A REPORT FOR THE WORLD BANK
DRAFT
March 7, 1999
Peter Cowhey and Mikhail M. Klimenko
Graduate School of International Relations and Pacific Studies
UC San Diego
La Jolla, California 92093
Pcowhey@ucsd.edu
Mklimenko@ucsd.edu

A technological revolution, changes in the competitive structure of the world economy, and financial needs have prompted many countries to transform their policies for the telecommunications industry in the past fifteen years. Yet developing and transitional economies have also differed significantly in their approaches to competition and privatization, leading to great variety in the degree of competition, the regulations governing competition, and the approach to opening the domestic telecommunications market to the global telecommunications market.

Unsurprisingly, rapid change and significant diversity in policies produced an impetus for finding some new common ground in the global market. The International Telecommunications Union tried to provide such a framework, but its legacy as the institution tied to monopoly in phone markets proved too great of a burden. Moreover, it lacked the power to lay down definitive rules for a market where cross-border supply of telecommunications services and capital, the hallmarks of every other market in high technology, was now a critical issue. So, in 1997 the new framework emerged through the World Trade Organization Agreement on Basic Telecommunications Services. This agreement combined binding commitments on market access from its participants along with a statement of " pro-competitive regulatory principles" that have rapidly become the definition of the policy revolution underway in this market.

This study assesses how developing and transitional economies have fared in profiting from changes in the telecommunications market and which policy challenges still remain. It pays special attention to the global market and regulatory milieu fostered by the WTO Agreement of 1997.

This study asks what this latest transformation has taught us about wise management of this vital part of the infrastructure of the world’ s economy. It focuses on the economics of managing the transition to competition, the design of proper regulatory policies and processes, and the embedding of domestic telecommunications in the world market. It does so in three parts.

Part One examines the significance of changes in market expectations embodied in the WTO agreement and then analyzes the economic and institutional factors that are crucial for achieving a successful market transition. It argues that the speed of the transition will further accelerate. The latest technological innovations involving Internet Protocol networking are one reason. Moreover, the WTO agreement spells the doom of a slower two-track option for reform that would have increased competition in domestic telecommunications markets but moved much more slowly toward genuinely competitive supply and pricing in markets for international communications services.

Part Two analyzes the record of seven countries in Eastern Europe and South America in regards to the transition to competition. The countries cluster into two approaches to introducing competition. We examine the tradeoffs in the approaches, and we highlight how the individual cases illustrate the principles discussed in Part One. Perhaps most importantly, the cases show that, as the world market evolves, the most important questions are two-fold. The first is how fast a country will move to general competition, and the second is whether it will institute the regulatory measures necessary for competition to yield its full benefits. Establishing the right processes for regulation is almost as important as the policies adopted, although all the procedures in the world will not redeem a flawed competition policy.

In light of these findings Part Three suggests priorities for further policy reform. We conclude that the key fundamentals include an effective interconnection policy, reform of universal service policies, and the true privatization of the telecommunications market (a challenge going beyond stock offerings in the national phone company). The design of regulatory policies and institutions is absolutely critical. Making the institutions credible and effective has proven a major challenge. Making them flexible enough to respond to technological change and converging communications services is a growing challenge. And, perhaps most importantly, an effective rebalancing of the pricing structure for communications services is absolutely critical. Without pricing reform it is very hard to achieve a successful interconnection policy, efficient investment to build-out the network, and the full benefits of technological innovation for consumers.

Every country seriously introducing competition finds that the transition from monopoly to competition is both economically rewarding and laden with policy dilemmas.¹ Part One examines the fundamentals of this transition.

Section A reviews the agreement on basic telecommunications at the WTO as a way of understanding the fundamental changes in the world market and its regulation. This WTO pact changed more than just immediate practices on market access. It fundamentally changed expectations and norms about operation of the international market that will in turn change the economic options of even the countries that made no WTO commitments. Thus, it was not surprising that the framers of the WTO Agreement felt it necessary to lay out common principles that should guide the regulatory oversight of competition, and the transition to it. we lay out the logic of the transition problem (and also expand on why the transition is necessary). Section B then steps back from the WTO agreement, which is a framework for managing the introduction of competition, to examine the basic economics of the transition in greater detail. We emphasize five major choices concerning the economics of the transition. Section C analyzes the issue of market confidence in national regulatory practices, especially during a time of profound changes in regulation and market structure.

We have a fundamentally new world market for telecommunications at the close of the century. This development marks an ironic closing of a full policy circle in which the market has moved through various phases from initially competitive circumstances.² Only later did monopoly emerge, and with it came a form of collective amnesia that believed monopoly had always been the way of the industry.

It was only in 1984 that the United States forced the divestiture of AT&T and thereby created competition in its market for long distance services. The divestiture also liberalized the market for competition in telecommunications equipment. Only the United Kingdom and Japan followed the American lead on services initially while also introducing the possibility of competition in local phone services. However, both countries restricted the number of new entrants. Most other countries simply rejected the notion of competition in telephone services until Australia, New Zealand, and Canada gradually embraced competition in this area.

In October 1986, the World Trade Organization (then the GATT) launched the Uruguay Round that included, somewhat ambitiously, trade in services for the first time on the multilateral agenda.³ It quickly became evident that trade in telecommunications services would be defined only as trade in value-added services such as data networking.

During the Round (which was completed in December 1993) three developments changed the telecommunications industry. First, the digital technology revolution began to change the market fundamentally. Digital technology forced a major reexamination of the opportunity costs of protecting traditional telecommunications equipment and service suppliers.⁴ An inefficient market for telecommunications threatened competitiveness in the computer, software and information industry markets. For example, after experimenting with limited competition in data and mobile communications through the early 1990s the members of the European Union concluded that monopoly control of the public telephone network would always discourage realistic pricing and provision of the infrastructure for information services and equipment. Second, after suffering the dislocations created by global stagflation through the early 1980s reforms in the economic policies of developing countries stimulated interest in privatization of state enterprises as a tool of economic reform. State telephone companies were particularly promising targets for privatization. Once privatization became a serious option these countries also explored other options for allowing selective competition. Third, even as competition began in the major industrial countries, their phone companies looked to foreign markets to create new business opportunities. Yet all phone companies faced major limits on foreign market access, and once in a foreign market they confronted serious regulatory uncertainties about how they would be treated. This was not simply a case of industrial countries pressing developing countries. Suspicion among industrial countries ran equally deep. Thus, just as the Uruguay Round closed in 1993, Europe and the United States warily approached the idea of expanding trade agreements to cover basic telecommunications services. Suddenly, dismantling traditional monopolies for telephone services (or basic services in the language of trade talks) had become a high profile test for the world trade system.

It is fair to say that most countries were skeptical or indifferent to the reopening of trade negotiations on telecom services as an extension of the Uruguay Round in 1994. But, to paraphrase the title of a classic Broadway musical, "a funny thing happened on the way to the trade forum." The success of neo-liberal economic reforms in Asia and South America had put even the most politically untouchable forms of monopoly up for reexamination in the mid-1990s. And the soaring U.S. economy, symbolized by its resurgent information industry, led all major countries to believe that a profound globalization of the information industry was both inevitable and a driving force for national economic growth.

The major industrial countries were impatient to secure their mutual rights to market access in telecommunications services, and the WTO was a convenient forum for achieving this goal. However, the multilateral features of the WTO (particularly the Most Favored Nation and National Treatment obligations) meant that mutual opening among OECD countries automatically conferred benefits on developing countries. The industrial countries realized that the issue of securing competition and open markets in basic telecommunications services in developing countries had to be faced immediately, or they would lose a trade deal among OECD nations for fear of forsaking later trade leverage for telecom reforms in developing countries. Thus, the fate of the WTO telecom talks became joined to the spread of competition in basic telecommunications services to developing countries.⁵

The trade talks could not have forced the developing countries to adopt an unacceptable reform. But the political effort generated by the negotiations induced leaders among the newly industrializing countries to make deeper and faster market changes that were irrevocable due to binding trade commitments. The timing was right because national governments in trade-oriented economies were putting regulatory reforms and introduction of competition in telecommunications sector high on their policy agendas. Increased volume of trade and factor mobility at both regional and global levels has intensified reliance of business users and households on telecommunications services. Households are demanding even more sophisticated services at lower prices. Commercial enterprises are getting increasingly concerned about the competitive effects of poor quality. Moreover, the pricing and flexibility of telecommunications services are becoming a larger factor in production. But, traditional state-owned monopoly suppliers largely have failed to provide low-cost, efficient, or even widely available services in many countries.

A number of empirical studies have found that investment in telecommunications infrastructure is a strong predictor of economic growth.⁶ This suggests that in order to accelerate economic development countries need to create policy environments conducive to a high level of investments in the telecommunications sector. Therefore countries which are in dire need of investments want assurances that operating surpluses from profitable segments of the telecommunications industry are transferred to network upgrades and expansions. Fortunately, competition tends to modify the trend followed by traditional monopolies of spending the surplus on vested interests without significant modernization. The number of local exchange lines in the Philippines doubled, for example, within three years after allowing competitive entry.⁷

WTO negotiations on basic telecommunications offered an instrument for consolidating and promoting liberalization of competition and trade in telecom services by making legally binding commitments on future liberalization plans. As far as regulatory reform in telecommunications is concerned, this definitely enhanced the ability of national regulators to convince markets that reforms in their countries were unlikely to be reversed.

While some governments used the WTO Agreement on Basic Telecommunications to accelerate policy reforms and make binding international commitments to future liberalization of basic telecommunications, other governments only bound the existing policy regimes or even took commitments representing less liberal market-access conditions than those that actually existed in practice. However, even if a government couldn't sustain the existing levels of liberalization for political reasons and took commitments binding at below status quo policy regime, such commitments were still valuable. For example, commitments binding at less than the current limit on equity to any foreign investor, will be "ratcheted up" after they enter into force because of the MFN principle. Using the MFN clause any new entrant from one country could demand the same level of equity participation as that granted to a supplier from another country.⁸

The three Central and Eastern European countries and four Latin American countries reviewed in this paper made commitments that bound the status quo in policy terms and/or promised future liberalization with respect to certain aspects of their regimes which was not planned prior to negotiations.

A major achievement of the negotiation was the creation of the "Reference Paper" on pro-competitive regulatory principles that was accepted by 60 of the 69 countries making binding offers on market access.⁹ The Reference Paper sprang from two motivations. The first was a sense that the negotiation was an opportunity to create a firm set of common understandings of how competition, or a transition to competition, must be governed. The principles are sufficiently broad to allow for diverse rules and practices, but sufficiently specific to hold governments accountable for fundamentals of market-oriented regulation. The second, and more immediate, motivation was distrust of any market access commitment that was not backed up by enforceable rights in regard to the "invisible" barriers to competition and market access. A government’s commitments to free trade can be inadequate to guarantee real market access for foreign suppliers of services because of the very high levels of concentration in the basic telecommunications sector. Monopolistic suppliers could frustrate competition from new foreign entrants in a many ways despite trade liberalization commitments.

Differences in the ways countries choose to regulate their monopolies may also inhibit free trade. Such elements of national regulatory environment as universal service obligations, terms of interconnection, licensing criteria, and procedures of regulators can create important indirect barriers to trade. Therefore regulatory reform is a more prominent component in services trade liberalization than in the case of trade in goods. That was the reason to include explicit regulatory principles in the agreement.¹⁰ Most remarkably, the parties could agree on what constituted the heart of pro-competitive regulation in the market. The government’s obligations to create effective interconnection rules plus the need to separate the regulator from the operator are at the core of the principles.¹¹ (See Box One on the next page.)

The WTO agreement has a significance that goes beyond the specific commitments.¹² Examining the share of the global market controlled by the agreement is one way to understand its significance. Sixty-seven governments made significant liberalization commitments. These numbers do not fully capture the market impact of the agreement. The United States Government, for example, calculated that approximately eighty-five percent of the world market, measured by revenues, was covered by strong market access commitments in the negotiations. With a few specific exceptions on particular issues or market segments all the OECD nations essentially were bound to unconditional market access on January 1, 1998. And a review of the major industrializing countries shows very significant commitments on market access that increased very rapidly over a period of a few years (typically after transition periods ranging from two to five years).

There simply cannot be a fundamentally new way of doing business, including regulating business, in eighty-five percent of the world market that does not spill over to the rest of the global market. And, for reasons spelled out later, the changes embodied in the WTO pact are going to accelerate as the convergence of communications services grows.

A second way to understand the agreement’s significance is to view it as a fundamental change in the "international regime." The concept of a "regime" captures the principles, norms and rules expected of participants in regard to a major field of governance in the world economy. In other words, it captures expectations about how the market and governments will interact that go beyond strict legal agreements.¹³ Precisely because of its potential to change fundamental expectations officials at the International Telecommunications Union were once highly skeptical of any WTO undertaking any negotiation on basic telecommunications services. They rightly saw it as a challenge to the traditional regime, premised on monopoly for phone services and limited competition for data services, long serviced by the ITU.¹⁴

A change in the international telecommunications regime has three major implications. First, for countries that are not yet members of the WTO, the terms of the WTO telecommunications agreement will influence the terms for their accession to the WTO. Their minimum commitments on telecommunications will have to be significant. Second, the agreement has changed the expectations of all economic agents, including governments. Countries with less regulatory transparency and little competition will be deemed by markets to be riskier simply because markets do not deem the continuation of traditional telecommunications practices to be sustainable. Moreover, any dominant set of regulatory arrangements creates its own set of supportive political coalitions. So, we can expect the WTO agreement will create interest coalitions in many important countries that will promote further market opening in countries not yet firmly rooted in telecommunications competition. These coalitions will use trade negotiations, transnational political lobbying, and market activities to expand the realm of competition.¹⁵ Third, the WTO agreement has accelerated the growth of new global carriers for communications services and new forms of cross-border information services using innovative technology. This last point requires special consideration because it shows how a new international regime changes options for domestic markets. The WTO agreement’s strong coverage of the industrial and industrializing countries made it easier to conceive and execute new ways to provide services on a global basis. As discussed in Section B, the result is a surge of new entrants with innovative business models and new technological approaches. These are reshaping the economics of the market for services between countries and the market within countries.

The WTO Agreement is a template for changing the telecommunications market. It does not contemplate a uniform set of national practices, but it does bind countries to common principles of governance. For developing and transitional economies it is a blueprint for transition. To understand how it can play out in these countries it is essential to examine some basic economic principles about the market. The shift in the policy consensus in favor of open competition does not change the significance of the principles. Rather, it underscores their importance for figuring out how to best manage the transition to competition.

The First Principle: Telecommunications networks have special cost characteristics. This principle is both fundamental and easily abused in its application to policy debates. A correct analysis of telecommunications networks has to begin by recognizing that, in theory, there is a potential for natural monopoly. Large sunk non-redeployable costs incurred by network operators imply that these firms may have declining long-run average cost schedule.¹⁶ Such a form of the cost schedule will result in natural monopoly in those segments of the industries in which the minimum optimal scale of production is large relative to the market demand.

In practice, both technology and the incentives for inefficiency in monopoly organizations (discussed in the second policy principle) make the policy case for granting a monopoly for any length of time quite weak. For example, long-distance networks based on microwave technology can achieve minimum efficient scale at relatively low traffic volumes.¹⁷ Until recently microwave radio was the primary technology employed to transmit long-distance messages (especially by new entrants to the market) whereas wireline technology was the only means of connecting customers to the local networks. This was one reason why many countries had several competitive long-distance operators while the local service was still supplied by a monopoly. However, technology options change and so do relative cost structures. For example, fiber optics (which require high volume utilization in order to achieve operational efficiency) began to replace microwave radio in long-distance networks even while local operators began to deploy cellular and personal communications service technologies. (Fiber-optic technology is characterized by declining long-run average costs and has a relatively large, minimum efficient scale of operation which in itself can be conducive to the emergence of a dominant network operator.)

A major element of the sunk cost of building a long-distance network is the cost of obtaining the rights-of-way. In many countries there are potential entrants into long-distance network provision who don’t have to bear this part of the sunk costs. Therefore, they can credibly contest the long-distance market. For example, rail and electric utilities can lay fiber-optic cable along rail tracks or electricity transmission lines. Moreover, a boom in demand suggests that many more operators may command the minimum scales of operation necessary to operate fiber networks efficiently than once thought. The sources of soaring demand include the elasticity effects of a decline of telecommunications prices, the traffic volumes created by build-out of voice networks in developing countries, and the emergence of huge volumes of data traffic on the Internet. Ironically, at the same time, the low, minimum efficient scale of the technology employed by local mobile networks reduces barriers to entry leading to more intense competition among local operators.

While the technology and economics of telecommunications networks are the same everywhere in their fundamentals, local conditions matter for some policy distinctions. For example, the spatial distribution of potential subscribers is an important factor of telecommunications infrastructure deployment. High spatial concentration is particularly favourable because it allows the utilisation of the economies of density and scope resulting in lower costs of operating telecommunications networks in concentrated urban areas. Telecommunications services in low-density areas have also traditionally been cross-subsidised by more profitable telecommunications services in concentrated urban areas. Therefore, a relatively uneven demographic landscape with large population concentration in a few select areas could also facilitate the penetration of telecommunications networks in sparsely populated rural areas.

To illustrate the point, the subscriber demographics in Central and Eastern European Countries are in many instances different from the demographics in Western countries. In some countries of the region, more than 90 per cent of the households are in blocks with five or more living units. This may justify the adoption of technologies (such as fiber-optic cables), which would be uneconomic in low density areas. Hoski (1998a) conducted an empirical study of telecommunications infrastructure development on a sample of 80 countries -- 23 OECD countries and 57 non-OECD countries -- during the period of 1990 to 1995.¹⁸ Hoski found that the concentration of population is the largest cities is positively and statistically significantly related to the penetration rates of mobile telephones.

The second principle: The difficulties of regulating monopolies make competition attractive even in cases where network build-out is a priority. More specifically:

2A) Even a high minimum, efficient scale of operation for major network facilities doesn’t necessarily justify monopoly on a national scale.

2B) The regulation of monopoly is imperfect and costly.

The example of Argentina with two regional monopolies suggests that a single firm doesn't have to operate local networks nationwide, even assuming the condition of decreasing average cost. Even more critically, many important assets in the telecommunications market do not fit the cost model of transmission systems. For example, as competition emerges, costs and other efficiencies in regard to marketing, billing, and switching systems (to name just three items) become very significant elements in the competitiveness of carriers.¹⁹

Perhaps most importantly, market competition may create cost savings and innovations in pricing and performance that a simple emphasis on static scale economies does not capture. For example, competition between two local network operators with declining long-run average cost curves may result in a downward shift of these curves generating efficiency gains which outweigh the loss of scale economies caused by the moves up along the cost curves. Moreover, as Oliver Williamson has made clear, a significant part of the cost structure of any firm is transaction costs.²⁰ Frequently, competition will induce major reductions in transaction costs that more than offset any losses on scale economies. Finally, in markets characterized by pricing that is only vaguely associated with efficient costing it may not matter whether new entrants can match the lowest theoretical costs of incumbents. There may still be substantial welfare gains from pricing and service innovations by the entrants.

Regulation of a monopolist is hard to accomplish, and regulation of limited competition often leads to costly market distortion. As a more realistic understanding of these points has emerged, it has swung the policy balance in favor of greater reliance on competition. Regulation has become more focused on interventions in markets designed to foster the transition to competition and to deal with residual market failures that competition may not be able to correct.

Potential market failures in unregulated industries based on technologies exhibiting scale economies have to be compared with potential regulatory failure when the government tries to regulate natural monopoly. Although regulation of imperfectly competitive industries is not entirely costless, these costs are lower when regulators can deal with several competitors in an oligopolistic market than a monopolist. For one thing, oligopolistic competition yields important economic information for regulators. For another, the presence of some competitive constraints means regulators have options other than relying on micro-management of carrier costs and revenues.

Recognizing the limits on effective regulation of a monopolist forces a reconsideration of the policy consequences of even the strongest claims on behalf of the potential for a natural monopoly in telecommunications. Suppose that it is not easy to determine whether the cost structure of a network operator is such that substantial scale economies will allow it to become a monopolist. In this case, allowing one operator to emerge as a monopolist under the conditions of free entry will still be the best way to determine if the scale economies were really important. Even if policy makers decide that the presence of scale economies warrants running a telecommunications network as a natural monopoly for some transitional period, the best way to choose the right operator for such network is through competition for the right to become a natural monopoly.²¹

More commonly, countries have delayed liberalization until a pre-specified date in the future as a way to stimulate higher investments in the telecommunications industry. For a policy-maker who adopts such strategy it is important to determine the length of delay and whether it should be exogenous or endogenous to the performance of incumbent monopolist.²² It is especially important to have a shorter schedule for transition because very long periods encourage entrenchment of rent seeking political coalitions tied to the monopoly.

