prices for basic goods, the lack of job
creation, the weakness of the ruble and the inability of reforms to work, all of this
was an indictment of reforms not working. Until the currency was made
convertible, this condition continued to exist in Russia. It also forced the CIS
Republics to adopt their own currencies, thus harming open trade between Russia
and the CIS countries. This policy was also designed to create problems inside
these Republics with the goal of ultimately reuniting the Soviet Union. This policy
was the stated goal of the old line Communist movement. The control of the
currency was a powerful tool in this effort.
The trade barriers between CIS countries became more and more acute. The
inability for any industry to pay for goods received in the past, because it received
no payment for the goods it had sold today, resulted in an acute cash flow shortage
for all industries, especially the privatized ones. They did not receive loans from
the government to sustain them. Once again this policy was tied to the political
aims of the old line Communists who were controlling the legislative process.
The barriers to trade also eliminated any hope for new job creation and
industry conversion. If a company had no capital and could not receive payment
for products produced, it was difficult to make the necessary modernization
required to establish a viable company. This was amplified if the company had to
buy products from overseas in hard currency. It could not receive hard currency
for payment of its product if its products were sold in Russia. Also, it could not
legally convert the rubles to hard currency to pay for materials purchased outside
Russia. If the black market was used for this purpose, the currency conversion
took all the profits away. It is a great circle without end. This is one way Moscow
retained control of the economy.
When considering any market entry, the lack of capital was the foremost
problem. Yet, the economy did not encourage the introduction of hard currency
investment because it was difficult or expensive to convert the associated ruble
profits to dollars and remove them back to the home country. An artificial barrier to
investment was the culmination of these problems, which in turn deterred small
 Thomas L Bradley, Paul B Eberle
146

business development. Again, this was conducive to the goals of the Supreme Soviet
leadership. If small business did not develop; if foreign investment was weak; if
internal growth was poor; if jobs were not created to employ the newly unemployed
working class; these factors played into the hands of the non-reformist groups.
An additional barrier to a company entering the economy was the confusion
involved in gaining approvals for becoming a legal business. This was the result of
layer upon layer of government workers each treating a decision which establishes
a free markets as a bad proposition. At every turn, they hindered and impeded a
new business. Often the need to pay fees, as well as bribes, to get approval stopped
a small company from getting started. The fees could be very high for the small
businessmen especially if they were a foreign investor.
The lack of a distribution network for products made any attempt to establish
a quick market presence virtually impossible. Moscow and St. Petersburg ended up
with the vast majority of new companies. The established method of distribution
was through the government run State stores. They did not carry foreign goods, but
only domestically produced products. Because there had never been a legal free
market, there was no other legal form of retail selling approved by the government.
Informal markets began to evolve typically located outside metro stations or
located in areas near high density apartment complexes. An additional source of
retail selling was the kiosks which appeared everywhere in Russia. These were
owned and controlled by the Mafia. They sold a variety of consumer products
focusing upon food, drink, household products, and music tapes. They were rented
by the vendor and supplied by the Mafia owner, with products from a variety of
sources. This was the only organized system of distribution in Russia other than the
State run stores.
If a new business had a product that was retail in nature, the only way to gain
access to the marketplace was to sell through these Mafia elements. This was
certainly an impediment to new business. The system was monopolistic in nature
with pricing competition completely eliminated. There was a violent Mafia faction
which enforced these pricing decisions. Several groups tried to compete in the
retail system, only to be murdered. Potential competitors feared the Mafia and the
threat of violence kept all completion out of the market.
The inability to own land forced manufacturing companies, retail chains,
distribution networks, and service oriented companies to work through the
government, since the government legally owned all of the of property and decided
who could use it and profit from it. This certainly forced many companies to stay
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
147
very small, or to only distribute rather than produce products. The fees associated
with rental property were usually excessive and out of range for all but the largest
companies. To pay a large up-front fee, then high rental fees, only to find out that
decided to let somebody else use it, can be devastating to any business. The lack of
enforceable property rights or property ownership severely hindered the economy
and prevented market entry.
The market was monopolistic for most products. This created high profits for
those which were involved in market distribution. However, because the
distribution system was also monopolistic, the ability to enter this marketplace was
very limited. It became a huge barrier to market entry. The profits were often made
by the distribution channel not the supplier. The pricing system was based upon
desired profit not the demand for the product. At the time, virtually every quantity
of any product could be sold, so there was no constraint at the time. This
dichotomy was unique among world markets. The supplier had only one channel
from which to distribute, so prices were kept low for them, while the seller had a
monopoly, so sales prices were high. The profits were earned by the seller who
often used the high inflation to further increase profits. This was done by delaying
payment for goods.
When all of these factors are considered together, the financial risks were
very high. This further impeded international and domestic companies. After
conducting a financial risk analysis companies were not willing to enter the
marketplace. The rewards were long term in nature unless the product was able to
be introduced into the distribution network at monopolistic pricing from the
supplier side. This was happening only in a limited range of products.

3.7. The Business Environment

By 1995, there were over 200,000 individual companies licensed to do
business in Russia, ranging from Coca Cola, to salespeople on the street selling
perfume. This grew to be from 60% to 80% of the actual consumer market. This
compared favorably with most Western economies when the value of the budget
from the government are subtracted from the GDP. This change began in 1987, but
was slow to evolve until 1991. The scale and degree of this transition from a
government owned economy to a free market economy is without parallel in
modern history. At the time, the closest comparison was the Argentina
privatization effort, as well as the rise of China.
The reasons this happened so quickly was tied to the value of the ruble. In
1991, before it was freed to float at market rates, the ruble was worth $1.10. At the
 Thomas L Bradley, Paul B Eberle
148

time, the Soviet economy was thought to be the second largest in the world with a
reported GDP of $2.3 trillion. This translated into a 2 trillion ruble economy. When
the ruble was allowed to float freely, it fell to 900 to the dollar. By the World Bank
standard this converted into a purchasing price parity of about $5800 for each
person in Russia. With this inflation and ruble value, the average Russian earned
about $15-20 per month. The change was dramatic both in its impact on the
Russian economy and the average person's standard of living. This also decreased
the value of savings accounts to virtually nothing.
Before 1990 the average Russian savings was reportedly around 25% of their
income, which was one of the highest rates in the world (Howard, 1976; Gregory,
1989; Mokhtari & Gregory, 1993; Mokhtari, 1996). The dramatic change in the
political and economic environment has caused the marketplace to also change in
new ways. While the average worker’s salary declined, there were now thousands
of newly created businessmen who were making high incomes from the free
market. The influx of imported goods allowed, for the first time in 70 years,
Russians with the money the ability to buy any product in the world. The new
Russian wealthy took advantage of this opportunity with an explosion of
consumerism. This was seen in every area of the economy from electronics to
automobiles from Europe.
The one aspect of this new consumerism was in the real nature of the
economy at the time. Previously, much of the GDP was to produce military
products of some kind or basic consumer goods. Most of the new wealth was from
trading and not production. No value added items were being produced. The
marketplace had become a consumer marketplace, almost opposite of the past
history. This continued until such time as the average consumer had finally
purchased all the previously unavailable items.
It was almost impossible to analyze the Russian market during the transition
because so much was in the underground economy and not reported. Tax revenues
fell dramatically with a reported 25% drop in actual production. In the past,
production figures were always inaccurate so it is difficult to compare these
numbers. However, the level of the outflow of dollars was over $20 billion in 1992
(Granville, 1993; Dabrowski, 2016a, 2016b). At the time, this surpassed the level
of foreign investment and aid going into Russia. Translate this into rubles and the
drain on the economy was extremely high. All of currency flight was by the new
rich, the Mafia groups, and the politicians who were getting the money out while
they could, just in case there was a political change once again.
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
149
In examining the privatization that took place, the vast majority of these
private companies were single owner entities engaged in selling consumer
products. Most of the larger production type companies were joint ventures (JV)
with foreign partners which were created from the privatization of existing
factories. The level of this privatization varied dramatically from region to region
depending upon the degree to which the local authorities desired reform. Most
were owned 25% by the employees on a non-voting basis, 25% by the management
group and 25% by the stockholders, with 25% left for the JV partner (Johnson,
1991; Fey, 1995; Wright, Hoskisson, Filatotchev, & Buck, 1998; Hare &
Muravyev, 2003; Sprenger, 2011). All control remained with the prior management
made up of former Communist Party members. It was the Supreme Soviet which
decided how the privatization was to take place. It kept the old power structure
intact, but also provided for worker dividends which often exceed the pay for the
average worker. As the need for modernization and capital developed, these firms
were seeking JV partners from the outside world. They were finding it increasingly
difficult to locate these partners due to the legal, political, and currency problems.
The economy was unable to absorb the technological changes needed to compete in
the modern world because of the lack of capital and export markets. The economy
was undergoing a transition from military production to consumer production, but
lacked the capital to complete this undertaking. The desire to convert these military
industries was universal because the Government had no money to buy the military
hardware. The only available market was the consumer market.
An example of this was in Kovrov, a region near Moscow that was making
tanks for the military. When production stopped, the region tried to find other
products to manufacture. It decided to make much needed furniture. Once
production was established, the first convoy of trucks went to Moscow to sell the
products. Instead of providing needed furniture for the expanding real estate market
in Moscow and earn profits for the company to expand; the local Mafia prevented
the convoy from entering central Moscow without paying a tax. However, that tax
meant the furniture sale would lose money instead of making money. Thus, the
trucks were forced to turn around, and the region suffered greatly because of the
lack of law and order, the corruption of the police, and the power of the Mafia.
The level of scientific ability among the Russian community was among the
highest in the world. The ability of the companies to utilize their talents became a
major problem. The talent base was used for military research and development,
but had no consumer marketplace in which to transfer those talents into the
research pool. As a result, thousands of scientists emigrated from Russia to other
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150

countries. It left a large group who were underutilized and very under paid as a
potential source of talent.

3.8. The Competitive Marketplace

As the Soviet Union collapsed and the transition took place, most of the
product markets were monopolistic. For the previous 70 years, no legal
competition existed for any products sold in Russia. When the marketplace was
allowed to be competitive in 1991, the concept was for many competitors to
establish a free market arrangement in which prices would be set through the forces
of supply and demand. This did not happen for a variety of reasons. Many of the
free market advocates and economists advising Russia told the Supreme Soviet and
Yeltsin that freeing prices before a competitive market, property rights protection,
and legal system were established would cause very high inflation, incredible
profits from monopolies, and the ability of those in control to keep out future
competitors. Because the reform effort was only partially implemented, this is
exactly what happened in the 1991-1995 period.
Instead of establishing a competitive market, the change that occurred were
the introduction of new products, but not competitors, to produce and sell these
new products. This spilled over into the privatization effort as well. The rules that
were established about the process of selling stock in the new company gave
management (the old Communist Party members) the only voting stock. Therefore,
the control was kept in the hands of the old ruling elite. This continued to be the
policy for all privatization efforts.
Because this privatization was in the hands of the old line communist
members, it was also in their best interests to not allow foreign competition to enter
the marketplace. They did this by stalling the new business and joint venture
accreditation and approval process in the bureaucracy of government. This was
very successful as only 20% of the applications for joint ventures were approved. It
was the exception, rather than the rule for a new company to begin any production
effort. The only new companies were those that were privatized without any joint
venture arrangements.
When examining the economic reform process the lack of competition created
the inability of Russian industry to modernize due to lack of foreign investment. This
was a circular situation in that those in control did not wish foreign involvement, yet
they need foreign capital. The reason that the communist managers did not wish
foreign investment was that they could continue to receive subsidies from the
Supreme Soviet as long as the factories were seemingly unprofitable. This money
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
151
was going directly into the hands of the managers. To allow foreign investment
would shut off this ability to literally steal money from the treasury. This continued
until such time as this source of revenue was discontinued.
Pricing competition did not exist in any product group. In fact, the pricing
was done on a monopolistic basis with very high prices relative to costs. The best
factory in Russia was the Altay Tractor Factory in Rubstovsk. According to the
managers, the cost of labor was 5-12% of the expenses. This is considered a
modern factory. By comparison even in an automated American factory the direct
labor costs averages between 15% and 25%.
There was never any audited study done which indicated that factories were
losing money. It was assumed by all parties that this was true. However, they were
able to sell everything they made with a labor cost less than an automated Western
factory. They had no rental payments for land or buildings, the energy rates were
subsided by the government and were the lowest in the world, there were no
dividend payments to be made to stockholders, transportation costs were very low,
no taxes were paid unless the company was private, and raw materials were sold at
the cost of delivery with no profit added. Even considering the low sale prices of
products in the marketplace in the past, the ability to sell everything produced,
combined with the low cost of manufacturing, would indicate that state industries
were in fact not as unprofitable as was reported and in fact may actually have been
profitable. One fact remains constant in this examination. If these factories reported
a profit, they would lose the subsidies from Moscow which were being used to
enrich the managers. It would appear that perhaps this was the overriding issue. In
reality, many of these factories were actually profitable even with the inefficiencies
of production. While certainly they were inefficient, this fact by itself does not
support the premise of all factories being unprofitable.
Even while production was not as it would have been in a marketplace
environment, the workers were paid by using a very simple plan. Each worker
received some of the production to sell, and they could keep the profits as their
salary. Evidence of this could be found along the Trans-Siberian Railway as each
stop along the way would find dozens, if not hundreds, of women selling the same
product, and waiting for the train riders to get off. One could learn what factory
was located in that city by the types of products being sold. In reality it was like
hiring a captive sales force.
These inefficient factories should have been converted into productive
organizations, certainly there was the low costs of labor present. The element
 Thomas L Bradley, Paul B Eberle
152

lacking was the initial capital to do the conversion. This should have come from
either a joint venture or a loan from somewhere in the international finance
community. With a guaranteed market for products and no competition, a company
had the ability to quickly become profitable.
This opportunity continued while the marketplace remained
non-competitive. The managers were able to maintain this situation because of
their past membership in the Communist Party. All the managers had direct ties to
the Supreme Soviet through their representatives who continued to direct policies,
and they continued this non-competitive marketplace. This situation continued until
foreign competition was allowed to freely enter the market and create competition.
The interrelationships between the factory managers and the Supreme Soviet
was a major source of conflict between the reform elements and the old line central
planning groups. The ability to either establish a business without interference from
these groups or to enter a market not already established was the only way to
compete in Russia at that time. Because of these conflicts companies found it was
almost impossible to resolve. At the time, this is why over 60% of the companies
who wanted to enter the Russian market did not enter.

3.9. The Russian Marketplace

It was almost impossible to predict the future because of the unique aspects
involved in the breakup of the Soviet Union. There was no place in history in
which such a large scale change had come from political, economic, and social
collapse. The magnitude of this change was only evident as the various struggles
within Russia and the Republics continued to unfold. Many of these events seem to
have had no rationale, nor were they controllable, and they certainly were not
understood by the outside world. It is for this reason that an understanding of the
actual forces that acted upon Russia is imperative to understand what happened to
the Russian economy.
At the time, the issues facing foreign companies during the 1991-1998
period included, but not limited to:
1. If the market was to be entered.
2. When the market was to be entered.
3. How the market was to be entered.
4. Why the market was to be entered.
At the time, it was very difficult to answer these questions since companies
did not have enough information to come up with a good answer. Companies only
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
153
had a framework upon which to base an analysis. The answers certainly changed
over time with the constant changes that were happening in the political arena.
What was once an opportunity became a closed market, and often a nonexistent
market. The question for any company was which products to produce or sell,
which areas of distribution to choose, and at what prices would the market allow.
An understanding of how the Russian system actually worked was key
toward establishing any meaningful criteria under which decisions were to be
made. The complexity of interrelationships among all groups created a web of
mystery and confusion unique to any world economy. The inability to receive
accurate informed opinions from media sources combined with the difficulty of
travel within Russia had created a series of inaccurate impressions of every aspect
of Russian life. Conditions in Moscow were said to be similar to that everywhere in
Russia, yet also were very different. The danger of only looking to the Moscow
region for market analysis was inaccurate and resulted in losing valuable markets.
Most research conducted, both during the transition period and later, focused upon
Moscow or St. Petersburg due to the easier ability to do research. However, this
region is only a small part of the Russian mainland. Thus, much research was
flawed as it ignored the other reality of life and economics in Russia.

4. CONCLUSION
The questions posed in this study, as well as the background information it
contains, should establish a different perspective on the real conditions and
concerns inside Russia during the breakup of the Soviet Union and the transition
period. The need to amplify these issues and questions in light of the continuing
changes is overwhelming. The greatest marketing opportunity in modern history
was fraught with the dangers of misinformation and miscalculation. If this market
was to be developed, and Russia itself was to survive as a free market democracy, a
universal effort had to be made in the context of the existing culture of Russia.
As Russia has evolved over the last 25 years following the transition into a
more modern, yet very controlled economy, the ability to establish an actual market
economy has been hindered by the political elements of the society. The ten years
following the collapse of the Soviet Union resulted in many attempts at reform that
always contained the disparate views of the political structures, the mafias of
society, the oligarchs of most economic elements, and the vastness of the nation.
This transition period could have resulted in a very different outcome had the
global interests focused upon giving Russia the means to control this out of control
 Thomas L Bradley, Paul B Eberle
154

transition. Rather than be happy with the collapse, the world should have seen an
opportunity to convert the society into a productive economic partner.
For more than one-thousand years Russia has always had a cultural tendency
toward authoritarian rulers, which, if not controlled, would certainly return as viewed
from the lens of 1991. In fact, without understanding that there are three reforms
needed, economic, social, and political not just an economic reform; the world lost
the chance to influence a peaceful transition as happened in most of the Eastern
European nations. Rather the lack of political change combined with a total
misunderstanding of the social changes also needed resulted in a reform that was not
organized in any way. It just happened as the power of those changing it desired.
The authors, having experienced first-hand the changes, the debates, the
failures of various reforms, foresaw that Russia would return to its cultural
tendencies of authoritarian rule and that this would prevent a real market economy
from being created. Looking back over the 30 years of change, the average Russian
is in the same place as before, but without the social safety net provided for them
and having no framework for how to succeed. The lack of social change resulted in
an increase in the ability of the political authoritarian tendencies to control the
changes. By not actually understanding communism as it pertains to society, the
opportunity was lost. By not understanding the need for a gradual change that
would have also changed this social fabric in a positive way, the opportunity was
lost. By not preventing the transfer of the state industries and resources to private
hands to be wide and expansive, the opportunity was lost. In conclusion, Russia has
recreated the very system in place before the 1917 Revolution.