The Third Principle: Interconnection policy is the bedrock for regulating the transition to competition. From the policy viewpoint new entrants may have operations with some cost and operational advantages but also have cost and operational disadvantages on some indispensable network functions. The most glaring example of such a disadvantage is the high cost and severe logistical difficulties of deploying local transmission systems to the end customer. Even if the new entrant could eventually deploy a separate delivery system, it may be impractical to do so in the medium-term. Ordinarily, one might expect that the entrant would then pay the incumbent a fee sufficient to rent the use of this capability, but the incumbent may find it strategically more advantageous to use its control of the "essential" facility to deny access to the customers to its rivals. This classic issue of antitrust policy is also the critical issue for interconnection policy, and it is fundamental to the WTO regulatory principles.

Interconnection policy addresses the terms and conditions for the use of essential facilities of incumbent carriers by new entrants. Properly understood, the policy requires incumbents with essential facilities to share these network economies on economically efficient terms with new entrants. One would not bother with interconnection if all costs and efficiencies of new entrants were genuinely higher than incumbents. But, as we have just noted, this is not the case. So, to gain the benefits of attractive new efficiencies offered by competitive entry it is necessary to devise rules to handle sharing the network costs of some facilities that may temporarily or permanently not yield easy duplication.

In addition to pricing rules, a credible interconnection policy insures that non-price discrimination does not hamper entry. For example, new entrants need reasonable flexibility in choosing among the network features obtained from a dominant carrier. The entrants should not have to use facilities that they can better provide for themselves simply because they need access to a single feature of the incumbent’s network. Therefore, unbundling rules are a vital part of interconnection policy. In addition, interconnection policies have to address all the major barriers to entry. For example, customers do not want to change phone numbers in order to switch carrier services. Therefore, a lack of local number portability will result in customer inertia.

One common misunderstanding of interconnection policy involves the calculation of costs for interconnection. The fundamental premise of a sound policy is that costs for telecommunications facilities should be analyzed no differently than the costs for an automobile plant or a natural gas pipeline. Therefore, it is not surprising that precisely the same disagreement about the calculation of costs arises in regard to telecommunications as happens in every other competitive market. The heart of the argument is this. The owners of a natural gas pipeline naturally want to calculate costs based on embedded costs (the costs incurred in building the pipeline as they appear on the corporate books) plus a competitive return on their capital investment. But economists agree that this is the wrong measure of cost in an efficient competitive market. The right measure looks forward, not backwards, at costs.

In a competitive market, a supplier will offer a product up to the marginal cost of replacing the plant efficiently (including the cost of capital and the profit necessary to raise capital).²³ This cost calculation does not reward the incumbent with essential facilities for past cost inefficiencies, just as a competitive market forced IBM in the late 1980s to price in response to new entrants in the markets for personal computers who had lower costs than did IBM. Writing off losses on older, expensive plants and pricing in line with newer and cheaper production facilities is common in dynamic markets, and it is one of the principal benefits of competition for the economy as a whole and consumers in particular. Allowing incumbents to charge for embedded costs from the days of monopoly simply inflates the costs of future networks deployed by new entrants, and it is not necessary to assure future investment and profits for the incumbent.

The fourth principle: Network externality effects are extremely important. Simply stated, networks are more valuable if there are more people utilizing them. Network externalities are especially important for consideration of interconnection and universal service policies.

The network externality is an additional reason for creating interconnection rules. A new entrant operating a smaller network has no chance of attracting customers unless it could interconnect them to the existing larger network. This is obviously true for phone services. But it also has manifested itself in data networking. One reason for the rapid rise of the Internet was the simplicity of using its protocols to interconnect a wide variety of data networks. And, as networks become interconnected, they became more attractive to users.

In developing and transitional economies where teledensities are rather low, the network externality effect may be very pronounced. This means that the marginal social welfare benefit of adding new subscribers to the relatively small network may be large. This may justify subsidization of access to the network for additional users.

In short, a subsidy for universal service is more than altruism, it enhances economic welfare. Advocates of competitive markets should not ignore this point.²⁴ Moreover, the point may also apply as much to extending connections to the Internet as to plain old telephone services. Nonetheless, universal service funding is costly, and an appropriate cost-benefit analysis for each major increment of funding is essential.

The imperfections of prevailing policies for universal service create major challenges for competition policy. The introduction of competition weakens the sustainability of traditional means of subsidizing universal service. For example, suppose that geographic averaging of prices by the dominant carrier is a vital mechanism for cross-subsidy. The carrier is, in effect, making more money on urban customers and less on rural customers (presumably it is losing money on the rural service). The sum of the revenues, however, allows adequate returns. Competition will undermine this approach because new entrants may well target urban areas initially. Lost revenues in the cities would undercut the pool of funds for covering costs in rural areas. Similarly, many countries charge very low rates for local service even after years of rate rebalancing. Korea, for example, charges less than ten dollars per month for household service. These rates discourage new entrants from targeting local service for service and network build-out. At the same time, they redirect entry towards the long distance market where prices are inflated in order to cover shortfalls on local services. And, even if a new form of subsidy is found for the dominant carrier’s provision of universal service, there is little assurance that the subsidy is competitively neutral in its effect. Universal service funding may inadvertently block competition, especially in rural areas. For all these reasons, the introduction of competition usually prompts the need to rebalance rates in a country and reconsider the method of assigning subsidies to carriers.

Fifth Principle: Rate rebalancing and openness to new technologies are critical for successful market transitions. We group together the issues of rebalancing rates and technological change for convenience’s sake. In practice, new technological options for communications services invariably subvert existing rate structures. And, as a result, many governments end up, intentionally or not, slowing the rate of technological innovation in order to finesse necessary changes in rates charged for telecommunications services. In general, the biggest rebalancing challenges in all countries are the need to raise the price for local phone service while lowering the rates for long distance (including international) and data-related services. Almost as big is the need to differentiate among the rates charges for local services. As long as governments maintain the same prices for local services in urban areas as in rural areas, for example, they will distort the market for telecommunications services and investment. This is not only costly to economic efficiency, it is unnecessary to achieve the policy objective of promoting universal access to communications services.

Simply put, prices (rates) give cues to producers and consumers. They tell investors and suppliers where to invest their money, even if they are monopolies. They tell suppliers what their cost structures must look like. They give consumers incentives to use more or less of a service. For the economy as a whole, they are vital for the efficient allocation of resources.

In most countries with limited competition rates bear little relations to costs. As the discussion of universal service just noted, a major cause for under-building of the local telephone network is the decision to charge rates that do not cover its costs. A principal reason why small international businesses in developing countries have problems in an "information age" economy is that they pay too much for international communications services, and monopolists have few incentives to look for innovative service packages for them. New service options might open the way to allowing the business to bypass inflated rates for the standard menu of services.

The WTO Agreement is proving to be a dramatic catalyst for rate rebalancing and technological innovation.²⁵ It shuts down the path that allows incumbent carriers to collect high monopoly profits from international services while facing growing competition in the domestic market. This in itself will force major rebalancing of rates and, eventually, create incentives to embrace new services and technologies that will work on the principle of taking much lower margins but creating much higher volumes of business. Understanding the significance of this change requires a brief foray into the obscure terminology and market arrangements that have traditionally organized the market for international telecommunications services.

The old international telecom regime favored the "joint supply" of international phone services using accounting rates.²⁶ Each carrier theoretically contributes half of the international phone (or fax) service (for example, taking the international call from a hypothetical mid-point in the ocean and terminating the call to a local household in its country). This meant also that, as a presumption, the supply of an international call should depend on each national carrier providing half of the facilities for the call. For contributing this capability the national carrier is entitled to a fee usually equivalent to half of the accounting rate. This is the "settlement rate". (We shall refer only to the settlement rate because it is the economically relevant concept.)

The settlement rate is not the end price to consumers; national carriers can, and do, further mark up the price for originating an international call. But the costs created by settlement rates influence the minimum price possible for the service. The key cost is the net settlement payment. A simple example can explain the concept. Suppose the U.S. sends ten minutes of calls to Mongolia at a settlement rate of one dollar per minute and Mongolia sends the U.S. a total of five minutes of calls at this rate. Then, the net settlement payment from the U.S. to Mongolia in this period is five dollars. The U.S. carrier must recover this five dollar payment from its own customers, a significant cost element in its pricing decision.

It was the nature of jointly provided services that one party could block production of the service. Given the problems with pricing in most developing countries there was a huge pressure to cover shortfalls on local services by inflating rates for international services. And it was particularly attractive to extract rents from industrial countries’ carriers by inflating settlement rates. Moreover, in the era of monopoly relying primarily on national public financing to build the network, profits from settlement rates were an important source of convertible currency to finance purchases of foreign telecommunications equipment.²⁷

The idea of joint supply by two national carriers under a settlement rate seemed logical in a world of national monopolies. But it was never economically necessary and, as competition emerged in some countries, it worked against, for example, the provision of end-to-end international services based on market costs by competitive carriers. Joint supply was an anachronism in a world economy where companies run sophisticated global production and distribution networks. Multinational firms choose to make or lease production or distribution capacity in running global operations in order to optimize costs, speed of innovation, and other market relevant criteria. However, outdated regulations determine how to produce and cost international services, an issue that was bound from the start to bring telecom regulations under intense pressure.²⁸

As a consequence of regulatory inefficiency, there is a very significant international dispute over how the system of settlement rate fees and the tradition of jointly provided services will change.²⁹ In theory, the WTO agreement did not demand radical changes in these practices. But, in fact, the ability to enter markets freely across national borders and to own and lease facilities for services on nondiscriminatory terms forced a rethinking of traditional practices.

At a minimum, carriers in competitive industrial markets who wanted to move traffic under the traditional system of jointly provided services had to get the settlement rates down to levels closer to the costs of owning and running a global network on their own. As a result, settlement rates among industrial countries have plummeted since the WTO agreement. Both the United States and the European Union have also adopted regulations designed to dispense with settlement rates for a large amount of international traffic. And the rapid changes in these rates have opened up very large numbers of opportunity for arbitrage in the delivery of traffic to developing countries.³⁰

In short, the world trade agreement accelerated changes that are radically changing pricing and supply options for the world market. Even developing countries with no commitments on telecommunications services at the WTO will face significantly different market economics and politics as a result of this change in the global regime.

Yet even this array of options only begins to capture the import of the digital packet network organized around Internet Protocols (IP networking). The revolution in pricing and supply of global services is only beginning. While all forecasts are suspect, most experts would agree that the following predictions capture the contours of the changes being accelerated by IP networking. McKinsey and Company estimated that global fax, voice telephone, and virtual private networking services over IP networks in 1997 amounted to about $2.2 billion, and total global real time multi-site videoconferencing services amounted to about $3.6 billion. IDC projects that those sums will rise to about $50.6 billion and $19.7 billion, respectively, in 2001. Virtual VPNs on IP networks will be worth about $25 billion of those totals, and much of the increase in real time video conferencing will be on IP networks. In comparison, the global telecom market in 1997 was about $600 billion.³¹

Another way of understanding the transformation is to look at the growth rates for voice and data in key markets. In the bellweather U.S. market the latest estimates suggest that the transmission capacity dedicated to long distance data will exceed that for voice somewhere around 2001. Revolutions in both fiber optic transmission capacity and in the price-performance measures for packet switches and routers are further speeding up the changes. One expert believes that router based switches for IP networks will double their price-performance ratios every 20 months, almost double the rate of progress for ATM switches (which were significantly better than traditional central office switches).³²

Every estimate shows that surging increases in the volume of packet switched traffic will also lead to far higher volumes of data than traditional voice and fax traffic on most international routes. The growth of electronic commerce over the Internet is causing transoceanic transmission of data to grow at rates of over 90 percent per year. Moreover, such businesses as "video chat rooms" on the Internet defy traditional distinctions in telecommunications and broadcast regulation. And worldwide use of the Web for commerce will explode. IDC Research expects buyers on the Web will grow from 18 million in 1997 to over 320 million by 2002. The volume of purchases will rise to over $400 billion by 2002, a compound annual growth rate of 103 percent annually from 1997.³³

Further propelling this change is the revolution in cross-border production networks that cover everything from agriculture through textiles and advanced computing equipment. As Francois Bar and Michael Borrus have shown, a fundamental change in international production has occurred because power, cost efficient networks for computing and communications have allowed whole new ways of coordinating work across national borders. Just in time production and delivery, including real-time changes in engineering, are possible on a coordinated basis across several countries. Rapid changes in pricing and inventory decisions are equally feasible. And, just as importantly, these changes are spreading. Even less powerful networks can, for example, tremendously assist African farmers in getting more timely and accurate information from urban markets. This allows them to pursue more cost-effective strategies while being less at the mercy of middlemen in the market.

The growth of cross-border production networks has a powerful political and economic effect on the telecommunications markets. Even large producers of telecommunications equipment, who once opposed competition in telecommunications services, now run cross-border production systems. As a result, they now view competition in the provision of telecommunications services favorably. The same will certainly happen to all the specialized manufacturers of information technology equipment throughout Asia and South America.

In summary, a change in the global market for cross-border communications services will further speed up changes in the communications market domestically. Rate rebalancing will have to occur. While this often leads to short term discomfort as, for example, prices for local phone services rise, rebalancing also makes it easier to manage the other economic fundamentals of this market transition, like building out local networks more quickly and faster adoption of new technologies (and thus better and less expensive services). The five principles discussed in Section B. explain much of the policy discussion over the future of telecommunications market policies.

Regulators in developed countries have attempted to eliminate the regulated firm's ability to exercise undue market power and ensuring that the services are supplied at minimum cost. This has led to the embrace of general network competition in all OECD nations. By contrast, countries with underdeveloped networks give priority to creating an environment that will stimulate investments into expansion and modernization of the telecommunications industry. However, this priority has similarly led to the growing introduction of competition. Competition is a tool to stimulate the total amount of investment and induce more efficient costs.

The major problem in non-OECD economies is the management of the transition away from limited competition while assuring access to needed investment and technology to expand service rapidly. Countries only hurt themselves if they do not create marketplace confidence in the fairness and effectiveness of the regulations guiding the change to competition. In effect, the risk premium assigned to any investment in the country rises, and the country pays more for technology and capital. Even more critically, many of the most innovative entrants in the global market may simply decline to enter. Therefore, this section pays special attention to the challenge of creating a transition that instills confidence in the market. In the case of developing economies there is the added burden of the absence of a long tradition of credible institutions for balancing property rights, the need for government interventions in markets, and consultation with relevant economic actors.³⁴

Until very recently the phone company was typically owned by the government, and the phone company effectively set the government policies governing entry and conduct in the market. Many countries have privatized the operator to some degree and increased the amount of competition. But this has created its own challenges. First, the government has to create confidence in the new regulatory system’s effective ability to oversee competition. Second, to build market confidence the government ideally should lay down stable rules governing the market transition. But due to a combination of inexperience, rapidly changing global conditions, and the difficulties of forging a political consensus on optimal policies the initial government plan for reform may be seriously lacking in more than one respect. The issue is raised in the next section of how to revise the plan without hurting investor confidence.

Network operation that needs a large degree of highly-specific sunk investment into non-redeployable assets is very vulnerable to a 'regulatory taking', i.e., expropriation through ex post changes of regulatory policy. In the practice of utilities regulation in Western countries this problem is often discussed in the context of 'stranded costs', i.e., the costs which utilities companies would not be able to recover as market structure moves from natural monopoly to open competition.35 Therefore regulators’ ability to commit to a certain reward structure for a regulated firm is essential to the creation of proper investment incentives in telecommunications. When a regulator's commitment ability is lacking or is not credible, the regulated firms limit the scale of their investments into network equipment and the size of the bids for operating licenses. Alternatively, the investors may demand much higher prices or higher rate of return on capital to compensate for the risk.

Institutional credibility is important to achieve, but the very factors that create or strengthen credibility may slow pro-competitive reforms over time. This discussion explains why the very measures designed to enhance credibility may work against an efficient policy over the medium term.

Several factors determine the regulator's commitment ability. The duration of regulators' office terms is limited. Successive regulators may be affiliated with different political parties. Rules imposed by local regulators may sometimes be superseded by rules imposed by central regulators. Regulatory rules may affect many diverse special interest groups that have different ideas of what constitutes fair regulation. Depending on the political power of these groups and their ability to affect regulation, the rules that seemed fair at one point of time may be perceived as unfair at a later point and the regulator may be subject to strong pressure to alter the rules.

Levy and Spiller studied the impact of national institutional endowment on the credibility and effectiveness of a regulatory framework, leading to facilitation of private investment, in the telecommunications industry in five countries: Argentina, Chile, Jamaica, the Philippines, and the United Kingdom.³⁶ They compare key political and social institutions in five countries and conclude that private investment in telecommunications infrastructures can be generated in a wide range of regulatory regimes, as long as countries are endowed with three restraining mechanisms that keep administrative arbitrariness under control. These necessary mechanisms are: (1) substantive restraints on the discretion of the regulator; (2) informal or formal constraints on changing the regulatory system; and (3) institutions that enforce the above formal, substantive and procedural, constraints.

Levy and Spiller note that no unique institutional endowment is necessary to provide these crucial mechanisms. However, utility regulation is far more credible and regulatory problems less severe in countries with political systems that constrain executive and legislative discretion and have a strong judiciary to limit administrative discretion. Such political systems should include separation of powers between branches of government, a written constitution limiting legislative and executive power, a legislative branch with more than one house, and checks and balances between legislative and executive powers. A strong judiciary is characterized by a tradition of upholding contracts and property rights, including enforceable regulatory contracts. Concession contracts (e.g., licenses or permits) enforced by an independent judiciary is the best way to organize credible regulatory commitment.

Countries with poor institutional endowments, like Central and Eastern European countries (CEECs), can import regulatory credibility from overseas. These countries can reinforce the credibility of their local regulators by either recognizing the jurisdiction of foreign courts over certain contracts between local regulators and private investors (like in Jamaica) or by signing international treaties protecting foreign investments (like Philippines). The credibility of regulatory agencies in CEECs have been greatly enhanced after the governments of these countries entered into the agreements with the EU governments on harmonization of their national regulatory environments in preparation for the accession of CEECs into the EU.

International organizations like the IMF and the World Bank may also help to enhance credibility of regulators in less developed countries by making financial aid to these countries conditional on their governments' adhering to the regulatory commitments. The national governments can increase the commitment powers of their regulatory agencies by participation in multilateral liberalization negotiations and exchange of legally binding commitments with respect to their present or future policy regimes in the context of WTO.

It is possible to distinguish between a core consensus on the minimum attributes of a credible regulator and the broader debate over the relationship between the regulator and general policy-making for telecommunications policy. The core consensus is that the implementation of national telecommunications should be in the hands of an independent agency separated from government ministries and charged with implementing licensing policy, pricing policy, competition policy, and universal service policy. The purpose is to build confidence that the use of expert discretion to implement telecommunications policy is politically accountable, but substantially insulated from everyday politics.

This transparency of the process provides two kinds of assurance. First, any effort to influence the opinion of regulator is on the public record. This disclosure limits the chance of an impropriety. Just as importantly, even in regard to perfectly proper campaigns to persuade regulators it allows all market participants to judge if they have a stake in lodging counter-claims. Second, regulators are accountable for the record on which they base decisions. A common complaint is that the government has made a regulatory decision based on private information known only to the dominant carrier and the government. This is a recipe for wrecking market confidence.

It is always difficult to ensure real independence of regulatory authority from the government given that essentially the regulator remains a branch of the government. Among the mechanisms available to ensure a degree of independence of the regulator from the government are the detailed public accountability of the regulator, the separation of the regulator’s budget from that of the rest of the government, independent hiring and firing ability of the regulator, and requirements for public reporting of communications between government ministries and the regulator. Countries with unpropitious environments ³⁷ can appoint regulatory boards consisting of several commissioners with fixed staggered terms rather than individual regulators. While a single director of regulation can be highly effective, as is the case with the Director of Britain’s regulatory authority (Oftel), requiring votes by a regulatory commission can de-personalize the regulatory process and minimize the risk of a maverick regulator.

There is less consensus on how to divide up the powers over telecommunications policy between the regulatory authority and the rest of the government. The Federal Communications Commission represents perhaps the strongest example of lodging most powers in the regulator. The authority of the Commission covers all forms of telecommunications and broadcasting policy. Congressional statutes set basic policy for the Commission but the Commission has broad discretion in issuing licenses and implementing telecommunications policy. For example, it is the primary agency for working out the plan for spectrum available for commercial services and it designs and implements rules for assigning spectrum licenses.

In contrast, many countries did not initially create independent regulatory agencies, even after they separated policymaking from the national phone company. Japan, for example, had competition without an independent regulator. Ministry of Post and Telecommunications made policy and implemented it. A more common pattern, however, is the British model, which subjects regulators to review and allows for the sharing of power with the Minister of Communications (or, in Britain, the Department of Trade and Industry). Countries on the British model, like Mexico and the Philippines, typically give the power to grant licenses to a ministry while giving the power to issue rules for competition to the regulatory commission. As we shall see, the division of power between ministries and regulators has produced a number of problems that suggest the need to rethink the use of this model.

Another important dividing line in regulation is the scope of the regulatory authority’s power. The FCC covers wire, wireless and broadcast services. The Radiocommunications Agency in the UK handles wireless policy while Oftel handles wired networks. Many countries have separate broadcast regulators.

A study of the impact of regulatory reforms on the development of telecommunications sector in 22 European countries - 15 EU countries and 7 Eastern European countries - during the period of 1990 to 1995, found that the type of regulatory agency has an important effect on the telecommunications service prices.³⁸ For example, the presence of an independent national regulatory authority, as opposed to regulation by a governmental ministry, in European telecommunications markets seems to create a market environment that facilitates greater diffusion of mobile telephones and provides higher penetration rates of pay phones. Furthermore, the presence of an independent regulatory authority was found to be related to a degree of tariff restructuring in the telecommunication sector: independent regulatory agencies seem to provide more cost-oriented pricing than markets regulated by government ministries.

No discussion of the credibility of regulation can ignore the legacy of government ownership of the dominant carrier in most countries. When the government holds a significant financial stake in the phone company it can create mixed incentives on the most important decisions influencing competition. For example, one major European country was planning to put the Minister of Communications on the board of directors of its largest phone company in order to represent the government’s significant ownership position. The United States quietly protested that this would create a huge conflict for the Minister when exercising his regulatory responsibilities, and he subsequently decided not to serve on the board.

The case of Korea is instructive for developing countries precisely because Korea launched competition in long distance services in 1996 while retaining substantial (72 percent) government ownership of the former monopolist, Korea Telecom. And, like many countries, partial privatization did not remove the issue of whether Korea Telecom had a special status in government policy. Foreign ownership in KT cannot legally exceed 33 percent of its equity. Even after liberalization of foreign investment rules in 2000 under the Korean commitments at the WTO, foreign investors will be limited to 49 percent ownership in other Korean telecommunications carriers.³⁹ For example, until October 1997 KT was a "government investment company." As such, KT had obligations to emphasize public objectives even if it interfered with commercial goals. And the government had the right to approve the budget, select senior management, and decide other key policies. Even though KT has now been converted into a normal enterprise as a legal entity, experts still raise questions about whether KT has full freedom to choose its senior management independently from a government veto. This continuing involvement in the affairs of the dominant operator is not unique to developing countries. For example, in the fall of 1998, the Communications Minister of Italy expressed displeasure when Telecom Italia made a major management change without his prior approval even though the company is a commercial enterprise.

While continuing government ownership complicates the relationships with regulators it also can yield some benefits. In the context of developing and transitional economies, privatization represents not only a way of improving internal efficiency of firms but also an important commitment device for the government to reinforce its promise not to interfere with operational decisions of management of privatized enterprises.⁴⁰ For example, regulatory credibility is significantly enhanced if privatization is phased in by stages. Regulatory takings at the early stages of privatization can significantly reduce privatization revenues at the later stages. The risk of loosing future privatization revenues serves as a credible restraint on regulatory arbitrariness. If all relevant assets are privatized at once, the government looses a credible restraint on arbitrary changes of regulatory policies.

Credibility of regulatory commitment is not the only problem which inhibits infrastructure investments in developing and transitional countries. Many countries lack well-defined property rights. Sometimes there are no clearly articulated property rights on assets as basic as land. Tornell and Velasco ⁴¹ showed that low investment typically emerges as a result of inadequate protection of property rights in poor countries. According to North, inefficient property rights exist because the cost of monitoring, metering and collecting taxes might lead to a situation in which a less efficient property rights structure yields higher tax revenues for the ruler.⁴² Svensson (1998) takes North's argument even further by arguing that in politically unstable countries it may be optimal for a rational government not to improve the quality of property rights even at the cost of low private investments. While an incumbent government bears all the costs of reforms leading to improvement of property rights, the benefits of such reforms accrue only to the future governments. Another reason why the incumbent government might be disinterested in institutional reforms clarifying property rights is reallocation of resources away from taxable activities in environments with poor quality of property rights. Such reallocations reduce tax revenue's of future governments and constraint their ability to spend on goods and services that are not valued by the current government. Svensson finds empirical evidence for his theory.⁴³

Hay and Shleifer ⁴⁴ point out that private enforcement of private rules regarding property rights may emerge in transitional economies as a market response to the failure of the state to improve the quality and protection of property rights. However, not all economic agents recognize private rules. Even if the rules are recognized, there are differences in interpretation and enforcement of such rules. This means that contracts based on private rules can have very high transaction costs. However, since the governments in polarized and unstable political systems have very weak incentives to provide law and order, it will take very long time to strengthen public legal apparatus to enforce property rights, i.e. public enforcement of property rights. Before this happens, an attractive interim strategy for the legal reform in developing and transitional economies is private enforcement of public rules. Public rules are not subject to the problems of multiplicity, obscurity and illegitimacy that are inherent in private rules. At the same time private enforcement of these rules creates strong incentives that do not exist in the public legal apparatus.

The implications of such legal reform for the telecommunications industry would be to encourage the industry to create its own private regulatory authority (as opposed to a spin-off from the ministry) and ensure that new network operators and service providers are represented in such body equally with the incumbent operator. Such arrangements are common in some industries. For example, the U.S. film industry has standing arbitration mechanisms for resolving disputed credits on the making of films. American courts give great deference to such private governance systems.

The WTO is one mechanism for allowing countries to make credible commitments to change regulations continuously over time. Governments that are preparing to privatize the national public network operators may be unwilling to subject them to foreign competition immediately because such action may reduce the privatization proceeds. The investors will pay a higher price for shares of the network operator if its monopoly position is guaranteed longer into the future. However, if the government preserves a large stake in the privatized operator, the policy maker's ability to make credible liberalization threats at some future date after privatization may be limited. And even if the government doesn't have any stake in the privatized monopoly, it may still be reluctant to implement policies that could reduce the market value of the company representing a large share of the total market capitalization of the fledgling local stock markets. The WTO can serve as a vehicle for overcoming the difficulty of making credible commitments to liberalize. Many countries scheduled gradual phase-in of stronger commitments on market access and national treatment over the years to come. The governments that violate their commitment schedules will have to compensate those who suffer losses. This obligation to compensate other nations for the costs they incurred as a result of the government’s deviation from the negotiated schedule increases the credibility of its liberalization intent.

Several Latin American and CEECs governments have used this commitment-enhancing quality of the WTO Agreement on Basic Telecommunications. In effect, they found a credible commitment device that allows them to shield national operators from competition for a limited period of time, and at the same time overcome a threat that interest group pressure might prolong this temporary protection indefinitely.

Neither the WTO nor the existence of an independent regulator can solve all the problems of consistency. Perhaps the biggest dilemma about consistency is when it leads to bad policy. As one famous witticism put it, consistency is the hobgoblin of little minds. But, as we have shown, it is also important for credibility.

The problem in telecommunications policy particularly flows from imperfect information and politics. Many countries begin reforming telecommunications markets with very few experts in their government and very limited information about the economics of their telecommunications markets. However anomalous it may seem, most national monopolists had no idea of their true cost structure and what little they knew was not shared widely with the government. This was not a special characteristic of developing countries. (Even in the United States, where independent regulators required reams of information on costs for decades, executives of AT&T acknowledge that it took many years after divestiture to figure out the company’s costs in a manner that would be demanded by any large business in a traditionally competitive market.) So, there is often considerable fumbling when looking at options for reforming policy. The growing number of competitive markets in developing countries is easing the problem because a market reformer can benchmark its market against those of other developing countries, although each country still has its own peculiar learning experience.

Politics simply make the problem of getting policy right the first time all the more difficult. Monopoly, or any set of regulations, breeds parties with vested interests in continuing the system as long as possible. National political structures may make it difficult to overcome the vetoes of particular special interests.⁴⁵ The result may be a bad policy compromise at the time of initial reform.

Good policymaking requires knowing when to correct mistakes, and having the skill to broker a compromise to do so. Unfortunately, in telecommunications the initial mistake often involves setting the terms for partial privatization of the state-owned telephone monopolist. All too often, the reforms have aimed to improve the monopolist’s performance while relaxing state ownership. But, as in the case of Jamaica, this may turn into a significant extension of the monopoly franchise of the privatized carrier. Today, the Government of Jamaica has expressed doubts about the wisdom of that decision. But it has to ask if a unilateral revision of the franchise to shorten the term for monopoly would seriously hurt its credibility (with all the adverse consequences outlined earlier). (See Part Two for a fuller consideration of the economics of transition periods.)

The precise balance between protection of mistaken policy and credibility of commitments is one of the toughest challenges for a country. But it is not a novel challenge. Competition in telecommunications services began in earnest about thirty years ago when regulators decided that monopoly did not cover the novelty of computer networks. The incumbent monopolists cried that this might be considered a revision that reduced regulatory credibility. And it certainly opened the way to still deeper de facto revisions in the market as entrepreneurs used limited legal exceptions to the monopoly to build gray markets in associated classes of services. The point is that technological change inevitably raises the "hobgoblin" question. And the answer surely requires a bit of skating on the edges of consistency while keeping enough commitment to law and contracts that no one thinks the regulator will routinely fiddle massively with the rules of the game.

Analysis of privatization in developed countries (e.g., Vickers and Yarrow, 1988)⁴⁶ suggests that efficiency advantages of private ownership over public ownership are considerably weaker in monopolistic markets. Private rent-seeking behind protective barriers cannot be expected to lead to socially efficient results. Therefore privatization should be accompanied by adequate measures to reduce market power.

Governments of the countries studied in this paper have differing approaches to the speed of liberalization. All telecommunications policy reforms adopted by the governments of developing and transitional economies can be classified into two major strategies. Some policy-makers in transition economies with urgent investment needs chose to introduce competition immediately, while others decided to delay it indefinitely or introduce it in the medium term and make the timing of liberalization contingent on the incumbent monopolist's performance. The distinguishing point in the strategies is the timing of the introduction of competition. The end point--general competition--is rapidly becoming a given. Moreover, the clock for market transitions is shorter today than just a few years ago because of other institutional developments. For example, the CEECs has ambitions to join the European Union, and the EU expects rather rapid movement to competition.

The first strategy was adopted by countries such as Argentina, Mexico, Peru, and the Czech Republic. It relied on fast-track privatization of the incumbent operator ⁴⁷ in which the incumbent operator was guaranteed its monopolistic position in different segments of the market for a number of years in future. A specific timetable for liberalization of those segments was set in advance, and in exchange for these guarantees against competition the incumbent monopolist had to commit to specific investments in network build-out and modernization. Incumbent's shares together with concessions for monopoly franchise in different segments of the market were typically sold through tender to private consortia which often consisted of a domestic investor and a major foreign company. The winning consortium appointed new management and implemented drastic restructuring of the business. To increase privatization revenues, prior to the tender the government typically allowed the monopolist to implemented a significant one-time increase in tariffs for services. After that the monopolist’s rates were controlled by some sort of price-cap regulation. Regulatory policy also controlled the speed at which the monopoly operator was permitted to rebalance its tariffs. These policies typically tried to yield a subsidy-free tariff by the time restrictions on entry were supposed to end and the incumbent operator had to face competition.

The ability of regulators to attract wealthy strategic investors capable of submitting generous bids at the tenders and implement efficient restructuring of the incumbent operator after winning the tender was critical for the success of this strategy. Most of the governments that pursued this strategy assigned to privatized monopolies challenging but realistic targets in terms of network expansion, quality of service and tariffs. It was very important that government regulators could ensure effective monitoring and enforcement of the service quality and network build-out commitments of the consortium which took over the monopoly operator.

The second strategy relies upon full competition at an early date as the main vehicle for delivering higher investment and improved efficiency. Poland, Hungary, Chile and other countries adopted this strategy of combining delayed privatization with early and complete liberalization of most of the telecommunication markets. Although the number of entrants was limited in certain segments of the telecommunications industry (e.g. international telephony), the monopoly was transformed into oligopolistically-competitive markets. Intermodal competition from suppliers using alternative technologies arrived with entry of wireless companies, cable TV and public utilities in both local and long-distance services. All countries that pursued this strategy implemented a series of price increases for basic services to rebalance tariffs, with varying degrees of success. This made the markets for basic services more attractive to potential entrants. Competition was also enhanced by making additional frequency bands of radio spectrum available to mobile operators wishing to provide fixed telephone services. The terms of network interconnection were governed by civil contracts and competitors could negotiate any agreements. Potential disagreements and conflicts over the contracts were subject to arbitration in courts.

Arguably, the most critical factor of these countries’ success was the creation of favorable conditions for local competition in all segments of the market. In all countries that followed this strategy the incumbent monopoly operator was subject to drastic restructuring that improved its microeconomic efficiency. Furthermore, it was very important that regulatory authorities developed flexible but consistent approach towards the regulation of interconnection and encouraged rate rebalancing and reform in the provision of universal service funding.

Our analysis now reviews the market and regulatory experiences of seven countries in CEEC and South America.

The service sector had a relatively low priority in the centrally planned investment decision processes of the CEEC governments. The Marxist bias in favor of manufacturing over services, low potential for generating foreign exchange revenues and the desire of communist governments to control information flows meant that the telecommunications industry was given very low priority in centrally planned economies. This resulted in dramatic under-investment in infrastructure. The reformist governments of CEECs have inherited very outdated equipment. Manual switches and analog technology were prevalent in the beginning of their transition to market economies. The teledensity in the CEEC was not only much below the European average, but also much below the level typical of newly industrialized countries in East Asia. Networks were heavily concentrated in urban areas. The teledensity in rural areas was appallingly low.

Therefore it became an imperative for CEEC governments to make large investments in network technologies. The governments are aiming to achieve a 30% penetration rate by the year 2000. They need to maintain an annual rate of line growth of 11% and attract more that $100 billion in investments over the period 1993-2000 to reach this target. By ITU estimates, achieving 40% penetration in this same period requires an investment of $173 billion.

In the beginning of reforms telecommunications tariffs were not only unbalanced in favor of residential and local calls, but did not give a reasonable rate of return on investments even on average. Under-investment and low tariff levels resulted in severe excess demand that effectively invalidated the existence of cheap uniform domestic call rates.

Monopoly regulation in advanced countries typically focuses on price control because even imperfectly competitive markets clear and quantity control is unnecessary. In contrast, telecommunications services in CEECs are so severely under-supplied that rationing will remain pervasive even if prices rise to a cost-reflective level. Under these circumstances the standard argument in favor of immediate full competition as a preferred economic environment for modern telecommunications industry is not so convincing,⁴⁸ as competition between firms entering new market often leads to duplication of investments. Duplication by competing firms might be beneficial if competitors come up with differentiated services to satisfy demand of sophisticated consumers, but the cost of duplication might lead to investment delays. And if the urgency of investments is a more important consideration than the benefits of competitive selection among service providers of differentiated efficiency, then a reasonable case can be made for the delay of competition according to a clear timetable. Yet given the perverse incentives for monopolists (see the discussion in Part One) the period of delay should be relatively short (perhaps a maximum of five to seven years) and the scope of the monopoly should be as narrow as possible (e.g., exempting all wireless, satellite, and data-related services). Best yet, there should be a date certain for competition so that the expectation of competition begins to discipline market behavior in advance of its arrival.

Any delay in competition makes regulation even more important. The institutional endowment of CEECs is lacking in important elements required for creating regulatory environment favorable for the development of telecommunications. So, these countries are trying to import some of these elements by adopting regulatory mechanisms of the European Union and taking part in multilateral negotiations on trade liberalization in services.

All six Central and Eastern European countries (CEEC) - Bulgaria, the Czech Republic, Hungary, Poland, Romania and the Slovak Republic - that signed the GBT deal have actively sought membership in the EU which requires them. To qualify for the admission into the EU the CEECs have to harmonize their laws with the laws of the EU.⁴⁹ The Czech Republic, Hungary and Poland have subsequently filed a formal application for full membership in the EU. In many aspects of liberalization of trade and investment in basic telecommunications services EU requirements for its current and prospective members go far beyond multilateral disciplines of the WTO.

Poland is the largest among Central and East European countries with the population of 40 million. It is a dramatic story of transformation and transition that shows how the details of interconnection and regulatory processes are vital for creating an efficient market.

Despite the fact that Poland has the largest telephone network among CEECs (7.5 million main lines) it also has one of the lowest teledensities - 19.32 lines per 100 - in Europe, second only to Albania.⁵⁰ During more than four decades of mismanagement by the communist government, the building up of telecommunication infrastructure had proceeded extremely slowly. The COCOM embargo was a major impediment for Poland in gaining access to the modern technology. As a result, the technical base of the industry is very backward: there is still a significant number of manual exchanges in use. The incumbent operator TPSA needs 18,000 of its 72,000 employees to operate and maintain the manual exchanges.⁵¹ Only about 65% of lines are digitalized and penetration in some rural areas is as low as 4 percent.

As a result of rapid collapse of the communist state the previously powerful interest groups such as the communist party, communist trade unions, management of the large state owned companies, lost their political influence. At the time of the enactment of the new telecommunications legislation, the political influence of the incumbent monopoly had significantly weakened because it was considered a communist organization, but consumers and new entrants had not yet organized themselves politically. Most of the special interest groups populating the political landscape in Western countries did not exist in Eastern Europe at the time of preparation and adoption of new telecommunications legislation.

The Polish Telecommunications Act--adopted in 1990 and amended 1991 and again in 1995--was the first post-communist telecommunications act among CEECs. The Act formally liberalized local networks; a license from the Ministry of Posts and Telecommunication was the only restriction on the entry of new local operators, which could be domestic or foreign companies.

Separation of post and telecommunications functions in January 1991 resulted in the formation of the state-owned operator Telekomunikacja Polska Spolka Akcyjna (TPSA). Currently, the industry is regulated by several institutions: the Ministry of Communications, the State Telecommunications Inspectorate, the National Radiocommunications Agency and the Antimonopoly Office. There is no specialized independent body to facilitate harmonization of regulatory activities in the industry and accumulate and disseminate regulatory expertise.

The Polish laws didn't clearly separate the Minister of Communications' functions as the regulator of the industry and as the owner of the incumbent operator. There was a possibility of a conflict of interest inconsistent with EU rules, which explicitly require that functions of operation and regulation be separated. The Minister who also represented the only shareholder in TPSA was in charge of issuing the licenses to its competitors. Implementing the Association Agreement commitments to EU in March 1997, Poland took a step in the direction of harmonizing its telecommunications regulation with that of EU and transferred state ownership interests in TPSA to the Treasury.

The regulatory authority is still a prerogative of the Ministry of Communications. Taking telecommunications operator out of the ministry structure and transforming it into a joint stock company controlled by the Treasury were certainly steps in the right direction. However, much remains to be done to eliminate the conflicts of interest which arise out of historical links between the Ministry of Communications and the structures that eventually have taken the form of TPSA.

The Polish government planned to begin privatization of TPSA in the second half of 1998. The first stage was supposed to be an initial public offering of between 15% and 20% of the company. Bids from strategic investors were expected in 1999, followed by a second share offering in 2000 or 2001. It was widely expected that the sale could raise around $ 2bn. If this expectation is confirmed, the listing would almost double the size of the Warsaw stock exchange. However, the emerging markets financial crisis which began in 1997 created uncertainty over Poland's expected sell-off and lead to the decline of the TPSA’s market value by 38 million dollars.