5. FUTURE RESEARCH
The understanding of the many aspects of the transition period was followed
by dramatic changes to the early economic, social, and political structures. While
there are a multitude of research papers on the post-2008 era, additional
comparisons between the reforms of Russia compared to the reforms of China
would provide insights into economies transitioning into competitive markets. The
two largest communist nations have undergone massive changes, but not in a
similar fashion. By comparing the two transitions and subsequent new economic,
political, and social models a lot can be learned about how to reform transition
economies all over the world.
Future research should also consider the three reforms, economic, social and
political as to how each influenced the other and which achieved the goals of the
 The Russian Economic Environment and the Collapse of the Soviet Union: A Retrospective Look
155
1991 Russian Revolution. This type of research can provide insight into what really
did create the new Russian model as it exists today.
In the social science field, a study of the life changes experienced by the
average Russian citizen would be most interesting. While eastern European nations
made very different transitions than did Russia, a view of how the changes affected
the lifestyles of both would provide much needed information that could perhaps
provide a future view of the coming Russian changes post Putin.

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 CASE STUDY

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 Volume 17, Issue 1/2024, pp. 161-196
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0007

PROPERTY TAX IN BULGARIA – THE NEED FOR UPDATING

THE TAX BASE

DESISLAVA ZHELEVA KALCHEVAi, DANIELA USHATOVAii

Abstract: In recent years, local authorities in Bulgaria and the European Union member
states have faced numerous challenges. The crisis related to the spread of COVID-19, the
war conflict in Ukraine, high inflation rates, increased energy prices, and disrupted supply
chains have significantly negatively impacted municipal budgets. The growth of local
expenditures not only outpaces revenue growth but does so at significantly higher rates.
The low elasticity of tax revenues prevents them from increasing in parallel with the
expenditures. The inflation recorded in recent months further creates fiscal gaps at the
municipal budget level. There are increasingly significant discrepancies between the
revenue and expenditure sides of budgets, and some municipalities are exacerbating the
problem of underfunded expenditures. Practitioners and academic experts are exploring
ways to increase local government revenues and enhance the tax autonomy of
municipalities in Bulgaria. Revenues from property taxes play a crucial role in increasing
the tax independence and own-source revenues of local governments. The aim of this study
is to analyze and assess the possibility of updating the tax assessment of real estate as a key
prerequisite for the growth of local tax revenues.
Keywords: words: property tax; tax assessment; update; municipalities; local taxes, Bulgaria
JEL Classification: G18, H20, H71

1. INTRODUCTION
In recent years, local authorities in Bulgaria and the European Union
member states have faced numerous challenges. The crisis related to the spread of
COVID-19, the war conflict in Ukraine, the high inflation rates, increased energy
prices, and disrupted supply chains have negatively impacted municipal budgets.
The growth of local expenditures is outpacing revenues at a high rate, leading to

i Sofia University ‘St. Kliment Ohridski’, Faculty of Economics and Business Administration,
Department of Economy and Industry Management, e-mail: [Link]@[Link], ORCID
ID: 0000-0002-4361-8981
ii PhD student, Trakia University, Stara Zagora, Department of Regional Development, e-mail:

d_ushatova@[Link]

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 Desislava Zheleva Kalcheva , Daniela Ushatova
162

discrepancies between the revenue and expenditure sides of the budget, with some
municipalities exacerbating the problem of underfunded expenditures. The low
elasticity of major local taxes prevents municipal budget revenues from
proportionately following the growth of expenditures.
The issues related to the possibilities for increasing local revenues are
becoming even more relevant and are the focus of discussions among both
policymakers and representatives of the academia. The aim of this study is to
analyze and assess the possibility of updating the tax assessment of real estate as a
key prerequisite for the growth of local tax revenues. The tax assessment formula is
evaluated, and the main factors influencing the proposed update are analyzed.
Examples of countries that have undertaken changes in tax base assessment, in the
last years, are explored and presented. Legislative changes related to updating the
tax assessment of real estate are proposed, and the main risks that the change might
lead to are outlined.
A change in the tax assessment of real estate could lead to a significant
increase in revenues from property taxes and taxes on the acquisition of property for
consideration. The change could have an indirect positive impact on certain state
budget revenues since the tax assessment in Bulgaria is used as the leading basis for
securing established and due public receivables, as a minimum basis for determining
the prices of real estate transactions, and consequently for notarial and other fees and
the tax on the acquisition of property for consideration, among others.
The COVID-19 pandemic has had a significant impact on the real estate
market, both in Bulgaria and in other European countries. Market prices of real
estate in major cities have risen significantly. Meanwhile, in Bulgaria, the norms
for determining tax assessments, which serve as the basis for calculating property
tax, have not been substantially updated in the last twenty-five years, with the last
update of the regulations concerning property tax made in 2019, easing the regime
for declaring real estate, including primary residences, which enjoy substantial
relief. There is a significant divergence between market prices and tax assessments.
This situation somewhat violates one of the basic principles of taxation—
proportionality, i.e., being aligned with the economic and financial status of
taxpayers. The lag in tax assessments from market trends, and thus the low level of
property tax, practically leads to non-compliance with the constitutionally
established obligation for citizens to pay taxes and fees, set by law, according to
their income and property.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
163
The Local Taxes and Fees Act (effective from the beginning of 1998) has
been substantially amended in terms of the method for determining tax assessments
only a few times over the past years:
- In 2002, the norms for the tax assessment of real estate owned by citizens
were changed, replacing Appendix No. 1 with a new Appendix No. 2. As a result
of these changes, tax assessments increased during the period 2002-2009, primarily
due to changes in location coefficients. It should be noted that until 2007, there was
a special provision according to which the tax assessment, in accordance with the
appendices to the law, could be changed, but no later than November 30 of the
previous year, when the index of market values of real estate increased or
decreased by more than 20 percent cumulatively for the period since their last
change. This index was determined by the National Statistical Institute (NSI).
During this seven-year period, a total of three increases were implemented, or
approximately every two years, an update of the location coefficients was made.
- In 2011, a requirement was introduced that the tax assessment of real estate
owned by enterprises must be the higher of their book value or the tax assessment
according to Appendix No. 2.
As a result of the need to increase municipal tax revenues, countries like
Ireland and Denmark have already taken steps to update the tax base for calculating
immovable property tax. In times of fiscal stress and the need for tightening fiscal
belts, topics related to changes that can lead to increased revenues and optimized
expenditures for public authorities are becoming increasingly relevant. On the
other hand, strengthening and improving the capacity for collecting local taxes,
combating tax fraud and evasion should be linked with measures to tackle money
laundering, tax evasion, and aggressive tax planning.
Similar initiatives are being implemented at the EU level as part of the
recommendations for achieving fair and transparent competitive conditions in the
internal market, fiscal consolidation, reducing public debt, increasing funds for
public investment, and improving the efficiency and fairness of national tax
systems. Of course, such proposals should be approached with great caution, as
changes in tax obligations are a sensitive issue for citizens. Before making specific
proposals, an analysis of social acceptability should be conducted, including by
municipalities and regions, and based on this, a comprehensive assessment of the
impact of the respective changes in tax assessments, and consequently, tax
obligations, should be prepared. The tasks we set in the study are as follows:
 Desislava Zheleva Kalcheva , Daniela Ushatova
164

1. Presentation of the characteristics of the property tax and the significance of

tax revenues for municipal budgets;
2. Analysis and assessment of municipal revenues for the period 2011-2022;
3. Analysis and assessment of examples from European countries that have
undertaken reforms to update the tax base of property tax;
4. Exploration of the possibilities for updating the tax base of real estate in
Bulgaria as an alternative to increasing local tax revenues, including an
assessment of the tax assessment formula;
5. Assessment of the main factors influencing the evaluation of the fairness and
efficiency of the tax system;
The object of the study is the local immovable property tax in Bulgaria, and
the subject of the study is the tax base for calculating the property tax and the
possibilities for its update. The main hypothesis defended in the study is that the
tax assessments of real estate in Bulgaria should be updated in a timely manner to
achieve sustainable growth of local revenues, increase the tax autonomy of local
authorities, and reduce the risks of tax evasion or money laundering. The update of
the tax base should also be pre-adjusted to the social acceptability for citizens, even
though there is no legal definition of this concept in national legislation.
The study is structured as follows: part one Municipal Revenues and the
Importance of Property Tax Revenues for Local Budgets; part two Reforms in
property tax base determination - the experience of Ireland and Denmark; part three
Interrelationship between property tax, investments, inequalities and law
compliance and Conclusion.
The methods used in the development include deductive and inductive
analysis, financial analysis, comparative analysis, forecasting, and planning. The
main database includes data from the Ministry of Finance, the National Statistical
Institute, EUROSTAT, National Statistical Institute, etc.

2. MUNICIPAL REVENUES AND THE SIGNIFICANCE OF

PROPERTY TAX REVENUES FOR LOCAL BUDGETS
2.1. Dynamics of municipal revenues for the period 2011-2022.
Municipal revenues in Bulgaria include tax revenues, non-tax revenues,
including revenues from municipal fees, sales of non-financial assets, and other
non-tax revenues, as well as revenues from state transfers. Transfer revenues
include revenues from the general equalization subsidy, the general subsidy for
 Property Tax in Bulgaria – The Need for Updating the Tax Base
165
activities delegated by the state, subsidies for financing capital expenditures, and
other transfer payments. Table 1. presents the structure of revenues of Bulgarian
municipalities for the period 2011-2022. The table also shows the dynamics of
state transfers and highlights some trends.
Table 1. Changes in the structure of local revenues

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Own local revenue,
41% 41% 41% 38% 40% 41% 39% 38% 36% 32% 33% 30%
incl.
- Taxes on
6% 6% 6% 5% 6% 6% 6% 5% 5% 5% 5% 4%
immovable property
-Other tax revenue 9% 10% 10% 9% 10% 11% 11% 11% 10% 10% 11% 9%
Non-target transfers 6% 6% 6% 6% 6% 6% 5% 5% 5% 5% 4% 5%
Target transfers 53% 53% 53% 56% 54% 53% 55% 57% 59% 63% 62% 65%
Source: Ministry of Finance, own calculation

The share of own municipal revenues decreased during the study period (from
41%) and reached 30% by 2022. The reason for this is the growth in revenues from
state transfers, mainly revenues from the general subsidy for activities delegated by
the state. The predominant portion of subsidies and transfers are of a targeted nature
and constitute a significant part of the budget of small and medium-sized
municipalities in Bulgaria. The total subsidies for local authorities account for only
4.5% of municipal revenues.
During the study period, the share of property tax revenues in municipal
revenues did not show significant changes. At the beginning of the period, these
revenues accounted for 6% of municipal revenues, and by the end of the period,
they decreased by 2% to reach 4%. The reason for this decline is mainly the growth
in transfer payments.
Local budgets receive revenues from the following taxes: property tax,
inheritance tax, vehicle tax, tax on the acquisition of property by donation and
gratuitous transfer, patent tax, tourist tax, tax on taxi passenger transport.
The powers granted to the municipalities in 2008 to set local tax rates in up
and down limits, stipulated by law, has also had a positive impact on the dynamics
of tax revenue. At the beginning the difference between the lowest and highest
possible tax rates was negligible and failed to produce any significant changes in
the tax burden in the different municipalities. (Nenkova P., 2014, p. 347).
 Desislava Zheleva Kalcheva , Daniela Ushatova
166
Table 2. Share of the tax revenue in total local tax revenue
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Immovable Property Tax 36.85% 37.38% 37.65% 37.41% 36.79% 34.94% 34.90% 33.45% 32.50% 31.73% 29.35% 28,49%
Inheritance tax 0.01% 0.02% 0.01% 0.00% 0.03% 0.03% 0.02% 0.02% 0.01% 0.03% 0.01% 0,01%
Vehicle tax 27.44% 28.19% 28.92% 29.62% 30.09% 32.05% 31.62% 33.53% 33.32% 34.29% 30.47% 29,67%
Taxes on the acquisition of
30.68% 29.44% 29.07% 29.07% 29.56% 28.93% 28.85% 28.86% 30.07% 31.50% 37.91% 39,17%
property for consideration
Patent tax 2.76% 2.34% 2.03% 1.81% 1.60% 1.91% 1.20% 1.01% 0.97% 0.93% 0.76% 0,93%
Tourist tax 2.11% 2.65% 2.18% 2.09% 1.94% 2.14% 2.24% 2.06% 2.09% 1.06% 1.28% 1,51%
Tax on passenger taxi
0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 1.17% 1.07% 1.04% 0.46% 0.21% 0,21%
transport
Source: Ministry of Finance, own calculation

From the presented data, it is evident that the taxes which have primarily
fiscal significance for municipalities are three - property tax, vehicle tax, and tax
on acquisition of property by donation and gratuitous transfer.
Revenues from the taxes on the acquisition of property for consideration are
highly volatile and directly dependent on the dynamics of the real estate market.
Revenues increase over the years due to active use of credits for property
purchases. With debt financing, the transaction must be carried out at the agreed
(market) price, not at the tax assessmentiii.
It should be noted that when imposing property tax, numerous tax reliefs
provided for in the Local Taxes and Fees Act can be utilized. For example, for
primary residences, taxpayers only pay 50% of their tax liability, and when the
primary residence belongs to a person with reduced working capacity from 50 to
100 percent, the discount is 75%. Taxpayers who prepay the full amount of their
tax obligation at the beginning of the year also benefit from a 5% discount, and so
on. The possibilities for utilizing tax relief for the tax on the acquisition of property
for consideration are wide-ranging, with over 20 types of reliefs available.
Inheritance tax generates negligible revenues for municipal budgets and its
application should be reconsidered, comparing the revenues from the tax with the
expenses for collecting them. The low tax revenues are due to significant discounts
enjoyed by taxpayers.
Revenues from patent tax and tourist tax depend on the economic profile of
the municipality and the opportunities for local businesses. Revenues are unevenly
distributed among individual municipalities. The same applies to revenues from the
tax on taxi passenger transport.
iiiThe law stipulates that real estate transactions are declared at a value not lower than the tax
assessment, which serves as the basis for declaring a number of real estate transactions based on the
tax assessment. This leads to a reduction in revenues from the tax on acquisition of property by
donation and gratuitous transfer. However, this possibility is eliminated in cases of credit financing.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
167
Revenues from property tax are sustainable over time and serve as a stable
source of income for local budgets. They are characterized by good predictability.
Structurally, during the study period, revenues from this tax ranged between 28.5%
and 38%.
Table 3. Share of the tax revenue in total local revenue
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Immovable Property Tax 5.54% 5.82% 5.89% 5.48% 5.79% 5.89% 5.69% 5.32% 5.04% 4.56% 4.50% 3,76%
Inheritance tax 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% 0%
Vehicle tax 4.12% 4.39% 4.52% 4.34% 4.74% 5.41% 5.16% 5.33% 5.17% 4.92% 4.68% 3,92%
Tax on Onerous
4.61% 4.58% 4.55% 4.26% 4.65% 4.88% 4.70% 4.59% 4.67% 4.52% 5.82% 5,18%
Acquisition of Property
Patent tax 0.41% 0.36% 0.32% 0.26% 0.25% 0.32% 0.20% 0.16% 0.15% 0.13% 0.12% 0,13%
Tourist tax 0.32% 0.41% 0.34% 0.31% 0.31% 0.36% 0.37% 0.33% 0.33% 0.15% 0.20% 0,20%
Tax on passenger taxi
0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.19% 0.17% 0.16% 0.07% 0.03% 0,03%
transport
Total: 15.00% 15.50% 15.64% 14.66% 15.74% 16.87% 16.31% 15.89% 15.52% 14.36% 15.34% 13,22%
Source: Ministry of Finance, own calculation

For the study period, revenues from property tax constitute between 3.76%
and 5.89% of municipal revenues, with higher values of this share - above 5% -
recorded for the period 2011-2019, and consistently decreasing to 3.76% in the
post-COVID period. The share of local taxes in municipal revenues for the period
ranges between 13.22% and 15.64%, with 2022 marking the lowest proportion in
local budgets. A clear trend is also evident that from 2011 to 2018, the ratio of
property tax revenues to the other two local taxes of fiscal significance consistently
decreases from an average of 1.23 relative to transaction tax and 1.21 relative to
vehicle tax, to 0.95 for 2018-2022. The main reason for this is the lack of any
changes to the property tax.
According to the researched literature, in 2018 Bulgarian municipalities can
be divided into three separate clusters based on revenues from immovable property
tax. A distinction is observed among the formed groups, as municipalities in the
first cluster are significantly ahead of the others with indicators representing the
importance of real estate tax revenues being many times higher. Only 19
municipalities fall into the first cluster (first cluster include the municipalities with
highest amount of revenue from property tax) (Nenkova, Kalcheva, 2018).
It should be noted that due to the uneven distribution and concentration of
buildings in large and resort municipalities, significant differences are observed in
the indicator of revenue from property tax per capita. Specific characteristics and
endowments of municipalities as drivers of disparities in terms of their revenue-
earning capacity are particularly manifest in local territorial units in Bulgaria that
exhibit outliers in own-source local revenue per capita (Nenkova, 2020, p. 78).
 Desislava Zheleva Kalcheva , Daniela Ushatova
168

2021 0,28
2020 0,28
2019 0,28
2018 0,30
2017 0,31
2016 0,32
2015 0,31
2014 0,32
2013 0,32
2012 0,29
2011 0,28

0,25 0,26 0,27 0,28 0,29 0,30 0,31 0,32 0,33

Figure 1. Share of revenue from taxes on immovable property in GDP for Bulgaria for the period 2011-2021
Source: European Commission, DG Taxation and Customs Union, Eurostat

Another indicator measuring the significance of taxes on immovable

property for the economy is the share of immovable property tax revenues in GDP.
For the period 2011-2021, it ranges between 0.28% and 0.32%, with an increase
noted for the period 2011-2016, followed by a gradual decline thereafter.
Compared to other European countries, Bulgaria records relatively low
immovable property tax revenues as a percentage of GDP.
3,0 2,4 2,3
2,5 1,9 1,7
2,0 1,2 1,2 1,4
1,5 1,1 0,7 0,9 1,1
0,7 0,8
1,0 0,30,2 0,40,20,4
0,6 0,50,50,5 0,7 0,4
0,5 0,2 0,30,10,40,0 0,2
0,0

Figure 2. Share of recurrent taxes on immovable property in GDP for EU countries in 2021
Source: European Commission, DG Taxation and Customs Union, Eurostat

Based on the data presented in Figure 2, the countries with the highest
property tax revenues for 2021 are Greece, France, Denmark, and Iceland.
Denmark and Iceland are the countries that have undergone reform regarding the
 Property Tax in Bulgaria – The Need for Updating the Tax Base
169
determination of the property tax base. The countries with the lowest values of the
indicator are Luxembourg and Malta.