One of the government’s major concerns was that full liberalization of all telephone services might have a detrimental effect on the TPSA share price at the time of the initial stock offering. This explains the government’s policy of balancing the need for compliance with EU competition requirements with a slow liberalization. Given the recent history of telecommunications reforms in other countries, it is unlikely that Poland could support a market with multiple operators without damaging TPSA’s valuation.

The privatization story shows why it is hard to instill market confidence in the authorities supporting competition. There is no perfect solution to the problem but the creation of an independent regulatory authority is one of the most urgent needs for the success of liberalization of the Polish telecommunications industry.

Polish policy supports competition and, according to the Telecommunications Act of 1990, existing network operators cannot refuse to connect another network to their own. So, the question is "has competition emerged?" The answer is yes, but less than it appears.

TPSA inherited the Polish national telecommunications network with its 7.5 million subscribers and has retained a monopoly on lucrative long distance and international services, despite the fact it was formally liberalized by the adoption of the 1990 Telecommunications Act.

Although according to the Act any company with a home majority stake in its capital can become a long-distance network operator, no Polish company has enough capital to build out a new network without a major contribution by a foreign partner. However, since foreign participation is not allowed in operating international networks, the provisions of the Act essentially preserve the incumbent operator's monopoly in long-distance and international networks.

The Act gave TPSA a significant competitive advantage over new operators, who in applying for licenses must present a formal strategic development plan to the Ministry of Communications and pay fees. By contrast, TPSA doesn’t have to declare its strategic plans and gets licenses free of charge.

TPSA uses revenue from long distance and international services to subsidize local rates. It is expected that TPSA monopoly on domestic long distance traffic will be lifted in 1999. The long distance tender is due to be announced around the end of 1998. However, TPSA will retain its lucrative monopoly on international calls until the end of 2002 and foreign investors will be limited to a share of 49 per cent in new operators.

In 1996, the Polish Anti-Monopoly Office (now known as the Office for Competition and Consumer Protection - CCP) became concerned that TPSA was charging excessive interconnection fees to cellular operators and to new local operating companies. In response, CCP proposed a solution that has proven popular in many countries. Under the CCP plan, new operators would be allowed to interconnect with the networks of major public utilities, the National Power Grid and the State Railways. With nationwide networks already in place, rights of way for new transmission facilities in hand, and foreign partners already lined up, these utilities can become direct competitors to TPSA.⁵² It should be remembered that these utilities have their own legacies as monopolists, and the decision to designate them as competitors to the dominant phone company may be as much a matter of politics as markets.

Until TPSA loses its position as monopoly carrier, all local operators have to use that company's trunk network for interconnection of calls. While the Act determines that the terms of the interconnection agreements should be stipulated in a civil-law contract concluded by the operators of interconnecting networks, it doesn't define what should happen when the parties are unable to reach an agreement. If the incumbent operator TPSA wants to prevent the entry of a competing network operator, it can simply delay negotiations on the terms of interconnection.

Ambiguous and inadequate regulatory legislation, together with the lack of a truly independent regulatory body, gave TPSA many opportunities to take unfair advantage of its position. Delaying interconnection agreements was not the only means by which TPSA tried to deter the entry of independent local network operators. According to Kubasik (1997) TPSA sometimes deployed small exchange offices that connected only the largest business customers in the given localities. This strategy crippled the business plans of many independent local entrants that needed the revenues from the business customers to recover costs.

Typically, after the new operators gave up, TPSA stopped building up its capacity in the area leaving it significantly underdeveloped. This is one of the reasons why, despite the fact that there have been more than seventy permits issued, so few operators have actually started providing services. The tactics of TPSA have prevented new entrants from gaining a bigger share of the Polish market. As a result it can still take two years to get a telephone line in Poland.

In short, the existing Polish policy falls short of the guidelines of the European Union for interconnection. It does not provide for specific negotiation procedures and timetables for interconnecting parties. It lacks pre-existing ground rules to guide interconnection decisions (a reference offer in EU terminology) that include a basic methodology for costing interconnection. And, of course, Poland has yet to establish an independent regulator that could arbitrate when negotiations come to a stalemate.

Despite TPSA’s clear advantage there is active competition in important segments of the Polish telecommunications market. There are about 200 new data/value-added service operators, 400 new cable TV operators, and various new VSAT and private corporate networks. There are around 70 new local operators and more than 100 interconnect agreements with local operators have been signed to date, although few are up-and-running.

The mobile telephone services market has been competitive since 1996. While it is rapidly accelerating in terms of subscriber numbers, the development of the market has been relatively slow because of the decision to broaden competition slowly. The two GSM operators started their services only in the autumn of 1996,⁵³ and another competitor holds the old NMT analogue license and offers a digital service under the first GSM 1800 license granted in Poland.⁵⁴ With around 900,000 subscribers Poland has become the largest cellular market in Central and Eastern Europe, but it is still far behind penetration levels reached in Hungary and the Czech Republic.

Sheltering TPSA has not produced a miracle in network modernization but rates of network expansion and indicators of efficiency have improved. The Polish telephone network is one of the fastest growing in the world, averaging 12% per year. While more than 1.7 million new lines were installed during 1991-1994, the telephone subscriber waiting list exceeded 2 million in 1995. The average call completion rate nation-wide is 40%, but in Warsaw significantly worse with only 25 percent.⁵⁵

The most striking aspect of the Polish story in regard to universal service is rural service. Most recent improvements in the telecommunications network have benefited urban rather than rural areas. With 36 percent of the population living in the countryside, inhabitants of the rural areas have access to only 13 percent of exchange lines. The teledensity in the rural areas of Poland is only 4.6 per cent compared to 18.2 per cent in the urban areas. In 1994 there were still more than 2,300 villages (4 percent) without a single telephone line. The telephone network deployed in the rural areas is very outdated: 43 per cent of the telephone throughput of rural areas in handled by manual exchanges, most of which operates less than 24 hours a day.⁵⁶

TPSA expanded its network primarily in urban areas because the economies of density and scope are more pronounced and the return on investments in new network is higher. The inhabitants of many residential and rural areas organized themselves into telephone cooperative groups consisting of several dozen to several hundred members. Members of such cooperatives typically acquired the rights of way on the local land and prepared it to the ducting using their own resources. The newly built local networks were then transferred to TPSA which compensated the costs of the cooperative's members by granting free units on their long-distance bill.

Given the scarcity of capital for the development of telecommunications infrastructure in the rural areas, cooperatives represented a quick and unorthodox way of raising funds for building out rural networks by mobilizing the capital reserves of local communities in unserved areas. The Polish government considers the development of local telephone cooperatives as the least costly means of a rapid rural telecommunications deployment. Over the last few years nearly 60 percent of the new main lines in rural areas were developed in the framework of telephone.⁵⁷

In Hungary, as in Poland, the telecommunications sector didn't receive much public investment resources and the impossibility of raising substantial funds in other ways led to a low level of network growth. From 1991 on, however, the rate of network expansion has accelerated to above 10 per cent and the Hungarian network is expected to grow to about 3.7 million lines by the year 2000. The waiting list for connection began to drop in 1994.⁵⁸

The fixed network consists of 54 primary networks which comprise 1,500 local exchanges. These primary networks are connected by trunk facilities to nine interconnected secondary exchanges. The only international gateway is located in the national capital. Telephone densities in Hungary decline with distance from the capital, and the peripheral regions in the eastern part of the country are characterized by the lowest densities.

Hungary was the first among CEECs to introduce public mobile cellular services. In 1997 the country had the broadest cellular coverage in Central and Eastern Europe. Analog and digital service were available to virtually the entire population of the country at comparatively low tariffs.

Hungary was the most successful among CEECs in building regulatory institutions. According to the Telecommunications Act of 1992 the concession contract is a major regulatory instrument in Hungary. The concessions are granted on the basis of competitive bids and should define quality, quantity, and technical requirements to service as well as the penalties for violating these requirements; the terms of interconnection with other telecommunications providers; and the regime for setting tariffs (OECD, 1997).

The Act deals with three types of telecommunications services: monopolized, partially competitive, and competitive. Telecommunications services supplied by monopolies or under limited competition have to be governed by a concession contract with the state regulatory authority. The concession contract with the incumbent monopoly operator Matav gives it an exclusive right to provide international, domestic long-distance service and some local public telephone services up to the year 2002.

While special regulatory rules apply to telecommunications services provided under concession, rates for non-concession services are subject only to the general fair-pricing principles outlined in the Competition Act. In early 1995 the government introduced price-cap regulation with the goals of establishing maximum tariffs for concession services and giving the service providers adequate financial resources for network build-out.

The Act confirmed the prerogatives of the Ministry of Transport, Communication and Water Management as the industry regulator. The General Communication Inspectorate is subordinate to the Ministry and implements the technical aspects of regulating telecommunications industry in Hungary. According to the Frequency Management Act of 1993 the Ministry of Transport, Communication and Water Management is also responsible for managing the radio spectrum use. The Frequency Act established the National Frequency Management Council which serves as an advisory body to the Ministry. An important regulatory role belongs to the Competition Council which conducts anti-monopoly policy, and any changes in telecommunications tariffs must receive a joint approval by the Competition Council and the Ministry of Finance.

Hungary separates the administration of the regulatory process from telecommunications network operation, and particularly from the main operator (Matav). The regulatory and ownership functions are formally separated as well. In December 1995 the Hungarian State Property and Holding Agency which acted as majority shareholder in Matav ⁵⁹ divested itself of the controlling stake while retaining responsibility for the 25 per cent, plus one golden share. As a strategic owner the State Property and Holding Agency is not subordinate to the Ministry and represents the shareholders’ point of view in the issues of Matav management.⁶⁰

The process of administrative and legal separation of regulatory authority from owners and operators of telecommunications network was not supplemented by adequate measures in insulating the regulator from political pressure. Although the Inspectorate in has a considerable freedom in the implementation of regulatory arrangements, its independence appears to stop well short of deliberation and design of new policies.

The adequacy of this arrangement in the future is in doubt. The overwhelming market dominance of the incumbent network operator and the comparatively high cost of market entry, particularly into network operation, create major difficulties. The need for strong independent regulation is most acute as a multi-operator environment develops.

Hungary’s pivotal choice was to allow a transitional monopoly mixed with competition. Early in 1993, the telecommunications ministry issued a tender for 30 percent of Matav shares and for the concession to provide long-distance calls over Matav's digital overlay network once it had been completed.⁶¹ The concession provided six years' protection from competition on public long-distance calls and on local calls, starting from January 1, 1994.

To be eligible to take part in the tender applicants had to satisfy minimum financial requirements. The winner in the tender was supposed to pay a concession fee to the Hungarian Government for the use of the digital overlay network. In addition, the winner had to pay 0.1 per cent of the future gross revenues into the budget.⁶² The winner also had an obligation to guarantee at least 15.5 per cent annual increase in mainlines for 6 years, to satisfy 90 per cent of the applications for main lines by July, 1997 and 98 per cent of the outstanding waiting list before the end of 1997.⁶³

Opponents of the privatization plan argued that it was out of step with the telecommunications rules of the European Union, which provided protection for monopoly suppliers only until January 1998. Moreover, the imposition of the same protection period for long-distance and for local calls put suppliers of the latter into disadvantage, since the local networks were still under development, while the overlay network had practically been completed. The critics therefore suggested a shorter period of protection for long-distance calls (until 1998) than for local calls (until at least 2000).

Four consortia submitted their bids: France Telecom/U.S. West, STET/Bell Atlantic, Deutsche Telecom/Ameritech/Cable & Wireless, and Telefonica/Dutch PTT/GTE. The highest bid in the first round came from the STET consortium (US$ 850 million), with the others offering between US$ 450 million and 500 million. The offers also differed in the proposed speed of network build-out. Taking network expansion into account, Deutsche Telecom (DT) had an advantage with its impressive record from former East Germany, where the standard EU level of teledensity (50 lines per 100 inhabitants) was widely expected to be achieved only six-years after the beginning of network deployment and at relatively moderate estimated cost of about $30 billion.

After the second round of bidding, a group of experts from the Ministry and the State Property Agency awarded the concession to DT-led consortium (MagyarCom). In the end MagyarCom paid $ 875 million for 30.2 percent of Matav's shares. Of this, $ 400 million was to be in the form direct investment in Matav’s operating capital, and the remaining US$ 475 million had to be transferred to the state budget and a special Communication Development Fund.⁶⁴

The result of this approach is that, in terms of the percentage of total revenue, 80 per cent of voice services over the fixed public network is provided under monopoly conditions. However, as in Argentina, Hungary has established a number of independent regional monopolies in local service, rather than a single national monopoly. A performance of one such monopoly serves as yardstick for measuring performances of other regional monopolies.

Of the 54 primary networks, MATAV controls 39. The other 15 networks were acquired by new independent companies through an open concession tender. These independent concession companies are controlled by five parent companies. In the end of 1994 the networks that belong to the independent companies represented only 12 per cent of the total telephone lines and were deployed in relatively underdeveloped areas with 22 per cent of the country’s population.

Wireless cellular network expanded dramatically after the Ministry awarded licenses to two competing GSM operators. However, competition in cellular and paging services will be limited until the end of the millenium since regulation provides exclusive rights for these services to at most three operators in each area. After the expiration of this regulatory restriction and distribution of higher-frequency parts of spectrum to cellular service providers the intensity of competition in the wireless segment of Hungarian telecommunications should increase as new services and technologies are introduced. Through commercialization of wireless local loop technology this competition should also spill over to the local wireline segment of the industry.

(a) Network Build-out and Performance

In the early 1990s the local governments received the right to put their public networks up for sale to the best bidder in tenders for local monopoly concessions. This allowed the localities to attract additional capital and technical expertise into the network. Prior to that the capital of the country, Budapest, received preferential treatment allowing it to reach a teledensity four times as high as the countryside, However, between 1991 and 1995, Budapest’s share of total access dropped from 45 per cent to 34 per cent. Although the national average number of mainlines per 100 inhabitants rose from 6.6 in 1984 to 21.1 in 1995, the countryside enjoyed a fourfold in crease in teledensity.⁶⁵

Most aspects of quality of service steadily improved since the beginning of regulatory reforms in 1992. Although the actual levels in Hungary are still lower than the OECD average level, certain indicators such as call completion rate and the number of fault incidences per mainline are steadily improving.

The incumbent monopoly operator Matav has shown consistent improvements of the most important productivity parameters over the period 1990-95. For example, during this period, the ratio of mainlines per employee grew from about 45 to almost 104, or about 131 per cent. Revenue per employee has increased tremendously as well, rising from US$ 20,000 to over US$ 50,000 in 1992. However, this parameter is still low compared with the average for the group of OECD countries of about US$ 150,000.⁶⁶

There has been a dramatic growth of investment in the sector. By the end of 1994, annual investment in the public network reached US$ 400-500 million with overall investment in telecommunications exceeding US$ 730 million. This makes annual investment in the industry close to 0.8 per cent of the GDP, which is significantly higher than the OECD average of 0.5 per cent and higher than any other CEEC.⁶⁷

The investment per mainline is US$ 420, about twice the OECD average. Since 1992 per capita investment in public telecommunications service, including both fixed and wireless networks, has risen from US$ 32 in 1990 to US$ 73 in 1994. This is still lower than the OECD average but rivals the levels of such EU members as the United Kingdom, Greece, Belgium, and Ireland.⁶⁸

The Czech Republic became a sovereign state on January 1, 1993 following the dissolution of the Czech and Slovak Federal Republic (CSFR). The dismantling of the former central planning regime and movement toward a market economy were begun under the CSFR in 1990 and have been continued by the Czech Republic. Eight years after the beginning of economic reforms the economy is still undergoing restructuring from the communist era.

The most important steps in the liberalization of telecommunications were taken with the modification of the Telecommunications Act in 1992. In 1993 the state-owned postal and telecom company SPT Praha was split into Czech Post and SPT Telecom. SPT Telecom owned and operated the public telecommunications network that was privatized in 1995 under the framework of the Czech voucher privatization program. Although the 1992 Act doesn't provide for an independent telecommunications regulator, the market benefits from a well-managed regulatory framework under the Czech Telecommunications Office (CTO), a government body that was moved from the Ministry of Economy to the Ministry of Transport and Communications in November 1996.

Three agencies have responsibilities for telecommunications policy. The Ministry of Economy is responsible for the main principles of regulation, grants licenses for public networks and services and approves tariffs for international communications. The Czech Telecommunications Office implements general administration and supervision of the telecommunications sector, determines technical standards, issues licenses for private networks and services, and manages the frequency spectrum. It also has the right to present new tariff drafts to the Ministry of Finance which then determines the tariffs.⁶⁹ The Ministry of Finance regulates tariffs with the goal to limit potentially inflationary increases. This division of power has created difficulties that we will discuss shortly.

As a result of the recent talks over accession to the European Union (EU), the Czech government came under pressure to liberalize the telecommunications market in line with EU norms. The CTO is expected to achieve independence from the government under the new Telecommunications Law currently being debated by parliament.

As a result of the voucher privatization program, the Czech government maintained a 74 per cent stake in SPT. At that point the government decided to proceed with selling 27 per cent stake in SPT to a strategic foreign partner. The tender was organized in 1995 and five international companies submitted their bids for SPT Telecom.⁷⁰ The initial asking price was $1 billion, and the winning consortium was required to implement a network modernization program worth $ 3.5 billion and ensure a 100 per cent increase in the number of mail lines by 2000. The most attractive bid was offered by the TelSource consortium that acquired a 27% stake for $ 1.45 billion. Among the factors that determined that success of the tender were successful economic reforms in the Czech Republic, political stability and strategic location in the middle of Central Europe. The Czech privatization of SPT can be compared to the sale of Matav by the Hungarian government to a DT-led alliance MagyarCom. While both tenders generated comparable privatization revenues, the two government found different uses for the raised funds. The Czech government used the privatization receipts to modernize SPT, while the Hungarian government used the money to pay its debts and to establish a special communications development fund.⁷¹

As of early 1998 SPT Telecom had a market capitalization of US$ 3.4 billion, making it the largest capitalized and most liquid stock on the Prague Stock Exchange. SPT is also the largest publicly listed company in Central Europe with 22% of its shares listed on the local stock exchange. Since its privatization SPT has outperformed the Czech market, and in 1997 was given an A rating by Standard & Poor's.

The degree of monopoly that the SPT was promised after the privatization as well as the future tariff policy played a central role in the determination of the value of its equity. The higher privatization proceeds realized in the Czech Republic in comparison with Hungary have been attributed, among other factors, to the more monopolistic market structure and more comprehensive regulatory framework.

a. Comparing Czech and Hungarian Privatization ⁷²

In 1996, SPT installed 417,000 new lines, and reduced its waiting list from 650,000 to 623,000. SPT planned to install 470,000 new lines in 1997. In 1998 the company aimed to add 480,000 new lines, increasing teledensity from the current level of 31.8% to 43% by 2000 and achieving 100% digitalization in 2002, up from a 1997 level of 33%.⁷³ SPT has invested about US$ 1 billion a year for the past three years in constructing the core of the new digital overlay network, of which SDH technology makes up about a sixth.⁷⁴ Increased digitalization gave a boost to the value-added services, such as voicemail, call-waiting and conference calls. In 1997 SPT also added other value-added services.

SPT planned to reduce its workforce from 25,000 at the end of the third quarter in 1997 to 15,000 by 2000. The implementation of this plan will amount to a 40% reduction in SPT’s staff and will allow the company to achieve a substantial productivity increase by the end of the decade. The combined effect of the productivity growth with network expansion, will be an increase in the number of lines per employee to 290 by the year 2000, up from current levels of 134, and well above the European average of 205.⁷⁵

SPT’s monopoly in the provision of long-distance and international telecommunications services is guaranteed until January 2001. Although originally intended to last until the end of the millennium, to SPT's monopoly was extended for another year to allow it to pursue an ambitious investment and restructuring plan. The new Czech telecommunications law, which is scheduled to be adopted in line with the 1998 European Union liberalization plan, is likely to include a clause to cut short by one year the monopoly of SPT Telecom but compensate the SPT for a breach of the privatization agreement.⁷⁶

The Telecommunications Act permits other private operators to run local networks through regional concessions. There are currently 16 such areas licensed to competitors and eight private competitors to SPT, servicing about 10% of the population. So far, the SPT has not considered the private competitors enough of a threat to warrant acquiring exclusive licenses for any of the areas.

The government made several attempts to tackle the problem of rate rebalancing. But the division of regulatory authority over rates has hampered the ability to implement European Union cost-based principles through raising line rental and local call charges. The Ministry of Finance, responsible for formulating the tariff policy, resisted SPT’s proposals to increase local call charges as a way to help generate revenue for its modernization plans. At the same time, SPT's international tariffs are regulated by the CTO, and SPT has been successful in reduced international (and long-distance) tariffs in line with EU norms. Nevertheless, the existing tariff structure is far from being cost-oriented. Tariffs for mobile and data services as well as some value-added services remain unregulated and relatively higher than the respective average tariffs in OECD. The new Czech telecommunications law, which is supposed to harmonize the Czech laws with the EU legislation, will provide for tariff rebalancing.

The Czech public utilities, in particular the electricity distribution network and the railway system, that have exclusive rights to build and operate their own communications infrastructure have mulled entry into the telecommunications market. The Czech railway company, together with several private investors, had started to deploy a US$ 120 million digital network. In 1996, the eight regional power-supply utility companies formed a joint venture -- Aliatel that controls modern, fiber-optic networks with sufficient capacity to carry public traffic. By 1999 this network was supposed to be accessible to 60% of businesses and to 50% of households nationwide. The company also planed to provide Internet and related services, virtual private network services with data, voice and picture signal transmission capabilities, ATM and public telephone service.⁷⁷

The Czech government opened the mobile telephone market to competition in 1996. Since that time, the two licensed providers of GSM mobile services have been competing for market shares through aggressive pricing. SPT is the major player in the market through its mobile subsidiary Eurotel. A second GSM license was awarded in March 1996 to Radiomobil. In the GSM market Eurotel had more than 100,000 customers after six months of operations, while Radiomobil had only 35,000. There were 508,000 cellular subscribers in 1997, which brought cellular teledensity to 4.9%, up from 1.9% in 1996. In an effort to increase its market share Radiomobil began offering long-distance service at half SPT's rates through its mobile phone network in 1998.⁷⁸ One additional 1.8GHz license was due to be awarded in 1998 by the CTO.⁷⁹

Overall, in the Czech Republic new operators trying to enter different segments of telecommunications market can count on a transparent regulatory framework and strong support of the regulators. However, until the monopoly rights of the incumbent operators expire, the new entrants must develop as niche players concentrating on corporate clients. It will take time and considerable effort on the side of the government regulators before the emerging companies will be able to compete with the incumbent monopolistic operators on a level playing field.

During the 1990s many Latin American nations restructured the government agencies responsible for regulation of national telecommunications markets and services. In many cases Latin American governments have created independent organizations to regulate, monitor, and guide liberalization of their telecom markets.

Many Latin American nations made market access commitments at the 1997 WTO agreement. We focus on four of them. Chile and Mexico opened basic telecom service to competition and foreign ownership prior to the January 1998 "start date" for the WTO convention. Both Argentina and Peru sold off their state telecom firms to private concerns in the early 1990s, and plan to allow full competition in 1999. All four countries have made efforts to align interconnection charges with long run incremental costs and have begun to erase cross-subsidization between local and long distance rates. This section discusses their challenges in implementing competition and the performance record to date.

Mexico was one of the early reformers of telecommunications markets in South America. It privatized its monopoly carrier, Telmex, in 1990. Two foreign investors, Southwestern Bell and France Telecom, took a minority interest in the new ownership headed by a prominent Mexican conglomerate, Groupo Carso. Privatization was the catalyst for a considerable pickup in the pace of network investment and reforms in management and work practices designed to raise productivity significantly.⁸⁰

In the wake of the peso crisis of 1994 the Mexican Government decided to use telecommunications reform to signal its determination to make the country attractive to foreign investment and to continue market-oriented reforms. As a result, in a remarkably short time in 1994 it drafted and passed legislation to permit competition in voice telephone services. Telecommunications seemed a particularly ripe market for the move in a middle of an uncertain economy because the very large flow of communications traffic between the US and Mexico was certain to draw the interest of US carriers. Moreover, Telmex was in good financial condition and so competition would not unsettle the stock market. (Telmex is a significant part of the total capitalization of the Mexican stock market.)

The start of competition in the long distance market seemed to be the crowning success of the reform policy. The Mexican government ended Teléfonos de México’s (Telmex) monopoly concession for domestic and international long distance on January 1, 1997, when six entrants initiated service in 60 of Mexico’s largest cities.⁸¹ The largest of the new providers, Alestra and Avantel, are 45% and 49% owned by US firms (MCI and AT&T).⁸² Local service opened to competition on December 29, 1998. Iusacell, controlled by Bell Atlantic International Wireless, was the most prominent competitor to Telmex in the cellular market.

As competition was rolled out in many Mexican cities it created a rush of subscribers, with nearly 4 million signing up for long distance service during the first half of 1997 (55.7% Telmex; 24.9% Alestra; 18.6% Avantel; approximately 1% between Iusacell, Miditel and Protel). By the end of the first year new entrants had claimed about 25 percent of the contestable long distance market (parts of the market would be rolled out later to competition) and 18 percent of the total long distance market. There was roughly a thirty to forty percent drop in long distance prices.⁸³ Furthermore, the initial burst of signups led to an increase in subscribers of 135%. Total lines in service also increased by 8% since 1997 (through May 1998), although Mexico’s teledensity figure has remained relatively constant during this period at 9.8 lines in service per 100 inhabitants).

Another significant reform for the market was the introduction of auctions to assign licenses for wireless spectrum. A successful auction can increase the speed and transparency of assigning licenses, while maximizing the potential for new entrants who have freedom to adopt market-based strategies. Increasing the number of licenses not only removes hopes of inflated profits from limited numbers of licenses, but also increases investment flow and can still generate substantial auction revenues, as witnessed by Mexico’s collection of over $ 1 billion in auction receipts. Mexican auctions in 1997 and 1998 for example, created 77 licensees in nine regions covering all of Mexico, including wireless local loop and PCS concessions.⁸⁴ Moreover, auctions also successfully made large parts of the microwave network of the country available to the new entrants in telephone services.

The new holders of Personal Communications Services plan to roll out services by the end of 1998 or early 1999. This will further intensify competition in a market where one competitor, Iusacell, doubled its subscriber base to 550,000 in 1997 through the use of prepaid service cards.⁸⁵ Allowing entrants like Iusacell to bundle wireless local loop with PCS also offers the hope of significant network buildout for local services. Cofetel hoped that it might double teledensity levels for Mexico.

The careful transition from privatization to competition was in many ways a textbook for reform. But at least three significant problems remained as competition got underway. We turn to questions about interconnection and rate rebalancing shortly. These problems played out in a particularly difficult way because of problems with the Mexican regulatory process.

The ambition and speed of Mexico’s reforms, particularly given its pioneering role as a developing economy in adopting such sweeping competition, was remarkable. But the tight time schedules for new regulations and implementation also created difficulties that the division of authority under the British model of regulation further complicated. The problems in Mexico are important precisely because they illustrate what can go wrong in a process that was in many respects a model for reform.

Mexico began the implementation of competition with power held in the hands of the Secretary of Communications and Transportation (SCT). The Undersecretary in charge of communications became the head of the new independent regulatory commission, COFETEL (Comisión Federal de Telecomunicaciones), in 1996. COFETEL and SCT followed the British model in the sense that SCT had the power over licenses. But SCT was in charge of setting the rules of competition. In practice, there was considerable overlap in authority.

Most critically, as a practical matter, COFETEL could not enforce its rules without the consent of SCT. Further compounding the problem was the Mexican regulator’s fears that its program for rapid policy and market changes could fall significantly behind schedule if it ended up in the Mexican court system. Therefore, it emphasized negotiations rather than regulatory intervention and final decisions when disagreements arose.

In addition, the speed of the process and the penchant for negotiation undercut the transparency of the regulatory process. New entrants did not complain of any improprieties in the process. And they repeatedly expressed admiration for the expertise of the Mexican regulators. They objected to the fact that an informal process with a minimal written record and few written explanations of decisions cumulatively favored the incumbent operator. Setting formal precedent in a transparent process, they argued, limited the power of the incumbent because the dominant carrier would have to choose one justification for its policy, and then stick to it.

In 1997 the Mexican Competition Commission stepped forward to explain similar views. And in 1998 the new head of COFETEL emphasized that a clearer consolidation of authority at COFETEL would address concerns over the transparency and enforceability of regulatory policies.

Two policy issues dominated the introduction of competition. Rate rebalancing and interconnection policy became almost inseparable challenges.

Contrary to the long-standing plans of Mexico, rate rebalancing for local services had been thrown off schedule due to the peso crisis. Telmex was thus able to argue that the economics of interconnection had to reflect this shortfall in fulfilling government commitments on interconnection. A more specialized form of the rate rebalancing issue applying to international phone services further complicated the issue.

Virtually all of Mexico’s international telephone and fax traffic is with the United States, and this traffic is so large that it is even the second largest international route for the United States. As one might expect, the amount of traffic originating in the US was about three times greater than that from Mexico (about 2.7 billion minutes of traffic versus 890 million minutes of traffic).⁸⁶ And, like virtually all settlement rates outside the industrial world, the settlement rate between the US and Mexico was vastly above cost at 39 cents per minute in 1997.⁸⁷ As a result, US carriers paid over $ 700 million per year in net settlement payments to Mexico in 1997, their largest payment to any country in the world. If competition in Mexico threatened this income stream for Telmex too quickly it would resist fiercely.

At the same time, as in other countries, structuring mutually acceptable, cost based interconnection charges proved difficult. Prior to competition, Telmex and the Cofetel agreed to interconnection charges in April 1996.⁸⁸ However, in 1997, Cofetel, Telmex and the other Mexican carriers were unable to settle on a finally mutually agreeable interconnection charge. The sources of the dispute were very instructive.

By spring of 1998 Mexico had largely rebalanced local rates. Indeed, at roughly $38 for basic local service every month it has one of the highest rates in the Americas. Local service is undoubtedly quite profitable for Telmex at this level, and it will be sheltered from competition in this market for some time as a practical matter because entry into local services is always the longest and hardest task for new competitors. Thus, in theory, there was ample latitude for Telmex to adjust to cost-based interconnection rates and lower long distance rates. And, in theory, there was quite a bit of progress on interconnection charges except in regard to the largest source of profits in the market, international services.

Telmex persuaded the Mexican regulator in 1996 that it should impose a 58% surcharge on the international settlement rate for incoming calls from the US (that is 58% of the settlement rate, amounting to $ 0.228 per minute in 1997). If there was no surcharge, Telmex argued, the new entrants would be tempted to focus only on customers who generated lots of international traffic with the United States. By winning a share of these customers the entrants would successfully "skim the cream" off the Mexican market by only serving the profitable international market.⁸⁹ Therefore, the regulator felt it had to forestall this possibility by reducing the margin on incoming international traffic. (Moreover, Chile had a somewhat similar surcharge and it had not deterred market entry.) Unfortunately, this decision effectively raised the average cost of an interconnection very significantly. Including other one time and miscellaneous fees, one competitor in the Mexican market estimated the average cost of interconnection per call at 7.8 cents per minute. While the regulator expected to phase out the surcharge on international traffic in two or three years the new entrants had no faith in a general unofficial promise and little patience with the interim costs. Meanwhile, as has happened in most markets on the introduction of competition, there were significant problems with obtaining timely provisioning of interconnection with Telmex facilities.⁹⁰

In February 1998, Alestra first presented a grievance to Cofetel concerning interconnection, especially the surcharge. Avantel had filed similar petitions in January, February and April, 1997. During 1998, both MCI and AT&T filed complaints with the US Government requesting that a grievance be filed at the WTO concerning this issue and interconnection policy in general.⁹¹ On March 5, Avantel filed a court complaint in a Mexican court to expedite a ruling over interconnection.⁹² On April 21, the Mexican court allowed Avantel to suspend payments of the 58% settlement surcharge owed to Telmex until another court decides if the fee is justified. Cofetel responded to Avantel’s petition by expanding the number of fees Telmex could charge other operators for use of its network including additional costs for failed call attempts and a new charge for switching center interconnection. Earlier in April, Cofetel did order operators to unbundle accounting statements to determine costs for individual services.⁹³

In June, Telmex presented a complaint to the Attorney General’s office denouncing the suspension of payments. Telmex reported that Avantel owed the firm 240 million pesos (approximately $ 28 million) in interconnection payments.⁹⁴ However, Telmex’s complaint was rejected the following month.⁹⁵ In mid-July all long distance operators, save Avantel, formed a coalition to continue negotiations with Telmex to set interconnection charges.⁹⁶ Finally, on August 25, Telmex signed an agreement with Cofetel which eliminated the 58% surcharge. Telmex also agreed to consider establishing interconnection fees at $ 0.027 per minute, beginning on September 23 and lasting until December 31, 2000.⁹⁷ (Meanwhile, even though the surcharge disappeared there was still a disagreement over the level of the settlement rates. Telmex agreed to comply with the FCC pricecap of 19 cents per minute due in January 2000. But it objected to making any significant reductions before that date.)

The delay in implementing interconnection reform could have a prejudicial effect on overall network expansion, especially as Mexico prepares for competition in the local service market. In February 1998, Avantel announced the postponement of a $900m expansion plan covering origination of traffic from one hundred cities. It claimed that high interconnection fees would make the investment unprofitable. (Avantel has already invested $ 600m in the construction of its fiber optic network in Mexico City, Guadalajara, and Monterrey, and has planned to spend an additional $ 1.2bn on network construction).⁹⁸ Likewise, it is feasible that interconnection charges inconsistent with actual costs could effect other firms’ investment plans. Over the next five years Mexican basic service providers have projected investments of over $ 8bn (includes Avantel, Alestra $ 1bn, Iusacell $ 1.2bn, and Marcatel $ 2.5bn).⁹⁹

In many respects Mexico has conducted a remarkably swift and skillful shift from a traditional monopoly to a fully competitive market. Its regulations are often worthy models for all other countries. But interconnection policy is hard even when the regulator wants to achieve economically efficient costs and serious rate rebalancing and the dominant carrier is in good financial condition. The enormous profitability of the market in international services is a particular challenge for regulators because it creates inefficient incentives for both the dominant operator and new entrants.

Argentina had a contentious political struggle to introduce privatization and competition. It used a Presidential decree to introduce competition in mobile wireless services in 1988.¹⁰⁰ It began privatization of the Empresa Nacional de Telecomunicaciones in 1990 by creating two new national operators. Telefónica de Argentina, controlled by Telefónica de España and CEL Citicorp Holdings became the monopoly provider of local, long distance, and international (through Telecomunicaciones Internacionales de Argentina (Telintar)) services in the southern region. Telecom Argentina, controlled by France Telecom and Italy’s Stet SpA acquired the monopoly concession for similar service in the northern region. The Buenos Aires market was split between the two operators (the two firms do not engage in competition).

In 1996, Decree No. 1185/90 created the Comisión Nacional de Comunicaciones (CNC) from existing federal bodies with the goal of assuring the continuity, regularity, and equality of services, and to promote universal service at fair and reasonable prices through effective competition (in services which are not currently exclusive). CNC’s predecessor organization had been buffeted by continous upheavals in its leadership. (Petrazinni, pp. 88-89) And CNC has not escaped some of the oscillations. Still, CNC has broad authority in theory. Its duties include:¹⁰¹

1. administer the National Telecommunications Fund, which relies on contributions from telecommunications operators of 0.5% of gross revenues;
2. grant licenses and permits for telecommunications operations; dictate norms and regulations for telecommunication services including quality standards, technical fundamentals, and network interconnection policy;
3. regulate the behavior of the market for exclusively provided services (including rate approval and management through a price cap system) but maintain a minimum of regulation for services open to competition;
4. approve interconnection contracts and resolve discrepancies which may arise during the negotiation of such contracts; administer electromagnetic spectrum, as a scarce resource, assigning frequency with a goal of optimizing its use and promoting competitive conditions;
5. apply sanctions to firms that do not comply with CNC regulations.

Despite foreign investment in its carriers Argentina’s politics were for a long time very sensitive to any issue about loss of national sovereignty. For example, Argentina was the only major country in South America to avoid all commitments on value added services in the Uruguay Round’s initial agreement on telecommunications in 1993. The United States and Europe had to work hard to convince Argentina to change policy in the 1997 WTO deal. But, in the end, Argentina made quite a good offer on market access. It included foreign ownership or control of all telecommunications services and facilities beginning in 2000; guaranteed market access for satellite services and facilities (domestic and international) beginning in 1999; and guaranteed pro-competitive regulatory principles. Services other than voice services (domestic, long distance, and international) are open to competition.

In a major shift of policy the CNC agreed to gradually liberalize voice telephony, with the goal of full competition by November 2000. Originally, both companies received seven year exclusive licenses which were renewed for a period of three years in November 1997. However, in March 1998, CNC announced that it would allow two new basic service providers to initiate operations in November 1999, ending the monopolies one year early. The two incumbents have requested $ 200 million in compensation for the early end to exclusive rights.¹⁰² CNC granted licenses to CTI (a mobile operator controlled by GTE and Grupo Clarín) and Movicom (a mobile operator controlled by BellSouth and Motorola). Furthermore, Telefónica and Telecom will be free to offer service in the regions where they do not currently have exclusive rights.¹⁰³ Additionally, Impsat, Kedata, and Comsat acquired licenses for long distance and international services beginning in November 2000 (Impsat will only offer commercial, and not residential service).¹⁰⁴ Qualifying firms for new basic service licenses were required to already provide cellular, cable television, or local, independent phone services in Argentina.

An important part of Argentina’s preparation for competition was rate rebalancing that began in earnest in 1996. The country had very high rates for long distance that restricted demand for services greatly (and encouraged call back services) At the same time, rates for local services were very cheap. While adjustments were imperfect, especially for international long distance, rebalancing made it easier to consider competition.¹⁰⁵

Argentina further prepared for the liberalization of the basic service market through the passage of the General Interconnection Regulation (1/1997), and the Basic Telephone Services Decree (3/1998). The Interconnection Regulation required all providers with essential facilities to offer nondiscriminatory interconnection and set charges at 78% of revenues of outgoing traffic. After the end of exclusive concessions in 1999, interconnection charges are to be based on long run incremental costs of unbundled services.¹⁰⁶ Argentina shrewdly decided that until dominant providers are able to provide long run incremental cost information, charges will be fixed by CNC using comparable conditions and charges from the following countries: Chile, Peru, Mexico, United States, Australia, New Zealand, UK, Italy, France, Spain, and Germany. Although not all these countries have set their final rates this basket should yield interconnection charges on the order of three to four cents per minute, significantly higher than the United States but close to the upper range of practices in the European Union.

Equally significant was the approach to advancing universal service. The most significant portion of the Basic Services Decree was the requirement that all basic service provides install a wireline network or wireless local loop in all locations with more than 500 inhabitants or where at least 30 clients request service during the transition period (before 11/1999).

Argentina’s liberalization has led to tangible improvements in basic services as existing firms prepare for a contestable market. In terms of network enrichment and expansion, Telefónica has invested $ 1.28bn between October 1996 and June 1998, and $ 6.37bn since it began operations in November 1990. During the past year, Telefónica has focused much of its investment towards digitalization of its network, achieving 100% digitalization in June 1998 (compared with 82.5% in December 1996). Likewise, lines in service increased by 12.4% between December 1996 and June 1998 (representing a teledensity increase from 21.4 to 23.8). During the past two years, the firm has also become more efficient, increasing lines in service per 100 employees from 256.1 in December 1996 to 335 in March 1998 (29.8%).

Telecom has also made significant network improvements since 1997. Total investment for 1997 was $ 502m ($ 5.2bn since 1991). Full digitalization was achieved by the end of 1997 (up 4.5% since the end of 1996). Lines in service increased 9.3% during 1997 (from 17.1/100 inhabitants to 17.7/100). Lines in service per employee also increased from 218 at the end of 1996 to 277 by December 1997, a gain of 27%. Meanwhile, in the already competitive market for wireless services, the market size doubled in 1997.¹⁰⁷

Although the prevalence of basic services in Peru is inferior to that of the three other Latin American countries mentioned in this region, the telecom market has become as efficiently regulated as any in Latin American. The Oganismo Superior de Inversión Privada en Telecomunicaciones (Osiptel) was created in July 1993, and enjoys technical, economic, financing, functional, and administrative authority over telecommunication market issues (including promoting competition and consumer rights, authorizing sanctions, fixing and approving rates, etc.). Osiptel also administers the Private Telecommunications Investment Fund (FIFTEL) which is used to promote services in rural areas and services of social interest such as universal access. Additionally, the Ministry of Transport and Communications (MTC) administers the general politics of the telecommunications sector including administration and concession of electromagnetic spectrum.