6,1
2011

4,8
7
5
3,9

5,8

3,3
3,1
2,9

2,9

4,6
2,7
2,6

4,5

2,2

2,2

2,1
1,8

1,8

1,8
3,5

1,6
2
3,2

1,3
1,3
1,2
2,9

2,9

2,8
0,9

0,9

0,9
2,7
2,6
0,6
3

0,5

0,5
1

2,3
0,4

2,1
0,1
1,8

1,7

1,7
1,6

1,4
1,4
0

1,3
1,1

1,1

1,1

0,9
0,6

0,6
0,5
1

0,2

0
Figure 3. Taxes on property as % of total taxation – recurrent taxes on immovable property
Source: European Commission, DG Taxation and Customs Union, Eurostat

Based on the data presented in the graph, the countries with the highest
property tax revenues for 2021 are Greece, France, Denmark, and Iceland. The
share of immovable property tax in GDP in 17 countries decreased on average by
0.5 percentage points compared to 2011. Countries with a consistent increase in the
share of property tax in GDP for the study period are Italy (1.7 percentage points),
the Netherlands (0.5 percentage points), Finland (0.4 percentage points), followed
by Norway, Greece, Hungary, and Iceland. Denmark and Iceland are the countries
that have undergone reform regarding the determination of the property tax base,
most likely due to the observed trend of overall decrease over the 10-year period.
It is concerning that during the period 2011-2021, the share of property tax
revenues in GDP and in public tax revenues decreased. The share of immovable
property tax revenues in total tax revenues under the consolidated fiscal program
decreased from 1.5% to 1.4%, and the share of property tax revenues in GDP
decreased from 1.1% to 0.9%. Revenues from this tax are crucial for funding the
budgets of local and regional authorities, and ways to increase them and "catch up"
with the growth of other public revenues should be sought.

2.2. The significance of property tax revenues for the local budgets
Property taxes constitute a portion of the revenues flowing into the budgets
of local authorities. These revenues are utilized according to the decisions of
municipalities and regions. There exists a connection between the economic
 Desislava Zheleva Kalcheva , Daniela Ushatova
170

activity registered within local territories and revenues from property taxes. Greater
economic activity implies higher incomes and living standards for residents,
leading to population growth in the respective municipality and consequently the
creation of a larger tax base. Notably, when determining tax revenues,
municipalities and regions have a certain degree of freedom and discretion in
conducting tax policies, often within constraints imposed by central authorities.
According to several authors (Musgrave, Bird, Martinez-Vazques, Bahl,
Swianiwicz), property tax is one of the most suitable local taxes because it targets a
weakly mobile base, which is relatively evenly distributed territorially; it does not
presuppose the export of tax burden; traditionally, property owners are also users
of public goods and services provided within the local territorial unit.
The scope of property tax can be distinguished in several directions: (1)
according to the purpose of property usage – for individual needs or for business
purposes and (2) according to the objects taxed – buildings, land, improvements on
buildings, etc.
Examined practices show differences in the application of property tax among
different countries. For instance, some countries tax agricultural land, forests, and
undeveloped areas, while others, like Italy, apply separate taxes for property used by
businesses and households. Taxes on property in Ireland and Italy (TASI) only apply
to property improvements, and only in three OECD countries – Australia, Denmark,
and Estonia – is a pure land tax applied (Blöchliger, 2015, p.9).
According to the European Charter of Local Self-Government, " Part at least
of the financial resources of local authorities shall derive from local taxes and
charges of which, within the limits of statute, they have the power to determine the
rate" (Article 9, paragraph 3).
Revenues from property taxes represent 2.6% of total tax revenues in the
European Union for 2021. The countries with the highest share of property tax
revenues in total tax revenues are Greece (6.1%) and France (5%). The countries
with the lowest share of property tax revenues are Luxembourg (0.1%) and Malta
(0%). At the end of 2021, property tax revenues in Bulgaria accounted for 0.9% of
total tax revenues.
According to Bulgarian legislation, immovable property tax is levied on
buildings and separate objects within buildings located within the country's territory,
as well as on land plots situated within the construction boundaries of populated
areas and settlements, and land plots outside these boundaries that, according to a
detailed urban plan, are designated according to Article 8, paragraph 1 of the Spatial
 Property Tax in Bulgaria – The Need for Updating the Tax Base
171
Planning Act and following a change in the land's designation when required by a
special law. Land plots occupied by streets, roads from the national and municipal
road networks, and the railway network up to the restrictive building lines are not
subject to tax. Additionally, land plots occupied by water bodies, state, and municipal
property are exempt from taxation. Agricultural land and forests are also exempt
from tax, except for built-up land - for the actually built-up area and the adjacent
terrain. Properties with a tax assessment of up to 1680 BGN are also exempt from
tax. Taxable property owners are considered tax liable persons.
Bulgarian municipalities acquired real tax powers in 2007, as a result of
changes in the Constitution of the Republic of Bulgaria, granting them the
authority to determine the size of local taxes under conditions, procedures, and
within limits established by law. The municipal council determines, by ordinance,
the tax rate within the range of 0.1 to 4.5 per thousand on the tax assessment of real
estate. The tax assessment is determined according to norms for tax assessment,
which take into account the following criteria: location of the settlement/area, type
of settlement, whether it is a resort of local or national significance, category of
settlement (functional type according to EKTTA), economic value of the property,
seasonal or permanent nature of the activity - for residential or non-residential
purposes, type of property construction, etc.
The tax assessment of buildings or parts of buildings is determined based on
the base tax value per square meter, correction coefficients, and area using the
following formula:
TA = BV x Km x Ki x Kh x Kv x Ko x A,
where:
• TA is the tax assessment in Bulgarian Lev (BGN);
• BV - the base tax value per square meter in BGN;
• Km - location coefficient;
• Ki - infrastructure coefficient;
• Kh - individual characteristics coefficient;
• Kv - height coefficient;
• Ko - coefficient for burden;
• A - area of the building or part thereof in square meters.
Local authorities do not have the power to determine the tax base. Their only
tool for tax policy, aside from setting specific tax rates, is the authority to designate
zones within populated areas. However, for populated places and municipalities of
functional types III to VIII, this zoning is almost impractical and without fiscal
effect. That is, for 5,200 out of 5,256 or 99% of populated places, including
 Desislava Zheleva Kalcheva , Daniela Ushatova
172

municipal centers, the location coefficients are incorrect and do not reflect reality
regarding taxable real estate.
The Local Taxes and Fees Act provides tax reliefs related to the determination
and payment of property tax. For example, "For a property that serves as the primary
residence, the tax is reduced by 50%. For a property that serves as the primary
residence of a person with reduced working capacity from 50 to 100%, the tax is
reduced by 75%. If more than one primary residence is declared, the reliefs do not
apply, and the tax is due in full for each residence and for the period in which
multiple residences are simultaneously declared as primary residences."
Additionally, under the Local Taxes and Fees Act, state and municipal
properties, public municipal property, diplomatic buildings, prayer houses,
temples, and many others are exempted.
Property tax revenues in Bulgaria are affected by tax preferences, including
those for buildings with energy performance certificates rated class B and class C.
Changes in the regulation of building energy characteristics in recent years have
shown that a significantly larger number of buildings meet the requirements for a
class B certificate, which would exempt them from property tax. To prevent a
significant reduction in future property tax revenues, there have been proposals in
the public sphere to exempt only class A buildings from tax and, if the policy of
exempting class B buildings is maintained, to find a tool to compensate for the
reduced revenues from property tax.
At first glance, the primary tool through which municipalities in Bulgaria can
implement tax policy is through the rates determined annually by the municipal
council. The boundaries within which local authorities can determine the property tax
rates according to the Local Taxes and Fees Act range from 0.1 to 4.5 per thousand of
the tax assessment of real estate. An analysis by National Association of Municipalities
in the Republic of Bulgaria (NAMRB) for 2023 shows that 21% of Bulgarian
municipalities apply tax rates close to the minimum of 0.1‰, 46% apply rates close to
the legislatively established average ranges, and 33% of municipalities apply rates
above the country's average. The average property tax rate for the country is 2.3‰.
However, it should be clarified that if municipalities with minimal rates
increase the tax rate, the additional revenues will be several times smaller compared
to increasing revenues through updating the tax base. This is because there is a
location coefficient not only for the municipality but also for the respective
properties. Since municipalities in the country do not have the right to differentiate
the tax rate by settlements and types of properties, imposing the maximum tax rate
 Property Tax in Bulgaria – The Need for Updating the Tax Base
173
with the highest tax liability will burden residents in the municipality center. For
other properties in the periphery and in composite settlements, where a lower
location coefficient applies, tax liabilities will remain lower.
It should be noted that at the national level, there is no information
maintained regarding the share of taxable residential properties in the total taxable
property tax base of built-up structures, as the higher of the two values, either the
tax assessment or the accounting value, is applied to these properties. Based on
publicly available data, a general ratio of the total built-up area of public buildings
to residential buildings can be derived, but similar data for industrial buildings of
enterprises is not available. However, for the purposes of investigating social
acceptability for citizens, the conclusion can be drawn that the ratio of the total
square footage of public to residential buildings is 27:73 (104.9 million sq. m.:
283.8 million sq. m.). This derived ratio is used for the purposes of this study in
assessing the contribution of businesses to property tax revenues, although the
square footage of industrial buildings and facilities is not included in the total
public service category.
Table 4. Building stock in Bulgaria
Total built-up
Category of buildings
area sq. m
Childcare facility (kindergartens and nurseries) 2 371 438
Other buildings, including nursing homes, orphanages, and shelters for
18 470 987
abandoned children, dormitories, car repair shops
Healthcare facilities (hospitals, clinics, etc.) 9 685 995
Retail stores (supermarkets and malls) 10 519 029
Educational institutions (schools, colleges, and universities) 8 927 599
Administrative buildings 14 878 947
Sports halls and facilities 1 793 216
Cultural and art buildings 2 296 810
Transportation hubs (train stations, ports, and airports); 2 803 990
Hotels and restaurants 18 898 840
Unclassified 14 276 437
Total non-residential buildings 104 923 286
Single-family houses 118 300 032
Multi-family residential buildings/apartment blocks 117 158 877
Mixed-use buildings 4 052 585
Dormitories, communal living buildings 1 103 153
Total year-round inhabited dwellings 240 614 647
Total dwellings in the country 283 833 436
Total building stock in the country. 388 756 722
Source: Long-term national strategy to support the renewal of the national building stock of
residential and non-residential buildings until 2050, draft based on the 2011 Census.
 Desislava Zheleva Kalcheva , Daniela Ushatova
174

Furthermore, in contrast to other European countries, private residences

owned by individuals predominate in Bulgaria. Their share in the total number of
dwellings is very high (Private owned by physical persons) - 96%, while those
owned by state, municipal, and private legal entities account for around 2% each
(State and municipal and Private owned by juridical persons). Since the enactment
of the Local Taxes and Fees Act (LTFA) in 1998, the following substantive
changes have been made to the norms for determining the tax assessments of real
estate, with fiscal effects on local budgets:
- From the adoption of the Law until 2001, the main indicator "basic tax
value" per 1 sq. m. was differentiated depending on the construction, type, and
purpose of the building. For this period, the tax assessment of buildings (for
citizens) was determined by multiplying the unfolded built-up area of the building
by the basic tax value (BTV), adjusted by a coefficient for location, and subtracting
depreciation. The Law contained two separate annexes for determining the tax
assessment - the first for determining the tax assessment for property taxation, and
the second for taxing inherited properties with inheritance tax. After this date and
changes in the Law, the second annex containing the norms for determining the tax
assessment became predominant, and the first one was repealed.
- From 2002 until now, Annex No. 2 of the LTFA has been amended six
times, with the formula being applied throughout the entire period:
TA = BTV × Km × Ki × Kh × Kv × Ko × AFA,
where:
 TA is the tax assessment in Bulgarian levs;
 BTV - the basic tax value per 1 sq. m. in Bulgarian levs;
 Km - location coefficient;
 Ki - infrastructure coefficient;
 Kh - coefficient for individual characteristics;
 Kv - coefficient for height;
 Ko - coefficient for depreciation;
 AFA - the area of the building or part thereof in sq. m.
Within these six normative changes, mainly until 2008 (i.e., within the last
15 years), none of the essential components of the formula have been changed. As
of 2019, one of the corrective coefficients has been removed, leading to an increase
in the tax assessment when implementing energy-efficient measures (concerning
aluminum joinery). At the same time, for infrastructure coefficients, the tax
assessment can still be reduced, albeit minimally due to the lack of telephone lines.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
175
For this reason, the basic tax value in BGN per sq. m. (Table 5.) remains at the
levels from 2002. No changes have been noted in the last twenty-two years.
Table 5. Basic tax value in BGN per square meter for the period 1998-2023.

Building Construction Residential Bulidings Non-residential

Apartments Houses buildings
from from from from from from
2001 2002 2001 2002 2001 2002
Welded construction 1,69 4,4 1,69 3,7 1,69 4,8
semi-solid construction 4,4 7,5 4,4 6,4 4,4 8,2
М1 - solid without reinforced concrete 6,6 11 6,6 9,4 6,6 12,1
elements or from assembled asbestos and
other surfaces (bungalows), solid with partial
reinforced concrete element
М2 - solid - large-panel 8 14 8 12 8 15,4
М3 - solid with load-bearing brick walls and 10 17 10 14,5 10 18,7
entirely monolithic or assembled reinforced
concrete floor structures, solid - assembled
skeletal and frame reinforced concrete
structures, packet-lifted slabs, large-area and
creeping formwork, skeletal-slab structures,
special construction (steel and others.)
Average value for all types of constructions 6,1 10,8 6,1 9,2 6,1 11,8
Source: Local Taxes and Fees Act, own calculations

It should be noted that until 2001, there was no detailed differentiation of

construction types for different types of properties - houses, apartments, and non-
residential properties. Subsequently - from 2002 onwards - the corresponding
differentiation was introduced, with houses inexplicably having significantly lower
values than apartments. It is striking that without being described in the law, the
deviation between the basic tax value per square meter for houses is 0.9 lower than
that for apartments, and for non-residential buildings, it is 1.1 higher than that for
apartments. In other words, upon the introduction of differentiation, without it
being necessary, a rule for a 30% dispersion between the highest and lowest basic
tax value per square meter for all types of constructions was applied.
- Location coefficients increase the basic tax value per square meter and are
determined differentially according to a table, based on the functional type of the
locality and the zone in which the property is located, with additional increases for
properties in resorts (by 50%) and in villa zones up to 10 km from the coastline (20%)
 Desislava Zheleva Kalcheva , Daniela Ushatova
176

- Initially, the basic location coefficient ranged from 1 to 40, with 40 being
for the capital, Sofia. Municipalities of the second and third functional type are
divided into two groups with different coefficients. Individual changes in location
coefficients have been made since 2006, 2007, and 2009, simultaneously
essentially changing the grouping of municipalities by the second functional type
and eliminating the grouping into the third.
Table 6 shows the changes in the basic location coefficients established in
the Law.
Table 6. Change in location coefficient 2002-2009 and to date.