Osiptel and the Peruvian privatization body Promcepri merged and sold the two state-owned carriers CPT and ENTEL in 1994, to of Telefónica de España. The new monopoly, Telefónica del Perú (TdP) was granted a period of exclusivity until June 27, 1999, when Osiptel was to begin to allow competition for basic services. Also, in accordance with its WTO commitments, Peru guarantees foreign ownership or control of all telecommunications services and facilities beginning, market access for satellite services and facilities (domestic and international), and pro-competitive regulatory principles beginning in 1999. Other basic services are to be liberalized in 1999 for long distance and international market segments and are liberalized without phase-in for supply in the local market. Furthermore, Peru has announced it will adopt a price-cap rate system, based on costs, and that interconnection charges will be based on long run incremental costs for unbundled service.¹⁰⁸

In August 1998, Osiptel hastened the transition to competition when it announced an agreement with TdP to end the operators monopoly status one year early, opening the telecommunications market to full competition effective August 1, 1998. There will be no limit to the number of operators who will be able to provide basic service (assuming firms are able to meet the outlined requirements).¹⁰⁹ Tele 2000, a cellular provider controlled by BellSouth, and Resetel has begun preparations to offer local service, and, according to Osiptel, a number of firms have expressed interest in entering the Peruvian market. The Peruvian government expects that competition will increase lines in service from the current 6.8 per 100 inhabitants to 20 lines (includes wireless, which now stands at 2.5 lines/100) by 2003 through investment of $2.5bn.¹¹⁰ Meanwhile, consistent with the trend of high growth rate throughout Latin America in the competitive market for wireless services, the number of wireless subscribers grew by 150% in 1997.¹¹¹

TdP invested $ 2212 in 1996 and $ 1500 in 1997. Lines in service increased by 17.9% from the beginning of 1997 through June 1998, raising the teledensity figure from 5.9 lines to 6.8 lines per 100 inhabitants. Furthermore, lines in service per employee have increased from 228 to 287 (25.9%). Digitalization of the network has only increased marginally during this period (from 85% to 88%). However, calls completed are up to 85% from 52% in 1994 (weighted average of local and long distance).

Chile was the first Latin American country to take significant steps towards liberalizing its telecommunications market. Prior to the 1980s, the state owned Compañía de Teléfonos de Chile (CTC) controlled about 90% of lines in service. However, by the 1990s, Chile, through the auspices of the Subsecretaría de Telecomunicaciones (Subtel), the regulatory body created in 1977, came to allow competition for all telecommunication services. Subtel has been effective in requiring cost based interconnection charges and encouraging competition in the basic service market through regulation of rates.

Although, like Mexico, Chile has a surcharge on incoming international traffic for the purposes of interconnection the surcharge has not become a source of really bitter policy struggle. One reason is that the traffic imbalances with other countries are much smaller than they are for Mexico. The traffic ratio with the United States is about 1.5 of incoming traffic for every minute going to the US, much less than the three to one ratio of Mexico.¹¹² However, the settlement rate itself is higher, about 36 cents per minute in 1998. This means that the cost of the net settled minute for a US carrier (adjusting the rate per minute to allow for income from return traffic from Chile), for example, is about 18 cents, instead of the roughly 70 cents for Mexico. This makes the effect of the surcharge on the average cost of interconnection in Chile much less important in Chile than in Mexico.

During the past few years, the Chilean basic service market has witnessed the exit of a number of firms, and has largely come to be controlled by four major carriers, CTC, Entel, Chilesat, and BellSouth. Although competition exists for local and long distance services it is clearly much more vigorous for long distance. Entel, the dominant carrier in long distance, has lost a sixty percent share of the market. In contrast, CTC remains by far the most important carrier in the country because of its overwhelming control over the market for local phone services.¹¹³ While interconnection charges of six cents per minute for domestic long distance calls suggest that regulators have yet to bring full cost-based interconnection to the market Chile’s regulators have generally put in place most of the key elements of a successful interconnection policy for local and long distance services.

The Chilean case supports the theory that a viable option for open competition in local services combined with vigorous entry in long distance can result in extensive investment into all parts of network expansion. CTC cannot assume that it will still dominant in local services. The ITU projects that Chilean basic service providers will invest $ 3.4bn from 1996-2000. This number is relatively impressive given the small size of the Chilean population (approximately 14m) in comparison with some the more populous countries in the region (see chart for comparison). High levels of capital investment has resulted in tangible increases in the number of lines in service in Chile, as teledensity has risen from 13.2 lines per 100 inhabitants in 1995 to 17.8 lines/100 in 1997, an increase of 35% over the two year period.¹¹⁴

Perhaps the most remarkable feature of Chilean policy is the approach to funding universal service. It features the use of an auction of distribute subsidies for service in rural areas with low teledensities. In effect, the regulator sets aside a certain amount of money to encourage network build-out. The carriers then bid by offering packages of network construction and service using the subsidy. The best offer gets the subsidy. This both creates significant incentives to lower costs for universal service and speeds up the deployment of new network in low teledensity regions. It also makes the subsidy to the carriers more competitively neutral because the auction gives rivals a chance to bid away any potential rent for the winner.

The strongest common denominator for policy in our case studies is the strong desire to accelerate network build-out. The privatization of transitional monopolies or the immediate introduction of general competition are alternatives to achieve this goal. A corollary to this goal is making sure that a greater part of the country has access to the expanded network. Thus, a policy on universal service is essential.

In our view a second policy objective is equally important. This goal is efficient and flexible pricing and supply practices. It is not enough to have lots of telephone plant. By the criterion of infrastructure build-out there was no problem in Europe or Hong Kong in the early 1990s. The problem in these countries was that communications are a vital input to the information economy, whether at the household level or the factory. As a key component of the fastest growing part of the economy (information technology investment now represents about 10 percent of U.S. GDP) it is essential that the pricing of communications services maximize efficiency in the marketplace.¹¹⁵

It is also critical that the providers of communications services are responsive to new opportunities and demands for utilizing them in the economy. For example, in the United States competition is responsible for new business practices by operators for installing leased communications lines. The timely provision of such lines was critical for allowing small businesses to scale up their capacities as needed, rather than having to undertake major financial commitments for communications capacity months in advance of proven needs. And MCI’s innovative billing software permitted such pricing innovations as "calling circle" discounts that stimulated demand in the long distance market.

The WTO agreement also makes a third goal more immediately critical--efficient embedding of the domestic communications market in the global market. The organization of the domestic communications market is not separate from the organization of the global market. As Part One argued, competition in the provision and pricing of cross-border services got a major boost from the WTO agreement. And technological innovation in the form of convergent services on the Internet is going to accelerate these changes.

Our review of experiences with the transition to competition leads us to focus on four policy challenges. The first is the need for quicker transitions to competition. The second is the critical role of rate rebalancing because it is essential to combining efficient competition with network build-out and universal service. If rate rebalancing succeeds, it is easier to get interconnection policy right, and interconnection policy (the third policy challenge) is indispensable to getting competition right. Finally, without the creation of a credible regulatory process it is much harder for a market transition to succeed.

Part One analyzed the economics of network development and suggested that transitional periods for the retention of monopolies may be justifiable. This point is critical for many of the poorest countries that have not yet embraced competition to any significant degree. But our case studies have also underscored a second reality, given further impetus by the WTO Agreement--countries are shortening the transition time for monopolies. Most of the benefits of a transition period can be claimed in a relatively short period, perhaps on the order of five years. The oasis from general competition will give the incumbent an incentive to build out and modernize aggressively. Contrary to the claims of incumbents new entrants cannot claim market share fast enough and large enough to negate the financial benefits of installed new plant. (No one has shown such a case to be true.) But the prospects of competition will also discipline its market behavior, and make consumers bargain more aggressively, in light of future competitive entry.

A corollary to the need for quicker transition is the narrowing of the range of services covered by monopoly franchises. Monopolies on public phone services are in no danger of losing their markets by a sudden exit of everyone to some other technological alternative. The great policy danger in developing countries is not putting enough communications alternatives in the economy at cost-based prices quickly. The case of Jamaica, reviewed earlier, illustrates the point.

Put differently, monopoly should not interfere with technological innovation. Perfect examples of this issue involve Internet and wireless services. For example, in some countries there have been significant controversies over the operations of Internet Service Providers. Some monopoly operators would like a monopoly for ISP service or for its underlying infrastructure. Yet Internet services are a perfect example of low cost capabilities that dramatically extend the flexibility of services for those users trying to gear up for the global information economy. Even in the United States they are not a threat to basic phone services over the next few years. And phone companies are finding it profitable to compete for the data traffic that they produce.¹¹⁶ If there is no threat to phone companies in the US, then the notion of a danger to monopolists in developing countries with insufficient infrastructure is surely an odd one. Similarly, new wireless technologies, like LMDS (local multipoint distribution services) or data broadcasting on part of the spectrum of television stations, offer new ways of providing additional data and voice services immediately in local service markets. They are not going to destroy use of the existing wire networks.

The other corollary to quicker transitions is that countries should welcome foreign investment as part of the effort to induce investment and reduce barriers to entry.¹¹⁷ Foreign investors bring not capital, they bring new business models that can benefit consumers. As the cases in Central Europe showed, foreign investment limits (even ones allowing substantial foreign investment) can effectively preclude competitive entry in the market for local communications services.

If transitions move faster then countries probably should take a fresh look at the "build, operate, and transfer" model that was so popular in the last ten years, especially in Asia. BOT presumes that foreign investors will build and operate new network capacity and then transfer it back to the national monopolist at a later date. Its attraction was as a way of reconciling continued monopoly with the interjection of fresh sources of investment capital and know-how.¹¹⁸ The quicker movement to competition characteristic of today’s market suggests that BOT may be less useful as a policy option in the future.

It is almost impossible to exaggerate the demand for more network capacity in transitional and developing economies. Certainly the traditional indicators of unfilled demand, such as waiting lists for phone service, vastly underestimate pent-up demand because they do not capture large numbers who don’t bother registering on the list and the even larger numbers that utilize capacity fully because of counter-productive pricing. Unfilled demand is a major loss for consumer welfare.

A particularly keen irony of prevailing practices is that one significant problem in regard to network build-out, irrespective of the degree of competition, is universal service policy. The typical mechanisms for providing universal service can become the enemy of greater economic efficiency and faster build-out. For example, the frequent practice of keeping local rates below costs to encourage universal service simply discourages investment in building out the local network.¹¹⁹ Yet this is a protection for consumers that treats the wrong problem. There is little evidence that bringing rates for local service into line with costs cause any significant dropping off from the network in any income group. (To the extent that there is a problem, there are far more efficient ways of handling it. See Box 3.) And it comes at the cost of discouraging adequate network infrastructure.

Other distortions of rates in the names of equity produce significant setbacks to efficient provision of communications services and create political disincentives for competition. For example, relying on subsidies from urban to rural areas (a byproduct of the geographic averaging of prices) can lead to the absurd result of poor urban workers subsidizing phone services for the country estates of business leaders. Meanwhile, incumbent phone operators have a powerful political weapon to use against introducing competition because they will argue that new entrants are likely only to serve urban areas (thus "skimming the cream" from the market).¹²⁰

Another difficulty of keeping local service rates are artificially low is that this creates incentives to inflate the rates on domestic and international long distance services (including data services). Inflated prices for domestic and international long distance are a significant tax on business. The extremely high cost of international calling is a barrier to export oriented growth by smaller firms.

All countries suffer from inflated rates for international services including the United States. But the situation in virtually every developing country is far worse than industrial countries. The rates for international services to and from a typical country are so high that, translated into equivalent tariff protection levels, they are equivalent to a tariff of 100 to 500 percent on communications and data services that are a key component of modern production and distribution. What finance minister would justify such a tariff for any important manufactured good? Why is it justifiable for telecommunications services and the Internet? High prices are strong disincentives for the creation of an information-based economy. In particular, it is impractical to advance the globalization of the economy without cost-based prices for international communications services and the discipline of market competition to induce flexible and creative arrangements for data services.

What can be done? The most important step is to move to cost-based rates for all services. This means significant rate rebalancing across classes of services and much less averaging of rates. Public policy should be seeking to duplicate the logic of other digital information markets. These markets cover costs in their pricing, but typically feature steadily declining prices to encourage high volume utilization, thereby driving down costs and allowing the supplier to maintain adequate margins even at lower prices. Rebalancing means that local service prices may rise (at least in some regions of a country) but many other prices will decline and tap significant demand elasticity.

The good news about rebalancing is that, while certainly subject to political controversy, even dramatic needs for rebalancing are manageable without causing loss of universal service. For example, the Philippines was especially dependent on revenues from international services from the United States. As those rates declined rapidly, the Philippines completed a significant rate rebalancing. (As of 1998, households pay about $20(US) per month for basic local service.) Lower prices for long distance services, along with the belated rapid expansion of cellular services, have also generated more domestic long distance traffic and income.¹²¹ And, more generally, modern financial techniques allow for effective commercial financing to handle many issues posed for cash flows while rebalancing. When these techniques are not enough, international financial institutions like the World Bank are willing to assist.¹²²

Getting rates in line with costs also means that rates should responds to the economic logic of the call. A good example is in cellular telephony. One reason why Israel, for example, jumped ahead of the United States in the use of cellular phones was mistaken pricing policy in the United States. The United States used a "receiver pays" principle for cellular calls. Israel, as in wire network calls, used "sender pays," a mechanism much more accurately responding to the economic incentives involved in calling someone.

A second policy measure should be greater flexibility for operators in setting prices. Price caps for broader baskets of services are one way of achieving this goal. Especially as competition is introduced it is especially desirable to allow more flexibility in pricing plans for local services. For example, regulators could allow more pricing options featuring variable rates (so-called metered calling) that allows operators to meet changing market and cost conditions.

A third policy choice involves controversies over the pricing of new services made possible by technological innovation. Regulators may become caught in a quagmire of cost arguments about services like Internet video conferencing. There is no perfect solution to such issues. But we think that there is much to recommend in creating a "safe harbor" for the pricing of new services. As long as existing communications markets are very imperfectly competitive and have badly flawed pricing, it may be wiser to exempt newer services and technologies from the regulatory errors of the past.

These services have a great potential for inducing dynamic corrections of past errors by forcing cost improvements and pricing reforms in traditional services. If the new services someday grow to become a major part of the national market, five percent of the total market as one example, then the regulator can reconsider the policy and make it more closely aligned with traditional services.

Interconnection policy is extremely hard to implement. Our country studies have noted that it has produced high levels of uncertainty and strife. Given the economic significance of the issue this should surprise no one. But there is in fact a policy consensus based on hard-won lessons from introducing competition.

Requirements for interconnection go to the heart of competition and therefore one should expect vigorous disputes over its precise terms. These regulatory and judicial disputes (especially in the United States) have created an impression in developing countries that there is no consensus on the correct principles and terms for the policy. But, in fact, there is a fundamental consensus in the industrial countries. Interconnection policy sets pricing for interconnection based on some version of long-run incremental costs. It requires timely provision of leased circuit capacity, significant unbundling of network elements available for interconnection, the non-discriminatory access to rights of way, and the portability of telephone numbers when subscribers decide to switch carriers. And it uses a process featuring direct negotiations among the commercial parties and a timely dispute resolution mechanism by which the regulator, relying on pre-announced guidelines (such as the reference interconnection offer required in the European Union), settles matters not determined by the commercial negotiations.¹²⁶

The disputes over interconnection pricing in industrial countries, for example, may focus on whether the basic form for interconnection between two local networks should cost $.01 to $.03 per call.¹²⁷ However, the fury generated by these disputes has created a mistaken impression in many developing countries that estimates of costs in industrial countries vary wildly. (Box 4 presents more information on these rates across countries.) Similarly, there is some dispute over the precise range of elements of the network’s functions must be unbundled and available to new entrants, but there is consensus that several elements require unbundling.

A telling example in the policy debate is the recent revisions of interconnection charges in the Philippines and Mexico, both lower middle income countries according to IMF classifications. Both countries were leaders in introducing competition in telecommunications services. Both have independent regulatory commissions. Both have dominant carriers (PLDT and Telmex, respectively) who have had significant build-out programs in the past ten years. Both still have a long way to go in achieving teledensity levels comparable to leaders among industrializing countries. Both relied heavily on revenues earned from terminating incoming traffic from the United States to compensate the dominant carrier for problems in pricing local exchange services. Yet when it comes to pricing interconnection the two could not be further apart. The reforms in the Philippines in 1998 lowered interconnection charges from about 28 cents (US) per minute to 19 cents.¹²⁸ The reforms in Mexico announced in December 1998 lowered the charges to 2.7 cents (US) per minute. At the Philippine level the new entrants who have been building out the network infrastructure and stimulating growth in the domestic market may stumble. At the Mexican level the prospects for the continuation of major new investment by entrants are good.

The Mexican rates are consistent with practices in Argentina (announced) and Chile (existing). Advocates of the Philippine rate point out the attacks on US interconnection pricing by the Bell Operating Companies, for example, but somehow ignore the reality that no Bell has ventured in recent years that the cost of interconnections is more than a few cents per minute. (For example, one of the new entrants complaining about the Philippine has Bell Atlantic as a major investor.)

It is true that it is hard to determine the costs of incumbents reliably, especially if one wants to pay some attention to historic costs. The necessary data are simply missing. But this is no reason not to use some form of international benchmarking to help determine interconnection costs. There is now a big enough pool of countries doing interconnection to provide an appropriate reference group. Even allowing for some upward adjustments based on uncertainties about local conditions a country would still get a much more realistic calculus for costs in a much faster period than the somewhat quixotic search for accurate embedded costs will every yield. (See Box Four on the next page for interconnection pricing around the world.)

It is even harder to execute a successful interconnection policy because many countries are chasing the goal of "real network investment." Many governments fear that new competitors will simply lease transmission and switching capacity from the incumbent carrier and resell telecom services at a discount. Unburdened by any investment costs they will pocket the profits from buying services on a bulk discount from the dominant carrier and then passing on only part of the discount to their customers. The result, governments fear, will be less investment in telecommunications infrastructure by the incumbent and no new investment by the new entrants. Mexico, for example, will give somewhat better terms for interconnection to carriers with significant network facilities.

A variant on the fear of resale is the fear that unlimited entry into the development of new networks will create surplus network capacity. In theory, there will be less investment because no one can make money if there is the prospect of surplus capacity. Alternatively, the government will admit that there may be lots of network investment but the government fears the negative consequences for the business climate if the new entrants fail. Korea’s limitation on the number of licensed international telephone carriers (three in all) seems driven by this fear. Several other Asian countries have similar policies.

Part One observed that such special national features as demography and the prior levels of network development can influence the timing and terms of a transition to competition. But network economics and technology are still fundamentally the same everywhere. The experiences of the United Kingdom and the United States suggest that the fears of resale and surplus network capacity are often overblown as long as countries make realistic plans for the transition to full competition.

The UK initially limited the number of network competitors but later decided that this policy had failed even though it had created a duopoly in long distance services. The policy had not maximized the building of new networks and it had not lowered prices as rapidly as desired. The Government then switched to allowing unlimited entry but it gave some regulatory advantages to carriers that build their own facilities based networks. In the context of the history of UK network development this represented a gamble that hybrid systems for cable television and telephone services could provide competition in local exchange services. Still, the UK Government was very careful to limit the advantage given to facilities based networks. By the late 1990s the biggest disadvantages for resale carriers involved two elements of what is generally called "equal access":

1. The UK did not grant their rights to "dialing parity" (their customers had to dial extra digits to access their services);
2. The UK did not grant "carrier pre-selection" for resale carriers (their customers could not choose a resale carrier as the automatic option when they made a call).¹²⁹

The British regulator reasoned that these advantages provided some added incentive for network investment but did not discourage resale operators from competing vigorously wherever facilities carriers lagged on pricing or customized services. This is a key point for consideration by regulators in developing countries where pricing distortions are one of the worst problems in the marketplace.

It should be emphasized that the British policy for network development had different policy priorities than many regulators in the developing world face. The British rightly assumed that long distance competition in the UK market was a goal achieved fairly easily, so its goal was to move up the next level to achieving a second wire to the home (and broadband connectivity). The priority in developing countries is to establish competition in long distance services and to use competition in local services to speed the achievement of higher levels of teledensity. In many ways a policy supporting a mix of equal access, unbundling, and resale may allow for greater technological and market flexibility. In any event it is fair to say that the British regulator’s enthusiasm for cable telephony never contemplated the measures advocated by many dominant phone companies in Europe today. These incumbents argue that new entrants must put switches into virtually every significant traffic point in their country or be denied favorable terms for interconnection. This is a strategy whose only justification is protection of the incumbent and one or two privileged new entrants.

The history of the United States is a strong argument for both unlimited entry and equal regulatory treatment for resale carriers. The US experience shows that it is very hard to define the difference between facilities based and resale carriers. Most resale carriers have some telephone switches. All facilities carriers also resell the capacity of other carriers. And, most importantly, until recently most new entrants in the market began primarily as resale carriers. Resale allowed the new entrants to build a customer base and cash flow. Successful resale carriers soon began to invest in facilities and eventually developed into facilities based networks. On balance, if you could build customer use up, it was cheaper to own your own facilities on key routes and there was a natural market incentive for large resale operators to build facilities. So, it took no regulatory discrimination in favor of facilities carriers to get new network investment.

Regardless of the U.S. experience the political attraction of a tilt toward facilities-based operators is considerable. Facilities represent visible building and investment, always good things politically.¹³⁰ While, in the long-term a sound policy will give equal standing to facilities and resale based operators some tilt in favor of facilities operators may occur in the short-term. If so, the regulator has to guard against any policy that, in the name of encouraging facilities-based operators, discriminates against easy entry and interconnection. Requiring many switches and points of network presence in order to qualify for favorable interconnection terms can defeat both resale and facilities-based entry.

This caution is especially urgent because technology is creating many opportunities for new services that will not fit neatly into the facilities versus resale distinctions of the past. For example, one of the most important developments in the United States and European markets is the development of backbone long distance networks operated by companies that are only in the wholesale business (see Box Two). They have made huge new investments in transmission capacity, hastened the introduction of packet switched networks far more efficient than the traditional networks of companies like AT&T, and lowered the price of services. Of course, the rise of these wholesale "carriers’ carriers" means that other carriers are reselling the services from those facilities. It is precisely this kind of innovation that interconnection policy should not penalize.

It is the nature of transitions that inheritances of the past can be as problematic as they are valuable. Managing the relationship between former government operators and the regulator is a major challenge, especially because privatization rarely happens instantly. An even bigger task is finding the right formula for ending monopoly, especially when the initial policy choice proves inadequate.

Our cases also suggest some guidance for addressing these issues. The Hungarian approach suggests the right approach to continued government ownership of the dominant telephone company. Hungary’s State Property and Asset Holding Agency manages the remaining government shares. This Agency is separate from both the communications regulators and the finance ministry. While this does not preclude government interest in the welfare of its stockholding it removes any specific incentives for senior officials in the key agencies influencing communications policies to favor the incumbent phone company.

The tougher issue is how to handle the end of monopoly. The pace for moving to general competition is speeding up considerably. Decisions on extending monopoly franchises made earlier this decade now look dubious. But reversing these decisions raise the credibility problems discussed in Part One.

The Czech Republic addressed precisely this kind of "regulatory regret" by using a "buyout" to achieve an earlier end to monopoly. It had good company. This was also the approach chosen by Singapore and Hong Kong when the monopolies on international voice services of Singapore Telecom and Hong Kong Telecom became serious sticking points in the WTO negotiations. (The OECD countries found no economic justification for these monopolies in such advanced economies.) Both had had their monopolies extended during the past decade. Both were listed on public stock exchanges although the Singapore Government had majority control of its carrier.

Both countries pointed out that they had built their credibility in world markets by sticking to their contracts. So, even if they privately agreed that they should no longer have a monopoly, they argued that they could not easily undo it. In the closing months of the WTO negotiations Singapore found an answer. It paid a very large sum of money (in the neighborhood of one billion dollars) to buy an early end to Singapore Telecom’s monopoly on both domestic and international telecommunications services. Some of the sting, of course, was less because it owned most of the carrier’s stock. After the WTO agreement Hong Kong followed a variant on this path.

The approach in Hong Kong included the use of its regulatory power to introduce international simple resale on all routes except to China (a measure that effectively allowed competitors to Hong Kong Telecommunications International to rent capacity on its international facilities and provide inexpensive international service). It also included granting Hong Kong Telecom significant increases in local phone rates through the year 2000 and greater freedom on setting its prices flexibly to meet competitive challenges. (Hong Kong already had competition in local phone and mobile services.) As a result, Hong Kong Telecom voluntarily agreed to end its monopoly on international telephone and fax services by 2000, instead of 2006 as originally scheduled. Because the Hong Kong and Singapore solutions involved a voluntary commercial agreement and compensation both advocates of consistency in commitments and advocates of market competition were satisfied.

The question facing many countries is what to do in similar circumstances. The Hong Kong and Singapore examples are certainly instructive. A change in the concession cannot be arbitrary and capricious. The buyout is an attractive solution. But, within reason, governments also have some other ways of altering the costs and benefits of the concession holder.

Some countries are taking as narrow a reading of monopoly concessions as they can. In effect, they are taking advantage of new technology delivery systems and new services to open the market. Mobile and satellite services are two examples of using new technology delivery systems to define new categories of services deemed outside the monopoly. Jamaica, for example, is allowing new licensees to build and operate satellite earth stations to serve private networks. Even before ending its monopoly on public telephone services Brazil relaxed its definition of what constituted a "private network" so as to permit a company to open its private corporate network to exchanges with all major suppliers and distributors. The Internet, including voice and video over the Internet, is another major opportunity. The key point is that changing the benefits of monopoly can induce a voluntary re-negotiation of the monopoly license by the incumbent. Some financial compensation may be necessary, but other offsets can include changes in pricing regulation or "dominant carrier" regulation that would improve the competitive prospects of the former monopolist.

One of the hardest tasks of the transition to a competitive market is creating an effective independent regulator with adequate expertise and information, adequate authority, and sufficient accountability. The problem is getting harder because technology is creating a greater convergence of services and eroding the logic of traditional regulatory distinctions.

The crucial first step is truly separating the regulator from the operator and then making sure that the regulator has adequate resources. (See Box Five.) Once achieved, a top priority is to work smart, not just work hard, by using tactics that simplify the task of regulation. Three are especially appealing.

First, the regulator should select its market policy so as to provide incentives for the timely disclosure of critical information. Competition and privatization are, in a very profound way, measures to induce better disclosure of information because now the financial markets and other suppliers are monitoring the claims of the dominant supplier. While competition is no bar to self-serving complaints by new entrants it does create a marketplace of information about the telecommunications market. For example, one reason for introducing more competition in wireless services, and tilting toward grants of greater bandwidth for many licenses, is to let market competition for the acquisition of spectrum and its use sort out hugely complex issues about what is the best use of spectrum.

Monopoly is the enemy of good information. If a country opts for a transitional monopoly it would do well to borrow from the examples of Argentina and Hungary. Both countries resisted granting a single national monopoly. Creating regional monopolies allowed government officials to benchmark the performance of the monopolists against one another. This is a highly imperfect device, as the limits on monitoring state telephone monopolies in the United States demonstrated. But it is better than dealing with a monolith.

Second, regulators can ease their burden by finding ways to use private property rights to simplify their jobs. As we argued in Part One, especially during the early years of establishing credible regulation, regulators should consider how to use private dispute resolution mechanisms to assist them. Reference offers for interconnection published by the regulator paired with private negotiation by the parties is one way of doing so. The trick here is also to impose a deadline for private negotiations before the regulator settles the dispute.

Spectrum policy is an especially demanding challenge for regulators. Better defined and fuller property rights for the spectrum could ease the burden of regulators. For example, it is a good idea to allow licensees greater discretion to determine how they will use their spectrum once the regulator has implemented pro-competitive licensing of the spectrum.¹³¹ (The Mexican auctions show that auctions can yield a large number of new entrants quite speedily and in a way that builds confidence in the regulatory process.) The grant of discretion lets the marketplace figure out what the highest value of the spectrum is rather than getting regulators excessively in the game of managing rapidly changing technology and its use.

Third, regulators can use international arrangements and consultations with other national regulators to simplify national policy. The WTO regulatory principles are a good example at the level of general policy. The challenge now is to create regular consultations among national regulators, as is done in the realm of central banking, to share best regulatory practices and experiences.¹³²

At the level of working detailed regulation the growth of mutual recognition arrangements for telecommunications equipment is an excellent example of globalization in order to simplify regulation. In an innovative arrangement, for example, the ITU "mark" is being put on the mobile handsets for Global Mobile Personal Communications Services being offered by suppliers such as Iridium, Globalstar, and ICO. Acceptance of the mark greatly simplifies issues of equipment testing and certification. Across the Atlantic (through an agreement between the United States and the European Union), across the Pacific (through an agreement within APEC) and across North America (through the NAFTA agreement) the approval of equipment for use in telecommunications and computing networks is being vastly simplified.

All of the techniques for improving regulation do not resolve the fundamental question of how to organize the basic power over regulation. An especially difficult problem is the question of how to divide up powers over regulation among different government agencies. There is no perfect answer here because regulatory systems reflect the terms on which power is delegated to regulators. Scholars have long known that different forms of government have different ways of delegating power to regulators.¹³⁴ The main point is to be clear about the tradeoffs.

The UK model has proven popular because it reflects some of the incentives of parliamentary governance that puts a premium on ministerial responsibility. The ministry formulates the parameters of regulatory policy (i.e., investment conditions for acquiring a permit, number of permits in a given area, sequencing of issuing the permits) and may even issue the individual licenses. Such a division can work effectively, as it does in the UK. But it is also prone to stripping the regulator of much of its power. The granting of licenses, and the conditions put on the license, become acts that undercut the authority of the regulatory commission. This can rapidly lead to fighting between the two authorities and make difficult decisions even harder to achieve. Worse yet, many countries do not grant regulators effective enforcement powers. If they do not control the licensing authority they have few powers to force good behavior by the dominant phone company. This problem has challenged policymakers in Mexico. And it may cause problems for some of the new regulatory authorities in Europe.

In contrast, the division of powers between the President and Congress does not easily allow for the kinds of delegation of authority between a ministry and regulatory authority seen in Europe. Thus, in the U.S. model Congress specifically legislates the creation of an independent regulatory commission and delegates powers to it. The purpose of the broad grant of authority to the FCC is to reap the benefits of expert policymaking in a very technical market. Getting the benefit of this expertise requires granting considerable discretion, and thus the FCC operates under a Congressional mandate to consider the "public interest" in developing and executing its policies.

When Congress delegates power it also creates elaborate safeguards. The "public interest" test is subject to extensive judicial review and precedent. It also requires elaborate administrative procedures to assure that the Commission’s policymaking is transparent. The result is a process that emphasizes the creation of elaborate rules rather than relying on ad hoc problem-solving to shape policy. Often the rules seem unduly elaborate, but the Commission is not free to invent major policy on the spot. For observers from Parliamentary systems this can be frustrating. Yet the big advantage of the Commission system is that it has the power to make decisions. It has control over rates, licenses, and universal service policies, for example.¹³⁵ Its broad span of control over wire, wireless, and broadcast networks also gives it a strong hand for dealing with convergence issues.

It is possible to design hybrids of what we have called the UK and US models. Central banking is an example. The premium on assuring the credible independence of the central banking function leads governments of all kinds to grant both considerable consolidated discretion to the central bank over monetary policy and to free the central bank from some of the administrative safeguards imposed on the FCC. The strong role of finance ministries means that central banks alone do not control monetary policy, but they do have considerable discretion in their domain. The central bank model is worth pondering when designing regulatory institutions for the communications market. However, unlike central banks, the detailed regulatory supervision exercised by communications regulators means that discretion cannot compromise transparency.

The telecommunications industry is undergoing a revolution. Happily, it is a benign revolution. Technological change and competition are making possible changes that were considered improbable even fifteen years ago. According to Luis Jimenez of Arthur D. Little, "It used to take countries 20 to 30 years to increase penetration rates from to 10 to 30 lines per 100 inhabitants. In many countries now it is taking a decade or under."¹³⁶ We believe that a quick transition to competition under the pro-competitive rules can yield even greater benefits in the future.

The WTO Agreement on Basic Telecommunications Services set a new regime for the world market. The basics of the regime require a close attention to regulatory fundamentals. These include low barriers to entry in the market for communications services, effective rebalancing of rates for services during the market transition, strong interconnection policies, and the creation of independent regulatory authorities with the resources and power necessary to foster competition and safeguard consumer welfare.

Arena, Alex, "The WTO Telecommunications Agreement: Some Personal Reflections" TeleGeography: 1997 (Washington, D.C.: Telegeography, 1997).

Armstrong, Mark, and John Vickers, 1996, "Regulatory Reform in telecommunications in Central and Eastern Europe," Economics of Transition, 4, pp. 295-318.

Armstrong, Mark, (1997) "Competition in telecommunications" Oxford Review of Economic Policy, 13, p. 64-82.

Bar, Francois and Michael Borrus, 1992, "Information Networks and Competitive Advantage: Issues for Government Policy and Corporate Strategy," International Journal of Telecommunications Management, Vol. 7, Nos. 6/7/8, pp. 398-408.

Baron, David P. "The economics and politics of regulation: perspectives, agenda and approaches," in Jeffrey S. Banks and Eric A. Hanushek (eds.) Modern Political Economy (New York: Cambridge University Press, 1995).

Bhagwati, Jagdish (1994) "Fair Trade, Reciprocity and Harmonization: The New Challenge to the Theory and Policy of Free Trade," in Deardorff, A. and R. Stern (eds.) Analytical and Negotiating Issues in the Global Trading System, The University of Michigan Press, Ann Arbor.

Bond, James, "Telecommunications is Dead, Long Live Networking--The Effect of the Information Revolution on the Telecom Industry," The Information Revolution and the Future of Telecommunications, World Bank 1997.

Braga, Carlos A. Prinzo, Emmanuel Forestier, Peter A. Stern, 1999, "Developing Countries and the Accounting Rate Regime," Viewpoint, No. 167 (The World Bank)

Brennan, T. and J. Boyd (1997) "Stranded Costs, Takings, and the Law and Economics of Implicit Contracts," Journal of Regulatory Economics, v. 11, p. 41-54.

Cairncross, Frances, 1997, The Death of Distance (Harvard Business Press).

Campos Jose Edgardo and Hilton L. Root, 1996, The Key to the Asian Miracle (Brookings Institution Press).

Cho, Sung-Woon, The Dynamics of Institutional Reform in Telecommunications (NY: Garland Publishing, 1998).

Commission, European, 1998, Fourth Report on the Implementation of the Telecommunications Regulatory Package (Brussels).

Cowhey, Peter F., 1990, "Telecommunications," in Gary Hufbauer (ed.), Europe 1992: an American Perspective, (Washington D.C.: Brookings Institution Press).

Cowhey, Peter F., 1990, "The International Telecommunications Regime: The Political Roots of High Technology Regimes," International Organization, Spring.

Cowhey, Peter F., 1994, in Bjorn Wellenius and Peter A. Stern (eds.), Implementing Reforms in the Telecommunications Sector: Lessons from Experience (The World Bank).

Cowhey, Peter F., 1999, "FCC Benchmarks and the Reform of the International Telecommunications Market" Telecommunications Policy, Vol. 22, No. 11.

Cowhey, Peter F. and J. Richards, "Dialing for Dollars: The Revolution in Communications Markets," in Jeffrey Hart and Akheem Prasash (eds.), Coping with Globalization (forthcoming).

Davies, G., S. Carter, S. McIntosh and Dan Stefanescu,1995, "Technology and policy options for the telecommunications sector," Telecommunications Policy, pp. 101-123.

Egan, Bruce L. 1996, Informational Superhighways Revisited -- The Economics of Multimedia (Artech House).

Eugster, Cristopher C., 1998, Gregory J. Besio, and Jeff Hawn, "Builders for a new age," The McKinsey Quarterly, No. 3., pp. 92-105.

Hoski, H. (1998a) The impacts of regulatory reform on the global telecommunications sector. Mimeo. ETLA.

Hoski, H. (1998b) Liberalisation, regulation and universal service provision in the European telecommunications markets. Mimeo. ETLA.

Hay, J. and A. Shleifer. (1998) "Private Enforcement of Public Laws: A Theory of Legal Reform," American Economic Review. Papers and Proceedings, v. 88, n.2, p. 398-403.

Hoekman, Bernard (1996) "Assessing the General Agreement on Trade in Services," in Will Martin, Will and AlanWinters (eds.), The Uruguay Round and the Developing Economies.

Hruby, Z. (1997) "Czech Republic: Towards limited competition and streamlining regulation," in K.E. Schenk, et al, (eds.) Telecommunications Take-Off in Transition Countries, Avebury, Hants, U.K.

Hudson, Heather, 1997, "Privatization and Liberalization in the Developed World, in D. Ryan (ed.), Privatization and competition in Telecommunications: International Developments (Westport, Conn. Praeger).

International Telecommunications Union, World Telecommunications Development Report, 1996/97 (Geneva: ITU, February 1997).

Keohane, Robert, 1984, After Hegemony: Cooperation and Discord in the International System (Princeton University Press).

Kubasik, J. 1997, "Poland: Problems of opening and regulating the public network," in K.E. Schenk (ed.) Telecommunications Take-off in Transition Countries, pp. 97-138.

Levy, B. and P. Spiller (1994) "The Institutional Foundations of Regulatory Commitment: A Comparative Analysis of Telecommunications Regulation," Journal of Law, Economics and Organization, v. 10, p. 201-245.

Low, P. and A. Mattoo (1997) "Reform in Basic Telecommunications and the WTO Negotiations: The Asian Experience," Staff Working Paper of the Research and Analysis Division, WTO.

Madden, G. and S. Savage, (1998) "CEE telecommunications investment and economic growth" Information Economics & Policy, v. 10, p. 173-195.

McKinsey and Company, Closing the Global Communications Gap (A Report to the ITU, 1995).

Michalis, M. and L. Takla, 1997, "Telecommunications in the Czech Republic," in ed. D. Ryan, Privatization and Competition in Telecommunications: International Developments, Praeger, Westport, CT.

Merrill Lynch, 1997, The Asia-Pacific Phone Book, First Quarter Review, (21 April), 103-104.

Mueller, Milton, "Universal Service in Telephone History: A Reconstruction," Telecommunications Policy, July 1983, pp. 352-369.

National Telecommunications Commission, Department of Transportation and Communications, Philippine Long Distance Telephone Company, Inc., CCC Case No. 97-039 (Re: Application for Rate Rebalancing with a Further Request for the Immediate Issuance of a Provisional Authority), November 10, 1997.

Noam, Eli, 1995, "Beyond Telecommunications Liberalization: Past Performance, Present Hype and Future Direction," in William J. Drake (ed.), The New Information Infrastructure--Strategies for U.S. Policy (New York: The Twentieth Century Fund).

Noll, Roger G. and Frances M. Rosenbluth, 1995, "Telecommunications Policy: Structure, Process, Outcomes" in Peter F. Cowhey and Mathew D. McCubbins (eds) Structure and Policy in Japan and the United States (New York: Cambridge University Press).

North, Douglas (1981) Structure and Change in Economic History. (New York: Norton).

Organization for Economic Cooperation and Development, 1997, Review of Telecommunications Policy in Hungary.

Ordover, J., R. Pittman and P. Clyde (1994) "Competition Policy for Natural Monopolies in a Developing Market Economy," Economics of Transition, v. 2, p.317-343.

Petrazinni, Ben A., The Political Economy of Telecommunications Reform in Developing Countries Westport, Conn: Praeger Press, 1995.

Petrazinni, Ben, 1996, Global Telecom Talks: A Trillion Dollar Deal (Washington, DC: Institute for International Economics).

Pr __ dorf, H. (1997), "Options and Reforms in a Political Economic Perspective," in K.E. Schenk, et al, (eds.) Telecommunications Take-Off in Transition Countries, Avebury, Hants, U.K., pp. 195-238.

Svensson, J. (1998), "Investment, Property Rights and Political Instability: Theory and Evidence," European Economic Review, v. 42, p. 1317.

Sallai, G., Schmideg, I., Lajtha, G., 1996,"Telecommunications in Central and Eastern Europe" Telecommunications Policy, June, v. 20(5):325-340.