Source: Local Taxes and Fees Act

It is striking that the third-largest city - Plovdiv, ranks only fifth when
differentiating location coefficients. Due to the lack of statistical data and considering
that the basic tax value has not changed from 2002 to 2023, an experimental study
was conducted to investigate the relationship between the total change in the location
coefficient, as shown in the previous table, and the changes in housing market prices,
adjusted with average housing price index for the period after 2015. Due to limited
data, the analysis was conducted only at the regional level and only for the six major
cities. As a result of the revised reporting methodology by the National Statistical
Institute (NSI), only housing price indices for the period 2010-2022 were taken into
account, with proprietary calculations made. The values of the changes in housing
prices shown in Table 6 were supplemented with the average values of the changes
in indices observed by the NSI from 2015-2023.
.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
177

Figure 4. Ratio of cumulative change in location coefficient to change in market house prices/house
price indices for the period 2002-2022
Source: National Statistical Institute, own calculation

It is noteworthy that until 2009, the tax assessments for the capital and other
regional cities included in the first group of municipalities of the first functional
type were closest to the actual conditions. At the bottom, or with the greatest
discrepancy between the actual conditions and the tax assessments, are the
municipalities in the second group of municipalities of the first functional type.
At first glance, Burgas and Varna are also undervalued, despite being
economic centers and national resorts. Throughout the period from the introduction
of location coefficients until now, tax assessments in major cities, as well as in
other settlements, increasingly lag behind real market conditions.
A significant problem for municipalities and taxpayers is the lack of detailed
statistical information on housing prices. Such information is not administered by
any state authority. At the same time, as a deficit in determining the functional type
of settlements, reference is made to the Unified Classification of Administrative-
Territorial and Territorial Units (EKATTE), approved by Decision No. 565 of the
Council of Ministers in 1999. However, practically, the purpose of this classifier is
different - to create unity in the identification and classification characteristics of
administrative-territorial and territorial units for use in automated processing of
various information in a territorial aspect. That is, it is a classifier for universal
territorial identification in databases for integrated spatial information systems at
national, regional, and local levels for managing the country. These unifications are
mainly used in EGRON, demographic statistics, population censuses, housing
stock, identity documents, and other computer systems that maintain and process
 Desislava Zheleva Kalcheva , Daniela Ushatova
178

information about citizens and demographic events. They are also used in cadastre
and real estate register information systems. However, the approach to
categorization does not in any way reflect the value of the properties in the
respective territories, nor the associated main indicators of urbanization degree,
access and quality of public and social services, etc.
For national resorts and the villa areas adjacent to them, as well as for villa
areas up to 10 km from the coastline, initially the location coefficient is increased
by 20%, except for Varna and Burgas. From 2004, the increase for resorts is 50%.
From 2005, a differentiation of resorts is introduced - into those with national
significance and those with local significance. The location coefficient for national
resorts and the villa areas adjacent to them, as well as for villa areas up to 10 km
from the coastline, is increased by 50%, except for Varna and Burgas, and for those
of local significance and for the villa areas adjacent to them - by 20%. From 2007,
exceptions to this rule are added for resorts like Borovets, Dyuni, Elenite, Sunny
Beach, and settlements of the first category.
The deficit in determining additional coefficients for resorts and their villa
areas is that they are also declared by a Council of Ministers decision, which unlike
the previous one for EKATTE, is published in the State Gazette. Such a decision
was last issued in 2012, announcing the list of resorts in the country and defining
their boundaries. This decision practically reaffirms previous orders and other acts
in this direction by government bodies. So far, there has been no attempt to
reassess the understanding of resorts of national and local significance, despite the
existence of a separate Ministry of Tourism.
Since 2015, with the Health Act, a requirement has been introduced for the
Minister of Health, together with the Minister of Regional Development and Public
Works, the Minister of Environment and Water, and the Minister of Tourism, to
determine by regulations the conditions and procedure for: declaring, using, and
protecting resort resources, resort zones and territories, and resorts, and for the
classification of resorts. Similar regulations have not yet been issued. Since 2020,
there has been a change in the Tourism Act, according to which the Council of
Ministers adopts a regulation for national resorts upon the proposal of the Minister
of Tourism and the Minister of Health, which determines both the criteria and the
requirements and opportunities for service utilization. Such a regulation has not
been issued. Due to the outdated list of resorts, many financially weak
municipalities with a high share of unemployed and elderly population have
inflated tax assessments compared to real market conditions.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
179
The deficits mentioned above in the Bulgarian system for determining tax
assessment and the lack of substantial reforms regarding local taxes can be cited as
the main reason for our country's weak performance on the European map. An
understandable and convenient excuse for the lack of any reforms is the excuse of
increasing the tax burden, although there is no specific definition of such an
increase in national legislation.
The results of applying the relevant legislation are checked through
subsequent impact assessments. Although it is mandatory for new laws to undergo
an impact assessment within 5 years of their entry into force, only one impact
assessment has been carried out on the Bulgarian Local Taxes and Fees Act so far -
in 2009, which focused more on financial decentralization and did not result in
specific changes regarding tax assessments.
According to the impact assessment of the Local Taxes and Fees Act from
2009, "National assessments reveal that by 2008 property taxes in Bulgarian
municipalities amounted to 10% of their European level. The reasons are complex:
low tax rates, underestimated and unadapted property tax assessments, low
incomes of the local population, etc. In this aspect, it is justified to impose higher
taxes where possible, for example, for owning more than one property for
residential purposes or introducing new taxes, for example, a local municipal tax.
In other words, although partly and not very consistently, municipal taxes are being
introduced in the country, ensuring a more stable increase in own revenues in the
municipal budget. ... Overall, tax revenues in municipalities account for a low
relative share of municipal revenues. Changes need to be made to the Local Taxes
and Fees Act to determine a new vital municipal revenue source linked to
economic development while maintaining the overall tax burden."

3. REFORMS IN DETERMINING THE TAX BASE OF REAL

ESTATE - THE EXPERIENCE OF IRELAND AND DENMARK
According to Blöchliger and Diagne (OECD), the potential of real estate
taxes is not sufficiently utilized in Central and Eastern European countries and the
Baltic States. According to the authors, despite the many challenges associated
with reform in this area, crises in public finances in recent years and increasing
costs associated with population aging necessitate changes related to real estate tax.
Several OECD studies show that strengthening taxation on real estate can help
maintain fiscal sustainability. Additionally, real estate taxes can be used to reduce
housing price instability and achieve more affordable housing for low-income
 Desislava Zheleva Kalcheva , Daniela Ushatova
180

households. These desired effects depend on the scope of the tax, which is
determined by the elasticity of housing demand and supply and the frequency of
reassessments - the more reassessments, the greater the effect (OECD, 2021).
Most countries in Central and Eastern Europe rarely update property values (or
cadastral values). Furthermore, owner-occupied homes are often fully or partially
exempt, further reducing revenues. For example, in Bulgaria, only half of the due tax
is paid when determining property tax on the primary residence of an individual.
Unlike most OECD countries, Poland, the Czech Republic, Slovakia, and
Bulgaria apply indicators based on area rather than value basis for assessing the
value of land and buildings, thereby undervaluing property values and making
property tax regressive.
European practice shows that reforms in the field of real estate tax can be
successful. Examples of such reforms are the changes undertaken by Denmark
and Ireland.

3.1. Ireland's Experience

Historically, Ireland abolished the residential property tax in 1978 but
retained local rates for commercial properties. It was only in 2012 that Ireland
introduced an annual household charge (€100 per household regardless of size) for
one year only. In July 2013, the annual household charge was replaced by a
property tax. In 2013, a half-year property tax was applied, and the property tax
would be applied for the entire year from 2014 onwards.
The tax rates are progressive, and the level of governance determining the
rates has changed over the years. Initially, the tax was central, but in 2015, local
authorities were given the power to change the annual rate by up to 15%. The aim
of this change is to strengthen local tax autonomy.
To cope with the unpopularity of property taxes, the Irish government
allows the Local Property Tax (LPT) to be deducted at source. Property owners
have the choice to 1) pay their tax obligations upfront, or 2) have the tax
deducted at source from their salary or professional pensions. The Irish
government requires employers and pension providers to offer this second option.
Taxpayers with gross incomes for a year below certain thresholds may be eligible
to defer property tax payments until their financial situation improves or until the
property is sold. A higher threshold may apply to taxpayers who took out
mortgages during the property boom. Interest at a rate of 4 percent per annum is
charged on deferred amounts.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
181
After the changes in 2013, the property tax assessment is self-determined
and declared by property owners, and the assessment determined in 2013 is valid
until the end of 2016.
The property tax rate in Ireland is determined by the central government. For
2014, the tax rate was 0.18 percent for properties with a market value up to 1
million euros. Residential properties over 1 million euros are taxed at 0.18 percent
on the first 1 million euros of value and 0.25 percent on the portion of the value
above 1 million euros (no grouping above 1 million euros).
The Local Authority could increase or decrease the rate by up to 15% from
the base rate (the ‘Local Adjustment Factor’ (LAF)iv.
In 2016, a new approach was adopted - the updating of the property tax base
is valid for a period of five years. Accordingly, for a property valuation date of
November 1, 2021, the determined tax assessment is used in the following four
years (2022-2025). The applied tax is progressive, meaning that as the market
value increases, so does the tax liability.
The tax in Ireland is self-assessed, meaning that the taxpayer calculates the
tax assessment, which equals the market value of the property. For this purpose,
individuals contact the revenue service, which answers questions and directs them
to use specialized software. When determining the assessment, taxpayers must use
information on properties similar to theirs, such as properties of a similar type, age,
and size. Taxpayers must keep copies of all sources of information they use and
any other supporting documentation. The revenue service may request this from
them when reviewing the assessment.
Taxpayers also use the register of housing prices to determine the prices of
properties sold in their residential area. There, they obtain information on the sale
price of properties similar in type, age, and size to their property. To obtain the
value of newly sold properties, taxpayers must add 13.5% VAT to the sale price
listed in the register. Alternatively, individuals can use the services of a
professional appraiser, who will assess the property for a fee.
Taxpayers can also use additional sources of information in their assessment,
such as newspapers or other media sources, information from local real estate
brokers, property sales websites. The information they use must be from recent
years to help assess the value of the property as of November 1, 2021. The
assessment also takes into account the presence of a yard, garden, farm, land,

ivFor more information visit the Irish Tax Institute: [Link]

policy/local-property-tax/
 Desislava Zheleva Kalcheva , Daniela Ushatova
182

adjacent rural house, garages, additional offices and buildings, etc. Under certain
conditions, tax relief may apply if the property is suitable for use by persons with
disabilities. Taxpayers declare the tax assessment of their properties, and if they
have submitted an inaccurate declaration, they can subsequently correct the
assessment of their property.
The legislature has defined 19 ranges of tax assessments. Depending on the
size of the tax assessment and the range in which the property falls, a
corresponding tax rate is applied. Table 7 presents the ranges and the single tax rate
at which real estate is taxed in Denmark for the period 2022-2025.
Table 7. Evaluation groups and rates

Number Rating range € Base rate €

1 0 – 200,000 90
2 200,001 – 262,500 225
3 262,501 – 350,000 315
4 350,001 – 437,500 405
5 437,501 – 525,000 495
6 525,001 – 612,500 585
7 612,501 – 700,000 675
8 700,001 – 787,500 765
9 787,501 – 875,000 855
10 875,001 – 962,500 945
11 962,501 – 1,050,000 1,035
12 1,050,001 – 1,137,500 1,189
13 1,137,501 – 1,225,000 1,408
14 1,225,001 – 1,312,500 1,627
15 1,312,501 – 1,400,000 1,846
16 1,400,001 – 1,487,500 2,064
17 1,487,501 – 1,575,000 2,283
18 1,575,001 – 1,662,500 2,502
19 1,662,501 – 1,750,000 2,721
Source: Revenue Agency of Ireland

Properties with a market value exceeding 1.75 million euros are assessed
based on the actual value of the property, not by assessment group. The tax for
these properties is the total sum of:
- 0.1029% of the first 1.05 million euros of the market value of the property
- 0.25% of the portion between 1.05 million euros and 1.75 million euros
- 0.3% of the portion above 1.75 million euros.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
183
In 2022, the assessment ranges are expanded, and the tax rates are reduced.
Local authorities can adjust the base rate for residential properties. These rates can be
increased or decreased by up to 15%. This is known as the local adjustment coefficient.
Residential properties with the same value in different areas of local authorities
may pay different tax liabilities, depending on whether the local authorities have
applied a local adjustment coefficient or not. The revenue service has an online LPT
calculator that calculates the tax after the local adjustment coefficient.
Until 2022, 80 percent of the monies raised are retained in the area, with 20
percent sent to local authorities. From 2023, it is understood that 100 percent will
be retained in the local authority, with central government making up any shortfall.
The results of the reform include an increase in the tax autonomy of local
authorities, the application of fairer tax bases when calculating citizens' liabilities,
and periodic updates of the property tax base. The reform is made regarding a tax
that has relatively less impact on economic growth.

3.2. Denmark's Experience

In 2017, Denmark undertook a significant property tax reform, leading to the
reassessment of fair market values of properties and reduction of tax rates. Tax
payments can be deferred until the house is sold, alleviating liquidity constraints
(Blöchliger, Diagne, 2023).
The property tax reform was approved in 2017 and came into effect in 2021.
New assessments will be applied and updated every other year, starting from 2020.
The new tax system replaces nominal tax freezing of property taxation with
proportional property taxation, while preserving the progressive element for the most
valuable residences. There have been no changes to deducting mortgage interest.
The property tax reform was approved in 2017 but took effect in 2021. New
assessments will be applied and updated every other year, starting from 2020. The
new tax system replaces nominal tax freezing of property taxation with
proportional property taxation, while preserving the progressive element for the
most valuable residences. There have been no changes to deducting mortgage
interest (Denmark-2019-OECD-economic-survey-overview).
Property owners are required to pay tax on property values. The annual
property value tax amounts to 0.92% of the property value up to 3,040,000 DKK
and 3% of the value above 3,040,000 DKK. However, if the property was acquired
no later than July 1, 1998, a deduction is granted. Property value tax is levied on
 Desislava Zheleva Kalcheva , Daniela Ushatova
184

properties in Denmark. Properties rented out are not subject to property value tax
regardless of their location.
Property owners are also obliged to pay taxes on the property and land to the
municipality where the property is located. The property and land tax are
calculated based on the land value and determined by the municipal council. The
tax is collected in each municipality.
Information on updated assessments of real estate is provided by the Danish
Property Assessment Agency. The aim of the new property assessments and the
new property assessment/tax system is to make more accurate and transparent
assessments of properties based on the realized property value in the area where the
property is located, meaning that homeowners pay property tax based on the actual
value of the property, not an outdated value that is either too high or too low.
According to Danish legislation (Ejendomsvurderingsloven), the assessment
is determined as follows: "In assessing a given property, the expected cash value of
a given property under normal market conditions is determined by the relevant
category of the property – taking into account the year of construction, size,
location, and other characteristics."
When determining the taxable value, the Danish Property Assessment
Agency applies the following steps:
- Determines the price per square meter - the price per square meter is
determined based on 15 realized sales (including the sale of the property in
question) in the area over the last six years. Properties must be of the same type
and in the same geographic area.
- The price per square meter is adjusted according to the characteristics of the
property. The Danish Property Assessment Agency considers building materials, age
of the property, location concerning wooded areas, water, highways, etc.
- The preliminary value of the property is determined by multiplying the
weighted area of the property by the adjusted price per square meter.
- The final value of the property is determined, including all adjustments due
to special conditions applied to the property – such as soil contamination, noise, etc.
Once the property has gone through the four-stage model, the Danish
Property Assessment Agency sends the property assessment to the owner, which is
in line with the realized value of the property in the respective residential area.
To avoid a significant increase in the tax burden for taxpayers, property tax
rates are expected to be reduced from 0.92% to 0.55% for the part of the tax base
 Property Tax in Bulgaria – The Need for Updating the Tax Base
185
that does not exceed 3,040,000 DKK (progression limit) and from 3% to 1.4% for
the remaining part.
Furthermore, the progression limit is expected to be raised from 3,040,000
DKK to an expected 8,300,000 DKK (6,640,000 DKK in connection with the
precautionary principle). In addition, it is expected that municipal property tax will
be reduced in 2024 (Minkøbermæ[Link]).
Based on the changes and the use of market assessments as the tax base,
property taxation acts as an automatic stabilizer in the real estate market.
Even after the property tax reform of 2017, periodic property taxes are low if
evaluated against normal interest rates; the tax relief for interest expenses is
relatively high and has no ceiling, while capital gains on owner-occupied homes
are exempt from taxation. This makes the tax treatment of owner-occupied homes
very favorable compared to other savings instruments in most other OECD
countries (OECD, 2019).

4. INTERRELATIONSHIP BETWEEN PROPERTY TAX,

INVESTMENTS, INEQUALITIES AND LAW COMPLIANCE
Opponents of any reforms in the system of local taxes and fees highlight
arguments that the tax burden on taxpayers will increase significantly without
considering the basic goal of tax policy. This policy is at the core of the state's
economic and fiscal policies and is an important tool for smoothing out
macroeconomic disparities. Policy - whether at the national or local level - is also a
crucial lever for promoting investment, economic growth, and employment.
The fundamental principles and rules on which taxes and tax relations should
be based are social justice, appropriateness, economic efficiency, simplicity,
flexibility, and diversity. In the present study, the problems of tax fairness are
examined, expressed in a system of principles - primarily uniformity in taxation
with local taxes and the ability to pay local taxes. According to a publication by the
EC from 2017 within the framework of the European Semester, the key
characteristics to be taken into account in assessing the fairness and effectiveness
of a tax system are the extent to which it:
- Encourages investment;
- Supports job creation and employment;
- Corrects inequalities;
- Achieves high levels of law compliance.
 Desislava Zheleva Kalcheva , Daniela Ushatova
186

Due to the lack of detailed information at the municipal level, the studies in
the following paragraphs are based on available information at the regional level
(NW - Northwest region, NCR - North Central region, NER - Northeast region,
SER - Southeast region, SCR - South Central region, SWR - Southwest region).

4.1. Interrelationship between property tax and investments:

According to data from the National Statistical Institute on expenditures for
acquisition, long-term tangible assets, including construction by economic entities,
the size of expenditures before the World Financial Economic Crisis still cannot be
reached. However, excluding values for 2008, when the last peak of these
expenditures occurred, and 2009 and 2010, during which the economy was
recovering, in the post-crisis period from 2011 to 2021, these investments have
been increasing annually nationwide. Investments in the Southwest planning
region, where the capital is located, are leading by regions. However, for the period
2011-2021, acquisition expenditures for tangible assets have increased
cumulatively between 1.15 (Northeast region) and 1.65 times (South Central).

Figure 5. Costs for acquisition of long-term tangible assets for the period 2011-2021 (million BGN)
Source: National Statistical Institute

For the same period, with the exception of the Southeast region (with
minimal decrease), cumulative foreign direct investments in the remaining
planning regions have increased between 1.05 (Northwest region) and 1.15 times
(South Central).
 Property Tax in Bulgaria – The Need for Updating the Tax Base
187

Figure 6. Direct foreign investments for the period 2011-2021 (million BGN)
Source: National Statistical Institute

Based on the ratio between residential and non-residential buildings derived

above, the relative contribution of businesses to property tax revenues has been
calculated for the study period. The amounts obtained for the respective years have
been related to the size of expenditures on acquiring long-term tangible assets and,
correspondingly, to foreign direct investments, with the results presented in the
following chart.

Figure 7. Revenues from real estate tax, PPP and acquisition costs of durable tangible assets
Source: Ministry of Finance, National Statistical Institute, own calculations.
 Desislava Zheleva Kalcheva , Daniela Ushatova
188

The property tax has a negligible share in the expenditures on acquiring

long-term tangible assets, as well as in foreign direct investments – between 0.3
and 0.5%. In this sense, any potential reform and reassessment of tax valuations
would not negatively impact these two indicators, especially since, as mentioned
earlier, businesses pay based on the higher of the two values – either the declared
value of the real estate or the tax assessment determined according to the valuation
norms. Additionally, businesses factor in all their tax expenses into the value of the
goods and services they provide. Therefore, a reform in local taxes and fees would
not jeopardize economic development.

4.2. Property tax and addressing inequalities.

An examination of changes in the overall income and expenditure, including
taxes by statistical regions, has been conducted to determine the coefficients of
their increase for the period 2011-2021.

Figure 8. Growth rate of total household income/expenditure 2021/2011

Source: Ministry of Finance, National Statistical Institute, own calculations.

Given that the methodology for observing household budgets by the NSI
examines households' non-consumption expenditures on taxes and social security
contributions, it is notable that the growth rates of tax expenditures for the NW,
NC, NE, and SC regions outpace the overall growth rate of incomes and total
expenditures for the period. This may be due to the highlighting of certain sectors,
the above-average increase in wage income for the NW, NC, NE regions (with
growth coefficients ranging from 0.1 to 0.4 above the country's average growth), as
well as the increase in foreign direct investments for the NW, SC, NE regions.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
189
For the purposes of this study, changes in the shares of various types of
household expenditures have also been examined, including traditional household
expenses, taxes, and expenses on alcohol and tobacco products. It is striking that
among the selected types of expenditures, household utility expenses have the highest
share in all regions. Expenditures on alcoholic beverages and tobacco products in
Northern Bulgaria constitute a significant portion of household expenditures.
Table 8. Share of types of expenses in households
Share in Share in
Household Growth
Types of Expenditure Share in Total Total Total
Expenditure Coefficient
Expenditures 2011 Expenditures Expenditures
Structure 2021/2011
2011 2021
Alcoholic beverages and tobacco products 5,1% 5,1% 1,7
Northwest region Housing, water, electricity, and fuels 13,3% 13,3% 1,7
Taxes 4,1% 4,1% 2,1
Alcoholic beverages and tobacco products 4,1% 4,2% 2,0
North central region Housing, water, electricity, and fuels 14,3% 14,3% 1,8
Taxes 4,1% 4,1% 2,6
Alcoholic beverages and tobacco products 4,5% 4,5% 1,9
Northeastern region Housing, water, electricity, and fuels 12,3% 12,3% 1,8
Taxes 4,1% 4,1% 2,6
Alcoholic beverages and tobacco products 4,4% 4,4% 1,3
Southeast region Housing, water, electricity, and fuels 13,0% 13,0% 1,7
Taxes 5,5% 5,5% 1,6
Alcoholic beverages and tobacco products 4,4% 4,4% 1,3
Southwestern region Housing, water, electricity, and fuels 13,6% 13,6% 1,6
Taxes 5,8% 5,8% 1,5
Alcoholic beverages and tobacco products 3,1% 3,1% 1,8
South central region Housing, water, electricity, and fuels 13,8% 13,8% 1,7
Taxes 4,4% 4,4% 2,1
Source: National Statistical Institute, Own calculation

To assess the change in the value of citizens' properties, the change in

average market prices in BGN per square meter (observed by NSI until 2014
inclusive) with the coefficients recorded after 2015 was examined. For the period
under review, average market prices of residential properties increase at the highest
rates in the Southwest Planning Region (SWPR), followed by the South Central
Planning Region (SCPR) and the Southeast Planning Region (SEPR). Prices in the
Northwest Planning Region (NWPR) and North Central Planning Region (NCPR)
increase at lower rates, while in the Southeastern Planning Region (SEPR), they
even decrease.
 Desislava Zheleva Kalcheva , Daniela Ushatova
190

Figure 9. Market prices of housing, BGN/sq.m. m.

Source: National Statistical Institute, Own calculation

In practical terms, homeowners own more expensive real estate compared to

its value ten years ago. During the same period, the GDP per capita increases, with
the country's average growth being 83%, with the lowest values recorded for the
South Central Planning Region (72%) and the highest for the Southwest Planning
Region (98%).
Given that the share of local tax revenues, including property tax, in total
revenues according to GFS has an insignificant share of 1.4-1.5%, an eventual
increase in the tax base would not pose difficulties for households in payment,
considering the nearly equal share of non-essential and even harmful expenditures,
such as those for alcohol and cigarettes.

4.3. Property tax and achieving higher levels of law compliance.

The change in the collection rate of property taxes was examined because,
according to GFS, citizens pay taxes and fees according to their income and
property. Due to the lack of detailed data, the calculations were made based on
public data from the Ministry of Finance, which relate to property tax assessments
for the current year, i.e., they do not reflect collected old receivables.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
191

Figure 10. Average collection of DNI for 2015-2022.

Source: Ministry of Finance, own calculations

The collection of current tax obligations is largely determined by the work of

municipal revenue administrations but also depends on the ability of taxpayers
(both individuals and legal entities) to currently fulfill their obligations. Over the
examined eight-year period, the lowest average levels are recorded in the
Southwest Planning Region (SZR) and in the Southeastern Planning Region
(SEPR), while in the other regions, it is at or above the national average. In the
SZR, 80% of municipalities have lower collection levels than the national average.

5. CONCLUSION
Based on the analyzed information, it can be summarized that the change in
the mechanism for determining the tax base and the increase in tax assessments
will not have a significant impact on household expenses but rather will smooth out
differences between regions and between the market and tax legislation.
However, some key risks accompanying such a reform should be
highlighted. Firstly, property tax revenues are inelastic with respect to the
dynamics of the economic cycle and do not have a direct link to the purchasing
power of property owners. While residents of major municipalities such as Sofia,
Plovdiv, Varna, and Burgas receive relatively higher incomes and possess
purchasing power above the national average, residents of small and medium-sized
municipalities have lower payment capabilities. High levels of inflation and the
 Desislava Zheleva Kalcheva , Daniela Ushatova
192

preemptive increase in basic household expenses are factors that could postpone
the implementation of a reform related to updating property tax assessments.
Another factor delaying the reform is the expected liberalization of the
energy market and the increase in household electricity bills.
It should be noted that property taxes are neutral with respect to central,
fiscal, redistributive, currency, and trade policies. According to some theoretical
frameworks, increasing local and regional government tax revenues should be
sought through taxes linked to local businesses and the local economy. This
implies a fairer distribution of the tax burden on one hand and creates incentives to
support local businesses by local authorities on the other.
Furthermore, from a political perspective, changing the property tax base is
one of the most unpopular decisions for increasing municipal revenues. Property
taxes are considered some of the most stable taxes, with an immobile base and no
possibility of shifting the tax burden. Changes in taxes and increased tax obligations
lead to voter exodus and a decline in electoral support for the ruling party.
However, despite the risks, the possibility of implementing a reform related
to updating property tax assessments should be considered, evaluated, and
implemented when the necessary prerequisites are identified and at an appropriate
time. The present study synthesizes guidelines and steps for changes.
Based on the study, the following basic recommendations (notes) can be derived:
- Allow municipal councils to differentiate tax rates by settlements. Relief
for non-taxable properties above a certain value should be replaced with a flat rate.
- Provide for the possibility of an automatic mechanism for updating
property tax assessments at certain intervals based on housing price indices or other
indicators observed by the National Statistical Institute (NSI). Successful reforms
in Denmark and Ireland are cited.
- Increase the base indicator - the basic tax value per square meter, according
to changes in conditions.
- Reduce the impact of location coefficients on the value of the tax
assessment or tie them to other indicators related to property prices. Reduce the
number of settlement categories from ten to a maximum of five.
- Allow municipal councils to differentiate coefficients applied.
- Take into account the development of urban infrastructure and services in
the respective territory and in the vicinity of the properties, such as: transportation
accessibility, access to schools and kindergartens, healthcare facilities, etc.
 Property Tax in Bulgaria – The Need for Updating the Tax Base
193
- Use a more understandable and universally accepted differentiation of
property types in legislation, based on construction, the data for which are provided
by a state authority.
- Reconsider tax exemptions, including for primary residences, by improving
the definition and method of reflecting this circumstance. In many cases, taxpayers
own more than one residence.
- Create national and publicly accessible information on the average tax
assessment per square meter by municipality and by type of property.
- Consolidate information at the national level on the fiscal effect of applied
tax exemptions and provide corresponding transfers to municipalities from the state
for the inability to generate the respective revenue volume due to their
implementation of national policy.
Excluded from the scope of this study is the taxation of agricultural land and
forests. However, it is worth noting that Bulgaria is one of the few examples
among the European Union countries where agricultural land remains exempt from
taxation. It should be borne in mind that agricultural land is subject to sale and
generates income for its owners (rents). According to the Local Taxes and Fees
Act, complex tables and formulas for calculation are used for taxation purposes
regarding transactions involving agricultural land and forests. An unchanged basic
tax value per square meter, differentiated by category and functional type of the
settlement, forest, or land, has been used for over two decades. These values of
agricultural land and forests lag behind transaction prices by over 20 times.
With the future introduction of the euro in the country, all normative acts
containing lev values will need to be updated with new euro values. Due to the low
values of the basic tax value per square meter for a number of properties, the values
of tax assessments will remain significantly underestimated.
In conclusion, the 2024 Policy Advice Document „Fiscal autonomy and
financial management of local administrations in Bulgaria“ of the Council of
Europe contains specific recommendations for updating the property tax
assessment in Bulgaria. According to the report, the tax assessment significantly
lags behind market values and has not been updated in recent years. This leads to a
loss of revenue and a sense of unfairness and dissatisfaction among taxpayers.
 Desislava Zheleva Kalcheva , Daniela Ushatova
194

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 Volume 17, Issue 1/2024, pp. 197-196
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0007

PHD RESEARCH

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Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
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 Volume 17, Issue 1/2024, pp. 199-212
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0008

THE IMPORTANCE OF AFFORDABLE HOUSING IN TERMS OF

ITS DEFINITION, CHANGING IMAGE AND REFRAMING IN SOCIETY

BRIGITTE STEINHOFF 1

Abstract: This literature review explores the complex landscape of affordable housing, its
international significance and policy implications. The lack of a clear distinction between
affordable and social housing, coupled with challenges in measuring affordability,
underlines the need for tailored policy assessments and indicators. The multifaceted issues
surrounding affordable housing, including quality, sustainability, and barriers to access,
are examined with a focus on Germany. This review focuses on reframing affordable rental
housing as a catalyst for social inclusion and economic growth and provides an academic
contribution by examining the economic and psychological perspectives. The analytical
framework addresses key research questions regarding definitions, levels of acceptance
and potential strategies to counter stigmatisation. The review also explores the nuanced
nature of the affordable housing problem, highlighting its historical complexity and the
lack of a single metric for assessment. It also examines efforts to reframe the stigmatisation
associated with affordable housing, emphasising the role of communication strategies. It
concludes with an examination of German policy programmes aimed at addressing housing
affordability, mark the importance of subsidy programmes and the symbiotic relationship
between investors and public authorities.
Keywords: Affordable housing, framing the issue of affordable housing, not-in-my- backyard,
social acceptability, policy programmes in Germany
JEL Classification: M14, M38, R21

1. INTRODUCTION
The term 'affordable housing' has attracted international attention in recent
years, both in policymaking and in research. It is often used as a synonym for
‘social housing’. More recently, it has also been used to define policy instruments.
However, it is not possible to draw a clear dividing line between the two concepts.
Measuring housing affordability is amajor challenge for most local authorities,

1 Doctoral School of Economics and Business Administration, "Alexandru Ioan Cuza" University,
14th Lăpuşneanu Street, 4th Floor, Room 424, Iaşi 700057, Romania E-Mail:
[Link]@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Brigitte Steinhoff
200

federal and state governments. Affordability problems prove to be complex. There

is no single measure to assess their nature and extent. This will require an
assessment of policy needs on these issues and an identification of indicators which
meet specific national policy needs.
Publicly social housing in terms of its quality, sustainability, and affordability
is a topical issue that is more relevant than ever. In order to achieve the politically
declared goal of increasing the number of social housing units and ensuring a social
mix in cities, the federal and state governments have launched subsidy
programmes. However, there are psychological barriers to investment in affordable
housing that are significant. Prejudices are widespread and, together with
misinformation, lead to misjudgements among potential investors. In addition to the
concerns and doubts of investors, the population and the neighbourhood of
affordable housing projects also have their doubts and fears. People are aware that
they accept change but do not want to allow it in their immediate neighbourhood,
known as not-in-my-backyard syndrome (NIMBY).
The literature review focusses on solutions for a reframing of affordable
housing. The approach here is to use affordable rental housing as a vehicle for
social inclusion and community development, and at the same time as an economic
force in new housing construction and aims to make a scientific contribution by
investigating the perception and significance of newly built affordable housing
from an economic and psychological perspective and to identify workable solutions
for a 'reframing' of social housing in Germany. The literature referenced in this
article mainly relates to America and Europe. A well-founded statement on the
understanding and acceptance of affordable housing in Germany is a gap in the
literature research system.
In summary, this literature review provides a comprehensive overview of the
multifaceted issue of affordable housing, emphasising the varying definitions,
historical complexities, stigmatisation challenges, and policy programs addressing
housing affordability. The subsequent research questions set the stage for further
exploration, urging researcher to delve deeper into the German context to enhance
the understanding of how the framing of affordable housing influences society.

2. ANALYTICAL FRAMEWORK
This literature review is divided into four parts. There are a number of
research questions addressed in this review. The first part provides background
information on the issues surrounding a common definition of affordable housing.
 The Importance of Affordable Housing in Terms of Its Definition, Changing Image and Reframing in Society
201
The second part looks at the nature and extent of the problem of housing
affordability. Part three looks at what can be done to neutralise or positively frame
the stigmatisation associated with affordable housing. It analyses reframing and
provides an overview of policy programmes addressing housing affordability in
Germany. The fourth part builds on this, points out the research gap and offers
options for further research into how framing of affordable housing influences
society in Germany.

3. SCOPE AND KEY TERMS

3.1. Defining affordable housing
The concept of affordable housing recognises the needs of households whose
incomes are insufficient to afford appropriate housing on the open housing market
without assistance (Milligan et al,2004). Discussions about the acceptance of
affordable housing in society are complicated by the ambiguity of the term. The
term ‘affordable housing’ is not clearly defined, and the term encompasses a range
of housing types, rents or prices, and resident income limits. Affordable housing is
the latest in an extensive list of synonyms for housing for those who cannot afford
the price on the open housing market (Koebel et al,2004:12). The term 'affordable
housing' is therefore used to describe housing that helps households on low and
middle incomes to find suitable accommodation without causing them undue
financial hardship (Milligan et al,2004). In recent years, the term 'affordable
housing' has been used as an alternative to terms such as 'public', 'social' or 'low
cost' housing (Gabriel et al,2005:6).
Many different definitions have a common cause. This is because
understanding the causal factors of the housing affordability problem itself is as
complex as conceptualising and measuring the income thresholds for those eligible.
As the affordability debate discussion shows, many conceptual and measurement
issues arise from contested understandings of the problem. Singles, lone parents,
and families with children may have to make trade-offs between high housing costs
and low or middle incomes and employment, travel, health, and other consumer
needs (Gabriel et al,2005:37). The following definition to assist state and federal
government by promoting and monitoring the supply of affordable housing is
accepted by the Australian policy. “Affordable housing is housing that is appropriate
for the needs of a range of low to moderate income households and priced so that
low and moderate incomes are able to meet their other essential basic living costs”
(Milligan et al,2007:26).
 Brigitte Steinhoff
202

Another common definition in the United Kingdom is that affordable housing

includes both traditional social housing (publicly or privately owned (by housing
associations)) and new forms of below and regulated market housing for sale or
rent. In the London Plan, for example, affordable housing is defined as " housing
designed to meet the needs of households whose incomes are not sufficient to allow
them to access decent and appropriate housing in their borough. Affordable housing
comprises social housing, intermediate housing and in some cases, low-cost market
housing" (MOL,2004:60).
Affordable housing (colloquially known as social housing) in Germany is
new housing that is built with direct funding from the federal, state, and local
governments. The legal basis for this is the Social Housing Promotion Act (WoFG).
In addition to the principles of affordable housing construction, the Act also
regulates the target group, i. e. households that cannot adequately provide
themselves with housing on the open housing market and are therefore dependent
on support. The federal states in Germany are responsible for the legislation and
financing of affordable housing, which is why the provisions of federal state law
must also be considered (BMI,2020). By granting public funds, the newly created
dwellings become affordable housing and are subject to the provisions of the
Housing Commitment Act (WoBindG). The occupancy commitment ensures that
only people in need are granted access to affordable housing on the basis of a
housing entitlement certificate (Wohnberechtigungsschein). The responsible
authorities issue a housing entitlement certificate, provided that the relevant
income limits are not exceeded. Rent control guarantees that the rents of subsidised
dwellings are tied to target rates that vary depending on the size of the
municipality, location, and facilities.
The comparative international perspective and the complexity of the topic
highlight the impossibility of a standardised definition of the term ‘affordable
housing’. The definition is specific and depends on the political and programme
context in the individual countries in which it is used. The challenge is therefore to
identify policy needs in this area and to develop measures that meet policy
requirements, for example to identify the scale and form of the problem, assess
trends in the housing market, provide information for policy design or provide
guidance to the industry (Gabriel et al,2005:37).
 The Importance of Affordable Housing in Terms of Its Definition, Changing Image and Reframing in Society
203

3.2. Nature and extent of the affordable housing problem

Affordable housing is becoming more important every day. However, there is
no consensus in the literature on how to measure affordability, nor is there a
standardised definition, as already described in the previous chapter.
The problem of measuring housing affordability can already be seen in
studies from the 19th century. Stigler recognised that there was already some
knowledge and attempts to define the measure of affordable housing. Conceptually,
theoretically, empirically, and methodologically, there had been numerous attempts
to analyse household consumption, but the studies were “a comedy of errors”
(Stigler,1954:95-113). The main practical application in housing was ‘a week's
wages for a month's rent’ which was a common way of describing housing costs in
the U.S. Kenngott's 1912 study found that at least twenty percent of the earnings
were needed for rent (Kenngott,1912:57,128-129,136). This late 19th century
saying about ‘a week's wages...’ is similar to the late 20th century saying that
twenty-five or thirty percent of income is the upper limit of housing affordability.
Both make only general assumptions about what the average household pays
or should pay for housing (the distinction is seldom clarified), with no indication of
which household is the average. Over the decades, observations about what some
households have been spending have been turned into assumptions about what they
'should' be spending (Hulchanski,1995:475).
It turns out that affordability problems are overly complex. There is no single
measure to assess their nature and extent. It is therefore important to identify the
policy needs related to these issues and to develop metrics that are tailored to the
specific policy needs in the different countries. In this way, developments in the
housing market can be assessed and provide essential information for further policy
development (Gabriel et al,2005:37).

3.3. Reframing the stigmatisation of affordable housing

Koebel, Lang, and Danielsen were the first researchers to comprehensively
address the concern about the impact of affordable housing. Affordable housing
policies are often situated in tension between conflicting assumptions, interests, and
fears. Primarily, the dispute stems from several interrelated factors that lead to the
NIMBY response, fear of negative impact on one's property value, anti-government
and anti-poor sentiments, and segregation. The dispute over affordable housing is
not one-sided, meaning that in some cases, concern about negative impacts can be a
cover for deeper conflicts about a fair society and the role of government (Koebel
et al,2014). Their study titled Community acceptance of affordable housing
 Brigitte Steinhoff
204

examined that communication is a crucial key component in promoting affordable

housing. The term ‘affordable housing’ has been stigmatised by failure of earlier
housing programs which led to NIMBYism. Federal and state governments are
challenged to reformulate the term, for instance in ‘housing that is affordable’, and
demonstrate that they are delivering a quality product that can be seen as a valuable
part of neighbourhood. In part, this is helped by the lower subsidies (and higher
incomes of residents) associated with today's subsidy programmes. Most of the
affordable housing produced today is for people earning between 50 to 60 percent
of the median family income in the area. This contrasts with the higher subsidies
and lower disposable incomes associated with previous affordable housing
programmes. This shift in the demographic composition of affordable housing is
expected to lead to greater opportunities for acceptance in society. It also underlines
the need for a distinction between different affordable housing ‘products’ in terms
of design, income limits, and quality of management (Koebel et al,2014).
More recently, Scally (2012) examined the nuances of local not-in-my-
backyard attitudes and actions in her study The Nuances of NIMBY: Context and
Perceptions of Affordable Rental Housing Development. This research investigates
the public perceptions behind NIMBY syndrome in attitudes and actions. Six case
studies within New York State, U.S. explore local acceptance and rejection of
affordable housing development. Interviews with local public, private, and
nonprofit organizations participants and an analysis of state, and local housing
studies and reports, reveals the influence of local housing legacies, development
environments and conditions and perceptions of affordable housing development.
As these studies confirm, NIMBY attitudes and actions against affordable housing
are highly differentiated and depend on the local environment, development, and
circumstances, as well as on the policies and views of society. NIMBY is not a
homogeneous public opinion based on consensus but differs according to those
affected. Attitudes vary from one place to another and can lead to completely
different local attitudes and approaches (Scally,2012).
The remainder of the studies on affordable housing in the context of historical
development, policy instruments in specific cities and countries, affordable housing
solutions, future policy developments and as such have not been included in the
present review of relevant literature (Czischke & van Bortel,2018; Deschermeier et
al,2019; Oxley et al,2008; Scanlon et al,2014).
Concerning framing the issue of affordable housing, there exist a slightly
larger number of studies examining the possibility of changing attitudes toward
affordable housing and housing policies. Society views housing as a consumer
 The Importance of Affordable Housing in Terms of Its Definition, Changing Image and Reframing in Society
205
good subject to the laws of supply and demand. This leads to a disregard for the
impact on housing costs and the fact that affordable new housing is available to
households with low or middle incomes. An effective framing strategy is needed to
promote public understanding of affordable housing and positive urban
development. The right framing can help overcome negative thinking, create a
better structural understanding of housing problems and solutions, and inoculate
against NIMBYism and scepticism about public intervention in housing
(Goetz,2008; Levay et al,2018; Matheis et al,2022; Nkubito,2022).
The study of the University of Minnesota examined the impact of affordable
housing in Bloomington. Bloomington is the fourth largest city in Minnesota, U.S.
Using a mixed methods research, the study analysed the benefits and challenges of
affordable housing regarding residents' perspectives on housing stability, mental
health, psychological health, safety, and security. This study involved a mixed
methods analysis conducted in the form of interviews and surveys of residents
living in affordable housing in Bloomington. The interviews focused on the
residents' experiences with affordable housing contribute to their quality of life. In
addition, surveys were conducted. The analysis was inductive, qualitative, and
looked for patterns within the data across the interviews and surveys implemented
(Amrhein et al,2023).
Suk-Kyung examined the housing market in the Tri-County Region of
Clinton, Eaton, and Ingham Counties in Michigan, U.S. As these regions
experienced economic decline after the departure of car companies in the 1990s,
but today experiencing economic and population growth, it is important to examine
current regional conditions in terms of demographic, socio-economic and housing
characteristics in order to identify future directions for the achievement of
sustainable community goals (Suk-Kyung,2014).
Goetz conducted another study. In a suburb of Minneapolis, U.S., which has a
high growth dynamic and therefore offers hardly any affordable housing, it was
evaluated whether language can influence public opinion. A survey was conducted
by the city to obtain information on the results regarding satisfaction with city
services, neighbourhood conditions, traffic, and so forth. The survey also included
a question on housing policy to point out the importance of issue framing. One half
of the respondents received a question using the term ‘affordable housing’ and the
other half received a question using the term ‘lifecycle housing’ (Goetz,2008).
Several studies have employed the private financing and institutional
investment in affordable housing and its regulation, as well as the relationship
 Brigitte Steinhoff
206

between investors and the federal and state government system. An overview is
given of the main legal frameworks that enable, among others, insurance companies,
pension funds and other institutional investors to generate profits from affordable
housing. The needs and interests of policy makers and investors providing patient
capital are closely intertwined. This interaction between investors and public
authorities is inevitably asymmetrical, especially at the local level. Leasing
arrangements with pension funds and insurance companies expose local authorities
and tenants to a range of long-term risks. The findings presented suggest the need for
a social understanding of the regulation on investment in affordable housing and
characterise the multi-layered entanglements between investment flows and housing
policy by illustrating the range of discourses and powers mobilised by state actors
and investors in the process of market design (Bloom, 2023; Whitehead, 2003).

3.4. Policy programmes addressing housing affordability on the example of

Germany
There are subsidy programmes in all sixteen federal states of Germany to
facilitate the creation of affordable housing. Thanks to the subsidy components
provided by the cities and local authorities through the state subsidy programmes,
investors can achieve a return comparable to that of privately financed housing
construction, despite lower rental income. In many large cities and conurbations,
the return on privately financed dwellings is incalculable due to the intervention in
rent formation (e. g. rent control). In addition, current new-build rents involve
value fluctuation risks that are significantly lower for subsidised dwellings.
Investment in affordable housing makes sense for several reasons. On the one
hand, a contribution is made to the societal and social problem of the affordable
housing shortage, and on the other hand the investor receives a sustainable and
profitable capital investment with added social value (Teichert,2017). Sustainability
is becoming increasingly important for many investors, as is social commitment,
which in turn enhances their social standing. Investors can use the various funding
modules to provide important impetus for new housing development in cities and
municipalities. As an incentive, investors receive high repayment discounts on low-
interest subsidised loans, for example, some of which are even offset against equity
(Suhlrie,2017).
Publicly subsidised housing is a contemporary form of property and at the
same time offers investors solid investment opportunities with planning security
and attractive returns. Publicly subsidised rental housing is a principal issue, both
now and in the future. The housing shortage in Germany is worsening, particularly
 The Importance of Affordable Housing in Terms of Its Definition, Changing Image and Reframing in Society
207
in large cities and conurbations, where there is decreasing availability of affordable
housing. Regardless of what government intervention is made in the housing
market in terms of subject or object promotion, new housing construction must be
accelerated in order to reduce the overall housing shortage. New-build dwellings
relieve pressure on existing markets. Households that move into a new-build
dwelling do not request an existing dwelling or, in the best case, vacate an existing
dwelling. The greater the increase in supply in relation to demand, the greater the
relief effect. At the same time, housing subsidies serve to ensure the affordability of
rents. Speculative vacancies and rental price explosions are prevented, and the
growing economic imbalance is curbed (Ringwald,2020:80). Affordable housing
promotion plays a significant role in the provision of housing. Private investors can
use the incentives provided by the funding programmes in the federal states to
enhance their public reputation and create housing, especially where demand is
particularly high. The aim of housing promotion is to strengthen the development
of social and rent control programmes so that groups that are unable to obtain
housing on the open housing market have access to adequate and suitable housing.
In particular, social rent controls are an important instrument for cities and
municipalities in the context of services of general interest and housing provision
(Abstiens et al, 2017:10).
Residential property has always been a positive investment for private
investors. The sharp rise in rents in the privately financed housing market in recent
years is increasingly being perceived as socially problematic. Political issues such as
rent freezes, rent caps, the expropriation of housing companies and housing shortages
are helping to ensure that affordable housing continues to become the focus of
private investors. Individual rental developments, which are constantly adapted to the
conditions of the local market, as well as subsidised terms of between 10 and 40
years, including redemption discounts and low- interest or interest-free loans,
guarantee an attractive return. In addition, the investor receives a remarkably
important level of income security, as the demand for affordable housing is
extremely high and the risk of vacancies and defaults is therefore low. "Die
sukzessive Mietanpassung entspricht in der Regel der allgemeinen
Einkommensentwicklung”2 (Niewöhner-Pape, 2020).

2 “The successive rent adjustment usually corresponds to the general income trend." (translation by
the author)
 Brigitte Steinhoff
208

4. ANALYTICAL SUMMARY AND CONCLUSIONS

This literature review shows that the definition of affordable housing has
various dependencies. These include its measurability, meaning and reputation in
different countries. One notable strength of the literature review is therefore its
thorough examination of the historical complexity and varying definitions of
affordable housing. It underlines the lack of a standardized definition
internationally and acknowledges the specificity of the term depending on the
political and programmatic context in individual countries. This recognition is
crucial for understanding the challenges associated with housing affordability and
the need for tailored policy solutions. Federal and state policy plays a significant
role in the provision of affordable housing. The literature review provides a
comprehensive understanding of the multifaceted nature of affordable housing. It
navigates through definitional challenges, the historical context of measuring
affordability, and strategies for addressing stigmatisation. The importance of
tailored metrics and nuanced communication strategies emerges as critical themes.
The call for reframing terminologies and the acknowledgment of the diverse factors
influencing societal attitudes are notable takeaways. The importance of effective
communication strategies in promoting affordable housing is underlined by the
debate on the not-in-my-backyard syndrome and efforts to reframe stigmatisation.
The inclusion of German perspectives enhances the global context, underscoring
the need for region-specific approaches. Additionally, the emphasis on policy
programs and investment incentives in Germany highlights the intersection of
social and economic considerations in the affordable housing discourse.
In essence, the literature review calls for a comprehensive approach,
considering the socio-economic, psychological, and policy dimensions in
understanding, promoting, and implementing affordable housing solutions. The
emphasis on reframing and tailored communication strategies underscores the
importance of a nuanced and context-specific discourse surrounding affordable
housing to address the complex challenges associated with it. However, the identified
research gap in literature in the German context calls for further exploration to
enhance the understanding of affordable housing in this specific setting.
 The Importance of Affordable Housing in Terms of Its Definition, Changing Image and Reframing in Society
209

5. FURTHER RESEARCH: HOW DOES THE REFRAMING OF

AFFORDABLE HOUSING INLFUNCE ACCEPTANCE IN GERMAN
SOCIETY?
The above-mentioned literature refers mainly to America and Europe, leaving
out Germany. A well-founded statement on the understanding and acceptance of
affordable housing in Germany is a gap in the research system. Based on this, a
research question could be decidedly about the new construction of affordable
housing and its effect on the population considering the socio-economic situation
and social needs in Germany.
Questions that then are consequently asked are:
 What kind of stigmatisation exists in society? Is there any? If so, to what extent
is it present?
 To what extent is there acceptance of affordable housing?
 Does this vary depending to socio-economic situation, own housing situation,
opinions, and attitudes towards housing, i. e. age, nationality, gender, size of
household, professional qualifications?
 What is the impact of influencing factors such as political ideologies, the
situation of the housing market and the fields of housing psychology, social and
communication psychology?
 What can be done to neutralise or positively shape stigma towards affordable
housing, i. e. reframing, image campaign of federal and state governments,
advertisement?
Long-term policy perspectives are needed to ensure the lifetime affordability
of housing. It is necessary to discuss housing affordability considering the costs
specific to each dwelling and its occupants, not just a single metric. Metrics alone
do not help to create a positive image of affordable housing. Policymakers and
society need to be convinced, and this can only be achieved by reframing
affordable housing.
 Brigitte Steinhoff
210

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 Volume 17, Issue 1/2024, pp. 213-226
ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0009

MOTIVES AFFECTING THE PROFESSIONAL IMAGE OF THE

MEDICAL IMAGING TECHNICIAN PROFESSION

SARIT H. MALUL MARKOVICHi

Abstract: This paper explores the motives affecting the professional image of Israeli
medical imaging technicians who provide doctors with a focused and clear picture for
diagnosing diseases and pathologies. This is achieved by multiple and diversified imaging
tests. However, despite technological developments, this profession suffers from low
image and, hence, workers’ supply is low. The research participants are 100 individuals
who wish to choose a career for life. The research instrument is a closed-ended
questionnaire. The research findings illustrate that the perception and awareness of this
profession are low since the public is not acquainted with this profession, namely the lower
the perceptions and awareness, the lower the professional image. Identification of the
motives that affect the image can help in bridging the gap in knowledge. Furthermore, this
can promote a marketing approach to the improvement of supply and an administrative
approach to the retention of workers in this important profession.
Keywords medical imaging technician, professional image, supply
JEL Classification:

1. INTRODUCTION
1.1. Research background
This paper aims to identify the factors that affect the professional image of
medical imaging technicians. This is one of the most required and needed professions
in the field of medicine. The medical imaging technicians are essential for the
identification of patients’ diseases and pathologies. They are the first line that helps
in the discovery, in many cases, of life-saving results. The medical imaging
technicians perform independently the tests and radiograms for the purpose of
diagnosis and treatment. Nevertheless, despite its demand and importance on the

i Alexandru Ioan Cuza University of Iasi, Blvd. Carol I, nr. 22, 700505, Iasi, Romania,
saritm4@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Sarit H. Malul Markovich
214

labor market, there are not many individuals who decide to learn this profession,
leading to low supply (Smith & Baird, 2007; Vanckaviciene, 2014).
The author of this paper is a medical imaging technician and has been
managing many imaging departments in hospitals. During all her years of work in
this profession, she has daily experienced the shortage of technicians, even up to
the point of limiting shifts due to manpower problems. Hence, the question is
raised: “Why do people avoid choosing to learn this profession and what are the
motives that affect their decision?”. The process of choosing a profession is,
undoubtedly, long, complex, and far from simple. Consequently, people are facing
a complicated decision, and part of this process is considering the existing
alternatives and deciding among them (Gati, 2016).
The fundamental assumption of this research is that this profession has an
image problem. Its professional image is low among the wider public and,
therefore, people do not consider choosing it as their future career. The empirical
literature supports this assumption, asserting that there is in fact an image problem.
People think that this is a technical profession and do not understanding how
essential it is (Rouger, 2018).
Comprehending the gap in knowledge and learning what affects the
professional image of the medical imaging technician profession, will enable
bridging this gap and, thus, improve the image. This will motivate people to be
interested in this profession and, at least, to consider it as an option among all the
alternatives that exist on the labor market, leading to improved supply. Herein
resides the motivation and importance of conducting this research.

2. LITERATURE REVIEW
2.1. The Israeli healthcare system
The healthcare system in Israel is a public system. It functions under the
supervision of the Ministry of Healthcare that is the regulatory body of the Israeli
government. The State of Israel (1995) has legislated the Health Insurance Law,
pursuant to which every Israeli citizen has a health insurance. The residents pay a
health tax out of their salary, and the state pays the difference (Bar-On et al., 2019).
The healthcare system copes on a daily basis with economic and human resources
difficulties (Buldor, 2013).
 Motives Affecting the Professional Image of the Medical Imaging Technician Profession
215

2.2. Medical imaging technicians

Medical imaging technicians constitute part of the healthcare system human
resources. Their main role is operating imaging machines, e.g., computerized
tomography (CT), magnetic resonance imaging (MRI). X-Rays radiograms, etc.
Moreover, within the framework of their role, they operate therapeutic devices,
such as radiation treatments. They are obliged to report any life-risking pathology
either to the treating doctor or to the doctor who decodes the test.
Medical imaging technicians possess extensive knowledge in many areas,
among them: anatomy, pathology, radiation dosage, physiology of the human body,
and others (Ministry of Health, 2022a). Unfortunately, the vital and crucial supply
of this resource is insufficient for the demands of the healthcare system, harming
the health of the community (Eisbruch, 2020).

2.3. Supply of medical imaging technicians in the world and in Israel

The shortage on the labor market is prevalent in many countries around the
globe. In the European Union, 50% of the member-states declare that they
experience a shortage of this resource (Rouger, 2018). In the United States, even
without a survey of this issue, people are aware of an 8.5 percent shortage of this
resource (American Society of Radiologic Technologists, 2019).
In Israel, there is no updated and accurate information about the number of
medical imaging technicians (State Comptroller, 2015). However, the reports,
particularly those related to the very long waiting times for a test or treatment, as
well as the heavy overloads, illustrate the problem of shortage of this profession in
the State of Israel (Haaretz Daily Newspaper, 2022). The shortage has been
included on the agenda of the International Radiology Association that prepares a
plan for addressing and reducing this problem (Frija et al., 2021).
As a result of the shortage on the labor market, people in the community face
unreasonably long time for an examination or therapy. Long waiting time
undoubtedly damages the quality of the treatment and, sometimes, risk the public’s
health (Biloglav et al., 2020). The failure to be treated on time due to the shortage
problem, compromises the right for appropriate healthcare service. This, in fact, is
a highly important social right because of its direct reference to the very existence
of life.

2.4. The professional image of medical imaging technicians

The empirical literature dealing with the professional image of medical
imaging technicians is not very rich. Over the years, studies have shown that the
 Sarit H. Malul Markovich
216

prestige and professional image of this profession is low. In a study conducted 20

years ago, the profession was ranked last from the aspect of occupational prestige
(Collins & Nolen, 2002). About 15 years later, the empirical literature has shown
that medical imaging technicians are still not appreciated for their professionality
and knowledge. Moreover, their skills are not acknowledged and do not comply
with their performance in the field.
In practice, medical imaging technicians identify life-risking pathologies and
report in real time about this. More than once they have saved a person’s life,
demonstrating that they are capable pf performing the tasks like the radiologists.
Both in Europe and in Israel, tests that have been traditionally performed by the
doctors who decode the results, i.e., the radiologists, are performed today by
medical imaging technicians, e.g., ultrasound tests. The transition from tests being
performed by radiologists to tests being performed by medical imaging technicians
has been proven to be efficient, saving time and money (Rouger, 2018).
From a historical point of view, the work of medical imaging technicians has
been considered as merely pushing a button of a machine. Apparently, the
impression caused by the problems of qualification and licensing of the profession in
some of the countries around the world, has made people think that every person can
push the button after several weeks of training (Collins & Nolen, 2002).
Nevertheless, the reality is different. Many studies have found that medical imaging
technicians are involved in the reporting of pathologies and they are sufficiently
knowledgeable for doing that (Mavrodinova et al., 2022; Rouger, 2018).
Only in 2023, has the Health Committee of the Israeli Parliament legislated
the bill that regulates the engagement in healthcare profession with reference to the
medical imaging technician profession (State of Israel 2022). The bill defines the
profession from the aspect of qualification and training of students who have
learned the profession in Israel and those who have learned it in other countries
(Ministry of Health, 2022b).
In spite of all the professional developments and the additional tasks that the
medical imaging technicians have to perform, the public still sees them as simple
professionals whose only action is operating a machine. The understanding is that
the appreciation and acknowledgement of the competences and tasks of the
medical imaging technicians will improve the perception of the negative image of
the profession (Mussmann et al., 2021).
 Motives Affecting the Professional Image of the Medical Imaging Technician Profession
217

2.5. Awareness of the medical imaging technician profession

People who are at the stage of making a decision and, particularly, important
decisions that affect their life, e.g., the decision what to learn and what profession
to choose as their professional career, have to choose among the existing
alternatives, while comparing the different professions. That is, in order to make
the decision, they need to collect the data, process them, and obtain the necessary
relevant information (Gati, 2016).
There are two key approaches to the decision-making process. The first is
the economic approach, the principle of which is that the way of making a decision,
acts on the rational mechanism. This is achieved by fragmenting the decision into
small parts in order to improve the knowledge requited for the decision-making.
On the other hand, there is the psychological approach, the principle of which is
making a decision on the basis of the emotional mechanism that acts in favor of the
decision-making (Oplatka,2015).
Consequently, it is important to understand that at the stage of making a
decision about the choice of profession, people need to acquire extensive
knowledge and acquaint themselves with the skills of the profession. The
knowledge and acquaintance help people in enhancing their confidence in making
the decision, as well as prepare them psychologically. That implies that for the
purpose of choosing what to learn, people should be familiar with the work in
which they want to engage. For example: nature of the work, professional hazards,
duration of studies, training for the profession, and so on (Gagova et al., 2017). The
Constructivist Theory underscores that knowledge is temporary and subjective, and
is affected by social relationships, beliefs, and personal experience and, therefore,
it can be changed. On the other hand, the Positivist Theory argues that there is one
truth that can be learned. The greater knowledge people accumulate and more
truths they learn, the more knowledgeable they are (Libman, 2013).
The medical imaging technicians operate machines, some of which emit
ionizing radiation. Hence, it is necessary to examine the level of the public’s
knowledge about the issue of radiation and the risks it involves. Many studies have
investigated this topic and have found that the level of knowledge is low and that
there are misconceptions of the risks of ionizing radiation, particularly when this
concerns imaging tests (Evans et al., 2015; Nasr et al., 2019).
The public’s misconceptions create directly a negative effect on knowledge
and learning processes (Ben-Zvi et al., 1986; Bodner, 1986; Brown, 1992;
Jonassen, 1991). The question is whether the public has the required and important
 Sarit H. Malul Markovich
218

awareness of the medical imaging technician profession for choosing it as an

option of learning among the existing alternatives. In fact, do people know what is
the duration of studies? The certificates awarded upon graduation? Training
pathways? And so on. The empirical literature indicates that no studies of the
public’s level of awareness of this profession have been conducted.

2.6. Perceptions of the medical imaging technician profession

When people decide which profession to learn, this is actually a step in the
process of consolidating their professional and self-identity (Hughes, 1958).
Moreover, in this process of choice and decision what to learn, the professional
identity is covert. That is, individuals’ self-esteem of that profession the purpose of
which originates in the nature of the profession and the identification with it
(Bamber & Iyer, 2002). By definition, the professional identity maintains
interrelations between the way professionals perceive themselves and the way the
environment perceives them (Kuzminsky, 2008).
There are several factors that facilitate the professional identity
consolidation. For example: prestige of the profession, i.e., the professionals have
all the knowledge and training required for performing the action that only they can
judge its performance (Marks et al., 2002). Furthermore, the hierarchy of the
professional image affects and consolidates the professional identity. That is, the
fact that the environment officially acknowledges the qualification and certificates
of the profession, as well as the fact that individuals are proud to say they engage
in this profession (Kremer & Hofman, 1982; Wackerhausen, 2009).
The terms of induction into the profession are also essential. The stricter they
are, and the more specializations and training the profession requires, the more
consolidated the professional identity (McCall & Simons, 1981). Importance is
attributed to the way individuals and society perceive the profession. This
undoubtedly impacts the decision-making, when individuals try choosing what to
learn. Research findings demonstrate that the family and circle of friends are the
people who assist in making the choice what to learn (Calcalist Newspaper
Supplement, 2017). No studies of the public’s perceptions of this profession have
been found.

2.7. Summary
The fundamental assumption of this research is that the image affects the
low supply of this profession on the labor market. When the image is low, people
simply do not choose to learn the profession. Hence, it is important to conduct this
 Motives Affecting the Professional Image of the Medical Imaging Technician Profession
219
research in order to explore the professional image and the factors that affect it.
When the factors are mapped, they will facilitate finding the way for enhancing the
image which, in turn, will increase the supply.

3. METHODOLOGY
Research aim: Identify the factors that affect the professional image of
medical imaging technician profession.
Research question: What are the factors that affect the professional image
of medical imaging technician profession?
Research Hypotheses
H1: There is a positive correlation between awareness of the medical image
technician profession and the professional image.
H2: There is a positive correlation between the perception of the medical
imaging technician profession and the professional image.
In order to answer the research question and relate to the research aim and
research hypotheses, quantitative research was conducted in Israel. The research
consisted of a closed-ended questionnaire consisting of four parts that related to the
following topics: demographics, medical imaging technicians’ professional image,
awareness of the profession, and perceptions of the profession. The questionnaire
was administered in 2023 to 100 Israeli individuals in the process of choosing a
career. The participants were chosen according to the snowball method, i.e., a
friend brings friend. It was built through the Internet by Google Forms software
and safeguarded full anonymity of the respondents. The questionnaire was ranked
according to a 5-point Likert scale (1=lowest value, 5=highest value.
Table-1: Reliability and source of the questionnaire
Questionnaire source Reliability Questionnaire part
Adapted from a study of professional self- 0.75 Image questionnaire
image among nurses in Belgian hospitals
(Siebens et al,, 2006)
Perceptions 0.94 Awareness questionnaire
Awareness 0.81 Perception questionnaire
All the research participants gave their informed consent to participate in the research.
 Sarit H. Malul Markovich
220

4. FINDINGS
This research examined the means and standard deviations of the research
variables, perceptions of the medical imaging technician profession, and
professional image. The following tables illustrated that the perceptions of the
medical imaging technician profession and its professional image were relatively
moderate, and awareness of the profession was relatively low.
Table-2: Means and standard deviations of the research variables
M SD
Professional Image 3.22 0.72

Perceptions 3.04 0.81

Awareness 2.10 1.02

* All variables were measured on a 1-5 scale.

Table-3: Means and standard deviations of perception items with relatively low levels

M SD
Salary 2.92 1.09
Prestige 2.67 0.90
Pleasant (nice to have) profession 2.84 0.99
Career opportunities 2.76 1.04
Access to employment offers 2.82 1.09
Profession which makes you feel important 2.68 1.05
* All variables were measured on a 1-5 scale.

Table 3 illustrated that the values for the perceptions of the profession were
relatively low in the following categories: salary (M=2.92, SD=1.09), prestige
(M=2.67, SD=0.90), pleasant (nice to have) profession (M=2.84, SD=0.99(, career
opportunities (M=2.76, SD=1.04), access to employment offers (M=2.82, SD=1.09),
and profession which makes you feel important (M=2.68, SD=1.05) (Table 3)
Table-4: Means and standard deviations of professional image items with relatively low levels

M SD
Medical imaging technician is a calling 2.76 1.19
Medical imaging technician is an admirable profession 2.85 1.09
Medical imaging technician works independently 2.43 1.09
* All variables were measured on a 1-5 scale.
 Motives Affecting the Professional Image of the Medical Imaging Technician Profession
221
Table 4 showed that the values for the professional image were relatively low in
the following categories: Medical imaging technician is a calling (M=2.76, SD=1.19),
Medical imaging technician is an admirable profession (M=2.85, SD=1.09), Medical
imaging technician works independently (M=2.43, SD=1.09) (Table 4).
Research hypothesis 1: There is a positive correlation between awareness
of the medical image technician profession and the professional image.
Research hypothesis 1 was corroborated.
Table-5: Correlation between awareness and professional image
Professional Image
Awareness .24*

*p<.05
A Spearman correlation test was performed for the purpose of examining
research hypothesis 1, according to which there will be a positive correlation
between awareness of the medical imaging technician profession and the
perception of its professional image, The results of the test indicated a positive
correlation, i.e., higher awareness was associated with more positive perceptions of
the professional image of medical imaging technicians [r(88)= .24, p<.05]. Thus,
the higher the awareness of the medical imaging technician profession, the higher
the perceptions of its professional image (see Table 5).
Research hypothesis 2: There is a positive correlation between the perception
of the medical imaging technician profession and the professional image.
Research hypothesis 2 was corroborated.
Table-6: Correlations between perceptions of
medical imaging technician profession and its professional image
Professional Image
Perception of medical imaging technician profession .63***

***p<.001
A Spearman correlation test was performed for the purpose of examining
research hypothesis 2, according to which there will be a positive correlation
between the perception of medical imaging technician profession and the
perception of its professional image. The test results indicated a positive
correlation, i.e., a more favourable perception of the medical imaging technician
profession was associated with a more positive view of the professional image of
 Sarit H. Malul Markovich
222

medical imaging technicians [r(89)= .69, p<.001]. Hence, the second hypothesis
was corroborated (see Table 6).

5. DISCUSSION AND CONCLUSIONS

The research findings showed that the professional image was relatively
moderate-to-low among the population. The empirical literature supports this
finding (Mussmann et al., 2021). Furthermore, the findings indicated that the
professional image was particularly low in the following items: medical imaging
technician is a calling, medical imaging technician is an admirable profession,
medical imaging technician works independently. This finding can be accounted
for by the fact that the wide public does not believe that the medical imaging
technicians work independent.
In recent years, in my work as a medical imaging technician, I have
experienced a different reality in the field. In fact, medical imaging technicians are
in the shadow of the decoding doctors, and whose who sign the document with the
results are these doctors although, actually, the technicians have identified the
pathology. Moreover, when medical imaging technicians perform an ultrasound
test and write down whether they have identified any pathology, still those who
sign the document with the results are the decoding doctor. The medical imaging
technicians are not mentioned at all.
The empirical literature supports this finding, illustrating that the reality has
changed in the last years. The medical imaging technicians perform tests that in the
past have been performed only by doctors, and they are involved in the
identification of the pathologies. This change has entailed a great rationalization of
time and money, especially due to the doctors’ distress on the labor market
(Ministry of Health, 2022b; Rouger, 2018).
Based on the above, the medical imaging technicians are not esteemed and
acknowledged for the actions in the field that they have been performing for many
years. Hence, the reputation and image of this profession are low, and the public is
unaware of its supreme importance as a life-saving profession with considerable
responsibility and meaning. Herein resides the highest importance of enhancing the
professional image by redefining the framework of professional responsibility of the
medical imaging technicians, matching it to their actual performance in the field.
Another finding is the low awareness of this profession, a factor that affects
the professional image. Thus, the lower the awareness, the lower the image. This
finding is in line with the research assumption that it is essential to be acquainted
 Motives Affecting the Professional Image of the Medical Imaging Technician Profession
223
with the profession in the process of choosing to learn it. At this stage, if
individuals are unaware of the profession, are not interested in learning it, and are
not familiar with the learning pathways, work environment, advantages and
disadvantages of the profession, they cannot include this profession among the
existing alternatives and, thus, will not decide to learn it (Gagova et al., 2017). The
findings show that if we improve the population’s knowledge about this profession,
this will raise the level of awareness and improve the image. Improvement of the
image will make more people interested in learning the profession, resulting in
greater supply.
Moreover, the findings show the low perceptions of the medical imaging
technician profession, particularly in the following items: salary, prestige,
importance, nice to have profession, and career opportunities. The low perceptions
affected the image, namely the lower the perceptions, the lower the professional
image. This finding can be accounted for by the consolidation of the professional
identity. When individuals think that the profession is not prestigious and has a low
professional image, the public’s professional identity of the profession is less
consolidated (Kuzminsky, 2008). The empirical literature supports this finding.
Even approximately 20 years ago, when the professional identity of the profession
was examined, the findings showed that it was not consolidated and flexible.
In some countries around the world, the medical imaging technician
profession still has a problem of qualification and licensing. When there is no law
that regulates the licensing for this profession, this implies that any person can
work as a technician without formal training and qualification (Best Colleges
Organization, 2021; Couto et al., 2017). Studies that explored perceptions of a
medical profession, found that previous experience and exposure to the profession
improved the perception of the profession (Algoso et al., 2019). Reinforcing the
professional identity will improve the perception and the improved perception will
enhance the professional image. This will entail improvement of the supply on the
labor market.

6. SUMMARY
It is essential to note that the data of this research were collected only among
people who were at the stage of choosing a career. No other populations, e.g.,
people interested in making a career change, were investigated. Nevertheless, the
findings of this quantitative research indicated that the factors affecting a low
image of this profession were the low perceptions and awareness.
 Sarit H. Malul Markovich
224

It is important to understand what motivates people to choose the medical

imaging technician profession. The realization that the professional image is
affected by the perceptions and awareness at the stage of choosing this profession,
can facilitate the understanding of what should be improved and preserved in order
to increase the required supply of this profession, Hence, conducting this research
is highly important.
This research is only a first milestone on the way to identify the factors that
can improve the low supply on the labor market. It is, therefore, necessary to
conduct further studies that will investigate the reasons for the low supply in many
countries worldwide.

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ISSN-1843-763X
DOI: 10.47743/rebs-2024-1-0010

BANKING SERVICE RECOVERY STRATEGIES: ENHANCING

RELATIONSHIP QUALITY AND BEHAVIORAL INTENTIONS

ATTIA ABDELKADER ALIi

Abstract: This study investigates the influence of service recovery strategies (apologies,
explanations, and empathy) on customer relationship quality and repurchase intentions
within the Egyptian banking sector. Data was obtained from a large sample of 517
Egyptian bank customers who had previously experienced service failure through the
administration of an online survey questionnaire. The collected data was analysed using
SmartPLS 4 software, and the findings revealed a significant positive impact of service
recovery strategies such as apologies, explanations, and empathy on customer relationship
quality. Moreover, the results also emphasized the critical role of high relationship quality
in enhancing customers repurchase intentions. Consequently, these findings indicate the
importance of banking organizations systematically adopting service recovery strategies
and building strong customer relationships to maintain satisfaction and repurchase
intentions. Additionally, this research contributes to a deeper comprehension of the role
service recovery strategies play in customer relationship management within the Egyptian
banking industry.
Keywords Apology, Explanation, empathy, relationship quality, repurchase intentions, banking
sector, Egypt
JEL Classification: M31, G21

1. INTRODUCTION
Service failure is inevitable, and despite the precautions service providers
take to avoid it, they cannot prevent all service failures (Maxham, 2001). Financial
services, especially banks, are among the service firms experiencing intense
competition globally (Pereira Câmara Leal, de Oliveira and Feldman Soluri, 2003).
Consequently, financial services characteristics are easily duplicated in intense
competition (Gelbrich and Roschk, 2011). Therefore, financial service providers

i Alexandru Ioan Cuza University of Iasi, Iasi City, Romania, University of Alicante, Alicante City,
Spain, Aaaa16@[Link]

This work is licensed under a

Creative Commons Attribution-
NonCommercial-NoDerivatives 4.0
International License
 Attia Abdelkader Ali
228

must differentiate their services and establish their position with competitors by
offering value-added services. Hence, bank managers must adapt to evolving
consumer demands and guarantee the fulfillment of customers' expectations. A
service failure occurs when a company fails to deliver the services promised to
customers, where any form of failure, whether primary or complicated in the
banking services, may result in consumer losses (Singhal, Krishna and Lazarus,
2013). Banking managers may adopt suitable service recovery by analyzing the
dynamics of the link between customer behavior and service failure severity to
overcome some of the banking industry's major categorized causes that can
contribute to service failures, such as slow banking, bureaucracy, and ATM-related
problems such as a limited ATM network (Azemi et al., 2019). Service recovery is
a purposeful action made to handle issues and alter the negative perceptions of
dissatisfied consumers, improve their willingness to make future purchases, and
ultimately maintain their loyalty (Miller, Craighead and Karwan, 2000).
Consequently, service providers might gain advantages by addressing a service
failure in a manner that customers find gratifying (Najjar, Smith and Kettinger,
2010). According to Kim and Tang, (2016), service failure presents a genuine
opportunity for a firm to enhance the quality of customer relationships. Hence,
proficient service recovery is crucial in obtaining a competitive edge and has
emerged as a pivotal subject in enhancing connection quality (Michel, Bowen and
Johnston, 2009). Consequently, while there is a substantial body of study on
service strategies, comparatively little research has been undertaken on service-
oriented businesses like banking, particularly in recovery.
Moreover, there is still a continuous need to perform additional and
renewable scientific research in this area, specifically in sight of the increasing
growth of the services industry in the markets of various nations across the globe
and the ongoing improvements of marketing and customer service technologies
(Zhu, Sivakumar and Parasuraman, 2004). As a result, the current study focuses on
how banks can efficiently retain lasting connections with their customers in the
event of service failure. The essential aim of this study is to investigate the
influence of bank service recovery tactics on the quality of customers' relationships
(RQ) and their willingness to make future purchases (RI).

1.1. The effect of service recovery strategies on relationship quality (RQ).

According to Kim and Benbasat, (2006) the extent customers engage in
relationship marketing is influenced by multiple factors, not just the personal
connection between company and customers. Consequently, commitment, trust,
 Banking Service Recovery Strategies: Enhancing Relationship Quality and Behavioral Intentions
229
and satisfaction were considered crucial elements of RQ (Verma, Sharma and
Sheth, 2016). Therefore, despite occasional service failures, service recovery
significantly impacts the QR between consumers and service providers. Thus, it
instills confidence in customers that long-term service providers will deliver
advantages. Conversely, if a customer is dissatisfied with the company's remedial
actions, the customer-enterprise relationship may be terminated (Parasuraman,
Zeithaml and Berry, 2002). Hence, service recovery is a component of quality
management that aims to preserve a positive link among companies and customers
(Schweikhart, Strasser and Kennedy, 1993). Effective service recovery tactics, such
as offering apologies and showing empathy, may raise consumer satisfaction and
foster confidence in organizations. Additionally, providing compensated service
recovery can further improve customer satisfaction and strengthen the quality of
the customer-business connection (Chuang et al., 2012). Moreover, based on the
literature study, the attributes of contentment, trust, and commitment play a crucial
role in assessing relationship quality. Consequently, prior studies have shown that
certain service recovery elements directly influence recovery satisfaction, which is
regarded as a constituent of relationship quality (Kandulapati and Bellamkonda,
2014; Kandulapati and Bellamkonda, 2014). Consequently, the subsequent
hypothesis will be developed per the discussion above:
H1. Apology will positively influence RQ.
H2. Explanations will positively influence RQ.
H3. Empathy will positively influence RQ.

1.2. The relationship between relationship quality (RQ) and repurchase

intentions (RI).
RQ refers to how consumers perceive and assess how well a relationship
meets their needs, desires, expectations, and objectives (Kim and Cha, 2002).
Furthermore, a strong RQ indicates that the customer trusts the service provider's
capability to fulfill on commitments made in the past, which have been consistently
satisfied (Olavarría-Jaraba et al., 2018), consequently, higher levels of customer
confidence and affective commitment correlate with elevated relationship quality
standards. Thus, increased customer confidence and affective commitment levels
correlate with improved customer retention and behavioral intentions, generating a
more favorable WOM and repurchase intentions. Furthermore, (Olavarría-Jaraba et
al., 2018; Shirkhodaie and Rastgoo-deylami, 2016) discovered a strong correlation
between RQ and favorable WOM and RI. Additionally, (Nadiri, 2016; Garepasha
and Aali, 2020) indicates that RQ significantly impacts consumers' WOM
 Attia Abdelkader Ali
230

communication and propensity to repurchase. Similarly, RQ is a strong predictor of

RI and WOM in the banking sector (van Esterik-Plasmeijer and van Raaij, 2017).
As a result, this study hypothesized that RQ plays a crucial role in determining RI.
Based on these considerations, H4 is proposed:
H4. RQ will positively influence RI.

Apology
H1

H2 Relationship H4 Repurchase
Explanations quality (RQ) intentions (RI)
H3

Empathy

Figure 1. Conceptual study model

2. DATA COLLECTION AND METHODS

Data for this comprehensive and detailed study was collected from the Egyptian
banking industry through an online survey to explore and understand customers' views
and perceptions about their experiences with service failure and recovery from banking
failure situations. Therefore, to ensure that participants belonged to the target
population for the study, some screening questions were used to verify that participants
had active bank accounts and had experienced failures or service-related issues.
Moreover, data were collected from a large and diverse sample of 517 bank customers
who had encountered problems and mistakes while dealing with a banking institution
across diverse geographical regions throughout Egypt, ensuring a fair representation of
various backgrounds and experiences. Furthermore, the online survey collected
participant responses through an elaborate questionnaire that used the popular five-
point Likert scale," this allowed participants to clearly express how much they agreed
or disagreed with different statements related to the topic being studied. The survey
instrument employed in this study was constructed by adapting and integrating
established measurement scales derived from pertinent prior marketing literature. More
specifically, service recovery strategies such as offering apologies were measured using
(4) items from previous studies (Liao, 2007, Bradley and Sparks, 2012). Regarding the
explanations, they were assessed using four questions that were modified from (Liao,
2007, Boshoff, 2005). At the same time, (3) items were used to measure empathy,
derived from (Liao, 2007, Boshoff, 2005). Furthermore, (6) items were used to
 Banking Service Recovery Strategies: Enhancing Relationship Quality and Behavioral Intentions
231
measure relationship quality (Aurier and Siadou‐Martin, 2007 , Grégoire and Fisher,
2008). Finally, (6) items to measure repurchase intentions were adopted from studies
(Bacile et al., 2018). The survey used in this investigation had two primary portions.
The first segment comprised demographic information about the participants, including
age, gender, and educational attainment. Based on the overall characteristics of the
participants, the majority were young individuals with a high level of education. The
second segment had 22 paragraphs that addressed the primary factors of interest in the
research. The demographic analysis revealed vital attributes of the research
participants. Accordingly, 53.2% of the individuals in the sample were male, while
46.8% were female. The most numerous participants comprised those between the ages
of 21 and 30 (50.7%). This was followed by individuals aged 31 to 40, making up
27.7% of the population. Most participants (60.3%) have a bachelor's degree.
Moreover, most of them were employed on a full-time basis. Most participants had
a commendable educational background that met the poll's criteria. Table 1 presents
demographic data and offers comprehensive descriptive information on the
characteristics of the participants.
Table 1. participants Profile
(N=517)
Gender Frequency Percent
Male 275 53.2%
Female 242 46.8%
Age
18 - 20 24 4.6%
21 - 30 262 50.7%
31 - 40 143 27.7%
41 - 50 30 5.8%
51 - 60 27 5.2%
More than 60 31 6%
Education
Less than a high school diploma 9 1.7%
High school 51 9.9%
Bachelor’s degree 312 60.3%
Postgraduate degree 130 25.1%
Other 15 2.9%
Work statue
Full time 192 37.1%
Part-time 82 15.9%
Not employed and seeking employment 59 11.4%
Not employed and not seeking employment 10 1.9%
Student 79 15.3%
Retired 55 10.6%
Other 40 7.7%
 Attia Abdelkader Ali
232
Marital status
Single 246 47.6%
Married 210 40.6%
Divorced 32 6.2%
Widowed 23 4.4%
Other 6 1.2%

3. DATA ANALYSIS
The research utilized the PLS-SEM technique, implemented through the
Smart-PLS 4.0 software package, for data analysis, a well-recognized method for
evaluating path models with composites, mainly for theory testing. In the study's
comprehensive evaluation of the internal consistency and reliability of our
variables, we utilized both Cronbach's Alpha (CA) and Composite Reliability (CR),
adhering to the guidelines of (Hair Jr et al., 2021). Table 2 and figure (2) shows
that all variables exhibit strong CA and CR values, all exceeding 0.7, affirming
their robust internal consistency. Moreover, as indicated in Table 2, all items
significantly exceeded the factor loading threshold with loadings above 0.70, and
every construct also surpassed the AVE threshold, with values well over 0.50.
These findings confirm strong convergent validity (Hair et al., 2021). Furthermore,
the analysis employed the SRMR to measure model fit. The SRMR value of 0.051
suggested a good fit. Additionally, NFI, which assesses the model's fit, was found
to be 0.91. This NFI value indicated that the proposed model satisfied the
recommended threshold, further supporting its adequacy.

Figure 2. Measurement model assessment

 Banking Service Recovery Strategies: Enhancing Relationship Quality and Behavioral Intentions
233
Table 2. Assessment of measurement model

Variables Outer Cronbach's CR CR

Codes AVE
loadings α (rho_a) (rho_c) VIF
QR RQ 1 0.775 1.922
RQ 2 0.843 2.557
RQ 3 0.839 2.504
0.907 0.908 0.928 0.683
RQ 4 0.822 2.423
RQ 5 0.836 2.379
RQ 6 0.841 2.496
APO APO1 0.880 2.895
APO2 0.887 2.980
0.886 0.888 0.922 0.747
APO3 0.892 2.722
APO4 0.794 1.810
EMP EMP1 0.867 2.120
EMP2 0.900 0.871 0.876 0.920 0.794 2.371
EMP3 0.906 2.507
EXP EXP1 0.841 2.021
EXP2 0.828 1.971
0.868 0.870 0.910 0.716
EXP3 0.861 2.189
EXP4 0.855 2.175
RI RI1 0.853 2.489
RI2 0.867 2.699
RI3 0.897 0.927 0.928 0.945 0.775 3.716
RI4 0.893 3.233
RI5 0.892 3.576
Note: APO: Apology; EXP: Explanations; EMP: Empathy; RQ; relationship quality; RI: Repurchase
intentions

The Fornell-Larcker criterion was employed to establish discriminant

validity. This included the comparison of the square roots of the average variance
extracted (AVE) values (represented by the diagonal elements) against the
correlations between the constructs (the off-diagonal elements). The results of this
analysis are presented below in table 3.
Table 3. Discriminant validity using the Fornell-Larcker Criterion
APO EMP EXP RI RQ
APO 0.864
EMP 0.654 0.891
EXP 0.634 0.785 0.846
RI 0.561 0.719 0.704 0.881
RQ 0.598 0.768 0.728 0.869 0.826
Note: APO: Apology; EXP: Explanations; EMP: Empathy; RQ; relationship quality; RI: Repurchase
intentions
 Attia Abdelkader Ali
234

3.1. Structural model assessment

After a detailed examination of the measurement model, it focused on
evaluating collinearity in the structural model. Hence, this involved an extensive
analysis of key indicators such as the inner Variance Inflation Factor (VIF) and the
coefficient of determination (R2) values. Table 4 shows that all the established R2
and inner VIF thresholds were met, indicating no significant collinearity concerns.
Moreover, the relationships between the study variables have been tested and
showed that APO significantly positively affect RQ (β=0.106, T =2.087, p < .005),
which is mean H1 is supported. Besides, it’s evident that EXP positively influence
RQ (β=0.291, T =4.743, p < .005), which means that H2 is supported. On the hand,
EMP is significantly positively influence RQ (β= 0.470, T = 7.314, p < .005),
which is means that H3 is supported. Furthermore, the findings showed that RI
positively impacted by RQ (β= 0.869, T = 56.575, p < .005), thus H4 is supported

Figure 3. Assessment of structure model

Table 4. Results of hypothesis testing

Bath B T value P values

R2 VIF Remark
APO -> RQ 0.106 2.087 0.037 1.870 Supported*
EMP -> RQ 0.470 7.314 0.000 0.637 2.920 Supported*
EXP -> RQ 0.291 4.743 0.000 2.792 Supported*
RQ -> RI 0.869 56.575 0.000 0.755 1.000 Supported*
Source: Author's analysis *Relationships are significant at P < 0.05
 Banking Service Recovery Strategies: Enhancing Relationship Quality and Behavioral Intentions
235

4. DISCUSSION AND CONCLUSION

With the expansion of financial services, service failures have become
inevitable. These failures often include customer inquiries being sent to the wrong
recipients, insufficient provision of crucial transaction details, technological
malfunctions caused by financial specialists, and several other issues (Wang, Hsu
and Chih, 2014). Therefore, service managers must thoroughly understand how to
address and resolve such problems and design exceptionally efficient recovery
techniques. However, there is a lack of information about how banks deploy
service recovery measures and how these measures affect the quality of customer
relationships and behavioral intentions.
The main objective of the study is to investigate the link between service
recovery strategies, such as apology, explanations, and empathy, and parameters
such as the quality of the relationship and the desire to repurchase. In addition,
offer efficient and actionable suggestions to enhance the performance of the
Egyptian banking industry. The result showed that APO positively impacted RQ.
Therefore, data suggests that providing genuine and kind apologies to service
providers improves the overall quality of the customer relationship. An apology
demonstrates accountability, contrition, and a willingness to address a problem,
therefore mitigating the adverse consequences of a service failure, restoring
confidence, and fostering a positive customer relationship. Furthermore, when
service providers articulate the causes of service failure and their strategies for
managing it, it enables consumers to comprehend the situation and demonstrates a
dedication to resolving their issues. This, in turn, may cultivate a more robust and
long-lasting connection.
However, when consumers see that their thoughts and feelings are
recognized and confirmed, it may alleviate annoyance, establish emotional bonds,
and cultivate a sense of attentiveness and empathy from the service provider,
eventually improving the overall RQ. These findings consist of the findings of
(Honore Petnji Yaya, Marimon and Casadesus, 2013; Kandulapati and
Bellamkonda, 2014; Stratemeyer, Geringer and Canton, 2014) that concluded that
service recovery strategies will improve RQ. Moreover, the solid and meaningful
impact of RQ on RI validates the essential function of the RQ between consumers
and financial service providers in improving customer loyalty and retention and
boosting purchase intentions. Therefore, when consumers have a strong perception
of RQ, which includes trust, commitment, and contentment, they are more inclined
to maintain their relationship with the bank and are more likely to have a greater
 Attia Abdelkader Ali
236

desire to repurchase their services or products. These findings are like the findings
of (Sadachar, 2014; Park and Ha, 2016; Sharma, 2015).
In conclusion, service recovery techniques are essential for preserving strong
customer connections after service outages. Consequently, this research's findings
demonstrate that offering apologies, detailed explanations, and empathy has a
substantial beneficial effect on the quality of the connection with consumers.
Furthermore, the results showed the importance of maintaining high-quality
customer relationships linked to higher repurchase intentions. Therefore, it is vital
that banks systematically adopt service recovery strategies and train their
employees to handle service failures in a professional and empathetic manner.
Furthermore, it is important to prioritize the establishment of strong and enduring
client connections by demonstrating dedication, openness, and attentiveness to
their requirements. Hence, this will aid in preserving customers' contentment and
allegiance, bolstering the bank's enduring prosperity and profitability. There are
some constraints in the research. For instance, the study was carried out only inside
the Egyptian banking business, which might restrict the applicability of the results
to other industries or nations. Furthermore, the data was gathered using an internet-
based questionnaire, which might potentially introduce participant bias or provide
erroneous responses. In addition, the research only examined three primary service
recovery techniques (apologies, explanations, empathy) without considering the
possibility of additional unexplored strategies. Ultimately, the data was gathered
within a defined timeframe, perhaps failing to capture the evolving consumer
opinions and preferences shifts over an extended period. Although there are certain
limitations, this research offers valuable insights into the significance of service
recovery techniques and the quality of customer relationships in the banking
industry.

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