Smith, Peter "What the Transformation of Telecommunications Means for Regulation" The Information Revolution and the Future of Telecommunications, The World Bank 1997.

Staple, Gregory, 1998, "Introduction," TeleGeography, 1998, (Washington, D.C.: Telegeography) pp. 20-21.

Szanyi, Miklos. (1997) "The economic aspects of transformation in the Hungarian telecommunications market," Russian and East European Finance and Trade, v. 33, p. 19-40.

Tarjanne, Pekka, 1998, "How would we recognise a competitive telecommunications market if we saw one?" Speech available at www.itu.int/speeches/1998/sp19/speech19.htm.

Tornell, A. and A. Velasco (1992), "The Tragedy of the Commons and Economic Growth: Why does Capital Flow from Poor to Rich Countries," Journal of Political Economy 100, 1208-1231.

Ure, John (ed.), 1995, Telecommunications in Asia: Policy, Planning and Development (Hong Kong: Hong Kong University Press).

Vickers, J. and G. Yarrow, (1988) Privatization: An Economic Analysis. Cambridge, Mass.: MIT Press.

Whalley, John and Colleen Hamilton, 1996, The Trading System after the Uruguay Round (Washington, D.C., Institute for International Economics).

Williamson, Oliver, 1985, The Economic Institutions of Capitalism (New York: Free Press).

Wissmann, Martin; Tietz, Heiko. "Central & Eastern Europe" International Financial Law Review, Aug 1997, 6-10.

Yunus, Muhammad with Alan Jolis, 1998, Banker to the Poor (London: Aurum Press).

1 In this regard telecommunications is no different than the kinds of transitional issues posed by macroeconomic reform. But, fortunately, the economics of the telecommunications revolution are fundamentally benign. No one embracing competition in telecommunications markets has faced the kinds of periodic crises involving international financial markets or growth rates that reengineering macroeconomic policy can occasion.

2 Mueller, 1993.

3 Whalley and Hamilton, 1996.

4 Cowhey, 1992 and 1996.

5 Cowhey and Richards, forthcoming.

6 Madden and Savage, 1998.

7 According to figures provided to the authors by the National Telecommunications Commission of the Philippines in 1998 competition for telephone services was authorized in March 1995. The number of main lines increased from 1.409 million in 1995 to 3.352 million in 1996 and 5.786 million in 1997, not including cellular lines. Most of the increase was due to build-out by new entrants in the market. The teledensity index in the Philippines rose from 2.01 in 1995 to 8.06 in 1997.

8 Low, P. and A. Mattoo (1997).

9 Arena, Alex (1997).

10 Some observers question whether harmonization and multilateral disciplines on regulatory principles in member states should be negotiated alongside trade liberalization. Bhagwati (1994) has argued that the effort to harmonize regulatory environments of trading nations is counterproductive because free trade is most efficient when there are differences among nations that can be exploited by industry seeking to specialize. By harmonizing their regulatory environments, nations deprive themselves of many of the gains from trade that exist in a more heterogeneous world order. Countries differ in their natural resource, technological and institutional endowments as well as social preferences and political structures. There is no reason for them to have a common approach to telecommunications regulation.

There are significant problems with this reasoning. To begin, the argument gives too little recognition to the point that trade in services is completely entangled with rights of foreign investment. Unless one objects to international agreements on rights of foreign investors there is no good reason why an agreement on opening competition on telecommunications services should not include components dealing with investment rights. In addition, most economists agree that non-tariff barriers are a legitimate object for trade liberalization. The regulatory and market access commitments on telecom services are an innovative way to address the problem that dominant carriers have the ability to block effective market entry in the absence of countervailing government rules. Finally, the critique exaggerates the market uniformity created by embracing common regulatory principles. The interpretation of the principles will still vary, as will other local market conditions.

11 Companies do not have rights and duties under the WTO. Only governments have rights and duties. Thus, if a dominant carrier discriminates against foreign owned carriers in the national market the parent government of the foreign company has to decide if it will bring a complaint against the national government of the dominant carrier alleged to be engaged in discriminatory action.

12 The number of especially significant because most WTO agreements emerge from multi-sector and multi-issue negotiations where tradeoffs can occur over many industries and items. The telecommunications agreement broke this pattern. Hoekman, Bernard (1996).

13 In terms of economic theory a close analogy would be a "focal point" in a bargaining game--a point in the continuum of options that comes to dominate expectations and thus shapes the initial strategies of actors. Keohane, Robert, 1984.

14 To their great credit ITU officials later embraced the WTO work as the most convenient vehicle available for organizing new multilateral rules for a more competitive world market. It now works actively with the World Bank on assisting countries with implementation problems involving WTO obligations.

15 See Baron, 1995, on how regulatory institutions can encourage particular political coalitions.

16 For diversified production, a more accurate definition of natural monopoly is based on the concept of cost subadditivity. A subadditive cost structure need not exhibit declining average cost over the entire range of possible outputs. Instead, the average cost curve may have the "U" shape and exhibit economies of scale only over a limited range of outputs. The test of existence of natural monopoly then rests on comparison of that range with the market demand.

17 The same may be true for several other new forms of wireless technology. McKinsey, 1995.

18 Hoski (1998a).

19 BT/MCI Order, 12 FCC Rcd, 1997.

20 Oliver Williamson, 1985.

21 Demsetz (1968) in a classic article suggested that if competition within the marketplace is not possible because of substantial economies of scale, policy makers should try to create conditions for the competition for the right to operate in the market, i.e., competition for the marketplace. This could be achieved by organizing bidding among prospective entrants for the franchise rights to serve the market.

22 That liberalization is only delayed until a certain date in the future implies that the incumbent monopolist operates under a threat of entry. In economic theory such a threat is assumed to lead to strategic behavior on the side of the incumbent firm which chooses its capacity so as to deter entry. The strategic investments to increase capacity with the goal of entry deterrence may be socially excessive in undistorted economies. But in the context of developing and transitional economies such over-investment may compensate for the lack of investments caused by other distortions and low regulatory credibility. Even if the incumbent's strategy deters all potential entrants, the mere threat of entry creates incentive for investments into expansion of the network operator's capacity.

23 In practice, if we had proper accounting of depreciation and past return on the pipeline, or telecommunications network, the difference between remaining embedded costs and forward looking costs of replacement would often be minimal. For a careful statement of the interconnection issue by an economist who is sympathetic to cost claims of incumbent carriers: see Egan.

24 Noam argues that the value to users of additional users of the network may decline beyond a certain point. Weakening the political coalition supporting universal service. This claim is less likely to obtain in countries with low teledensities unless the cost of adding new users significantly raises costs.

25 Braga, et al, 1999.

26 Accounting rates are the negotiated price for end to end international services created jointly by two national carriers. Carriers conduct these negotiations and conclude a commercial contract to establish this accounting rate.

27 It was so attractive that finance ministries routinely diverted the monies to cover other budgetary needs. The International Telecommunications Union constantly urged member countries to resist the temptation of diverting the funds to other budgetary purposes.

28 The WTO negotiation carefully finessed the issue of whether the accounting rate system has features that makes it incompatible with trade obligations. The agreement included a "standstill agreement" that practically exempted all countries from a WTO challenge to accounting rate policies until January 1, 2000. (Arena, 1997).

29 The Federal Communications Commission created an international uproar when, in August 1997, it introduced the equivalent of price caps on the settlement rates that American carriers may pay to foreign carriers. Whether or not the FCC is able to sustain its "benchmarks" it is safe to say that the initiative will contribute to a fundamental change in the costs of terminating traffic in developing countries. Already, a very significant share of all international traffic to and from developing countries is operating on terms and conditions that defy traditional practices concerning settlement rates. Cowhey, 1999.

30 Settlement rates are very inconsistent. Rerouting traffic through a third country may be cheaper for a carrier than sending it directly to a country.

31 Eugster, et al 1998.

32 Staple, 1998, pp. 20-21.

33 IDC web site: www.idc.com/F/HNR/081798ahnr.htm.

34 Campos and Root, 1996, p. 171.

35 For the discussion of the stranded costs problem in deregulation of utilities in developed countries see Brennan, T. and J. Boyd, 1997.

36 Levy and Spiller, 1994.

37 Levy and Spiller (1994) say that regulatory environments in countries with poor institutional endowments are "unpropitious".

38 Hoski, 1998.

39 Cae-One Kim, Young-Suk Ohn, and Sang Hyon Kyong, Korea Telecom in the Twenty-First Century: A Vision and a Strategy for Change (Draft report, October 1998).

40 More on that point see Ordover et. al. (1994).

41 Tornell, A. and A. Velasco (1992).

42 North, D. (1981).

43 Svensson, J. (1998).

44 Hay, J. and A. Shleifer. (1998) 403.

45 See Cowhey (World Bank) and Noll and Rosenbluth (1995) on the examples of Argentina, Mexico, and Japan.

46 Vickers and Yarrow, (1988).

47 Similar strategic alternatives were outlined by Davies et. al (1995) and Hruby (1997).

48 Armstrong and Vickers (1996).

49 This harmonization is governed by the far-reaching Association Agreements with the EU, so-called Europe Agreements. The Agreements became effective in 1994 and have brought about considerable liberalization of trade between CEECs and the European Union. The Agreements also include commitments by CEE countries to adopt many of the disciplines of the Treaty of Rome.

50 Poland: Land of Opportunity on a Troubled Battleground, European Telecommunications, February 20, 1998, V.16, No. 4.

51 Kubasik, J. (1997).

52 The National Power Grid (PSE) has 5000 miles of fiber-optic cable deployed along its power distribution networks and was investing $70 million to install additional digital lines. Tel-Energo SA, a joint venture between PSE and several regional power distribution companies, has a license to lease switches and provide telecom services to the energy industry and plans to provide local telecom services in several areas in Poland. The PSE and its subsidiaries have already acquired significant operating experience through their involvement in a cellular consortium, which includes AirTouch and TeleDanmark. Additionally, Tel-Energo executes about 30% of all interbank transfers in Poland. Tele-Energo also has plans to carry CATV services between Poland's numerous urban cable networks, when the incumbent operator, TPSA, loses its monopoly status. Another potential competitor belongs to the Polish State Railway (PKP) which leases switches and provides basic voice services for the railway utilities. The company had 200,000 subscribers as of March 1997 and operates a network with 1500 miles of optic cable. PKP has the capability to extend its own telecommunications system to cities throughout Poland. (Communications International, Mar 1998, 25(3):43-48)

53 Polska Telefonia Cyfrowa (PTC) operates under the brand-name of Era GSM. It includes US West and Deutsche Telekom as its main foreign investors each with 22.5 per cent stakes. It already claims more than 300,000 subscribers and will have invested around $ 500m by the end of 1998 in a network covering around 80 per cent of the country and 90 per cent of the population. Its main rival Polkomtel, which operates the Plus GSM network, is close behind with nearly 300,000 subscribers. Its main investors are AirTouch of the US and TeleDanmark.

54 Centertel, which is owned 66 per cent by TPSA and 34 per cent by France Telecom, holds the license. Financial Times Survey: Poland, March 25, 1998; P. 08, Hanging on the telephone.

55 Kubasik, 1997.

56 Kubasik, 1997; Sallai, G., 1996.

57 Hudson, H., 1997; Pr __ dorf, H., 1997; Kubasik, 1997.

58 OECD, 1997, Review of Telecommunications Policy in Hungary.

59 Until December 1995 the Hungarian State Property and Holding Agency held 64.86 per cent of Matav's shares. (See Hungarian Ministry of Economic Affairs. Telecommunication in Hungary. http://www.ikm.iif.hu/english/economy/industr/telecom.htm).

60 Szanyi (1997).

61 Early in 1991, the postal, broadcasting, and telecommunications divisions of Magyar Posta were spun off as three independent limited-liability companies: Magyar Posta Vállalat, Magyar Müsorszóró, Vállalat, and Magyar Távközlési Vállalat (or Matav). Matav was subsequently restructured.

62 The sale of 30 per cent of Matav was expected to raise around US$ 400 million.

63 OECD, 1997.

64 Compared to the firm's estimated market value (US$ 3.3 billion), these figures suggest that Matav was sold off rather cheaply.

65 Hungarian Ministry of Transport, Communication and Water Management, 1997, "Post, Telecommunication, Broadcasting Reflected in Numbers (1991-1996)" http://www.mav.hu/khvm/docs/postae/text.htm#a3.

66 OECD, 1997.

67 OECD, 1997.

68 OECD, 1997.

69 Wissmann, M. and H. Tietz, 1997.

70 The bids were submitted by the following consortia: TelDanmark in partnership with BT, Ameritech with Deutsche Telecom, a Swiss-Dutch-American consortium TelSource, the Italian operator STET and an alliance between France Telecom and Bell Atlantic.

71 Michalis and Takla (1997).

72 Michalis and Takla, p. 95.

73 Financial Times Survey: Telecommunications, March 19, 1997.

74 Financial Times Survey: Telecommunications, March 17, 1998.

75 SPT to take rationalization lead - Finance East Europe, n7, 97/04/11, p. 14

76 Prague Business Journal, November 2, 1998.

77 Keeping the upstarts down, Communications International, Mar 1998, 25(3):43-48.

78 Prague Business Journal, November 2, 1998.

79 Feasibility studies were to be first carried out, with the CTO deciding whether to award a national or regional licenses. In the latter case two licenses could be awarded.

80 Ryan volume).

81 With certain limited exceptions on satellite services and foreign investment, Mexico committed to open its market in full subject to the regulatory reference paper in the WTO negotiations. As in other reform-minded countries the regulatory agency had been a strong proponent of making such commitments in the hope of locking in its market reforms.

82 Under Mexico’s WTO commitments there are still limitations on majority ownership of basic service firms (capped at 49%).

83 Based on data received from one of the carriers.

84 Most regions had four wireless concessions for fixed local loop services, two 30 Mhz PCS licenses, and two 10MHz licenses. Elizbeth Biddlecombe, "Mexico’s Wireless/PCS Auction in Danger of Repeating Past Mistakes," Communications Week International, 10 September 1997 (available at www.totaltele.com/news); Katherine Baldwin, "Mexico to Raise $1Bln from Wireless Licenses," 13 May 1998, Bloomberg News (available at www.totaltele.com/news).

85 Richard Lapper, "Bullish Sentiments over Prospects," Financial Times, September 30, 1998, p. XV of FT Telecoms Supplement.

86 TeleGeography, 1999.

87 Unlike many countries Mexico has never argued that the 39 cent rate is based on costs. While it disagrees with the United States on the precise cost of international traffic it has always emphasized that the real issue is rebalancing rates, including settlement rates, on a timely and fair basis.

88 Sheridan Nye, "AT&T Calls on Mexico to Act to Avert Settlement Rate Crisis," at www.totaltele.com/cgi-bin/news.cgi/11070/worldmore.htm.

89 This complaint is a mirror image of one by US carriers against some foreign carriers entering the US market. Both Mexico and the United States have a proportionate return rule for international traffic. Simply stated, this rule says that AT&T, for example, is entitled to the same share of voice telephone traffic from Mexico that it sends to Mexico. If AT&T has a fifty percent share of voice traffic to Mexico, the rules says that it must receive fifty percent of the traffic from Mexico to the US. Given inflated settlement rates it makes sense for a new entrant in Mexico to discount aggressively to win outgoing traffic to the United States.

90 The issues about provisioning are so common to all markets that regulators should simply anticipate them. As a matter of degree those existing initially in Mexico were far worse than normal although the situation improved in the second half of 1997.

91 Katherine Baldwin, "Telmex Defies US on Settlement Rates," Bloomberg News 24 February 1998. Available at www.totaltele.com/cgi-bin/news.cgi/11791/worldmore.htm.

92 Eduardo Garcia, "Avantel Invokes Mexican Law to Force Interconnection Ruling," Bloomberg News 6 March 1998. Available at www.totaltele.com/cgi-bin/news.cgi/12318/worldmore.htm.

93 Eduardo Garcia, "Mexican Court Backs MCI in Inbound Call Fee Row," Bloomberg News 22 April 1998. Available at www.totaltele.com/cgi-bin/news.cgi/14357/worldmore.htm.

94 "Panorama Empresarial," Excélsior 8 June 1998.

95 "Tribuna Rechaza Queja de Telmex," Excélsior 7 July 1998.

96 Alberto Navarrete, "Sin Avantel, las Telefónicas Negociarán en Grupo con Telmex," Excélsior 16 July 1998.

97 By November, Telmex and its competitors were again unable to reach a final settlement on interconnection rates, and Cofetel announced it would set the charge for 1999. A spokesperson for Alestra claimed that the interconnection charges proposed by Telmex included an allowance for recovering costs for network infrastructure, and represented a figure five times greater than actual interconnection costs. In Decmeber 1998 Cofetel affirmed that the rate of 2.72 cents would apply for interconnection. "Telmex Still Unable to Agree with Competitors on Interconnection Fees for Long Distance Service," SourceMex, University of New Mexico 11 Nov 1998 (Lexis Nexis Document).

98 Eduardo Garcia, "Mexican Court Backs MCI in Inbound Call Fee Row," and www.avantel.com.mx/spanish/avantel/redavantel/redfiber.htm.

99 From Telmex and Alestra websites, www.telmex.com.mx/comp_1.htm and www.alestra.com.mx.

100 Petrazinni, p. 71.

101 CNC information can be found at www.cnc.gov.ar.

102 Susan Schneider, "Argentina’s Telecom, Telefonica Seek Deregulation Compensation," Bloomberg News, 23 December, 1998, available at www.totaltele.com/news.

103 Jarvie and Keaveny.

104 Richard Jarvie and Jake Keaveny, "Argentina Stands Firm on Monopolies’ End," Bloomberg News 10 March 1998, accessible at www.totaltele.com/cgi-bin/news.cgi/12472/worldmore.htm, "Los Cambios, tras la Liberación del Negocio," Clarín 17 June 1998, accessible at www.Clarin.com.ar/diario/98-06-17/o-03102d.htm, and, Marcelo Canton, "Impsat Dará Servicios de Telefonía sólo a Empresas," Clarín 18 June 1998, accessible at www.Clarin.com.ar/diario/98-06-18/o-03601d.htm.

105 One analysis put Argentina’s rates in Spring 1996 at one quarter of the level of Mexico for local services while they were almost five times higher for domestic long distance and twice as high for international. Oppenheimer and Company, International Research, Telecom Argentina, May 1996, p. 5.

106 At www.cnc.gov.ar/resol/r_49_97.html, www.cnc.gov.ar/resol/r_61_97.html and www.cnc.gov.ar/resol/r_98_0264.html.

107 Richard Lapper, "Bullish Sentiment over Prospects."

108 As it is probable that it will not be possible to collect complete information regarding firms’ interconnection costs, Peru will utilize a benchmarking for interconnection charges until 2000, implementing Chile’s interconnection policy as the best example in the region (63% of the local tolls). See "Modelo Peru papa Las Telecomunicaciones," at www.osiptel.gob.pe.

109 El Comercio 6 August 1998: A1, E8.

110 Osiptel website. James Craig, "Peru Says Four Companies May Win Long-Distance Phone Licenses," Bloomberg News, 21 January 1999 (available at www.totaltele.com/news).

111 Richard Lapper.

112 TeleGeography, 1998, p. 245.

113 CTC controls 92% of the local market while the market share for domestic and international long is split among these four firms (Entel 40%, CTC 33%, Chilesat 16%, BellSouth approximately 10%). Entel, has joined with Motorola to build a national PCS network to offset its declining share of the long distance market. See: Estrategia 25 Aug 1998 and 27 Oct 1997; the BellSouth International website, www.bsi.bellsouth.com; Michael Smith, "Chile’s Entel to Raise Cash for PCS Network with Motorola," Bloomberg News, 19 August 1996, Communications Week International (at www.totaltele.com/news).

114 International Telecommunication Union, "World Telecommunication Development Report 1996/97" and ITU website, www.itu.int.

115 There is a huge benefit for efficient resource allocation in the economy if the market disciplines this major flow of new investments. After all, Marxist economies were perfectly capable of investing a lot in an industry (as witnessed by rusting steel plants in Russia). It is efficient allocation of investment resources that is critical.

116 There are controversies in the United States about whether or not Internet telephone services should have to contribute to universal service funding by paying access charges for use of the local phone network. They have been shielded from such charges because they were considered data services. Regardless of the right answer to this controversy, there is no serious worry that Internet providers could cripple local phone companies.

117 See, for example, the remarks of the Secretary General of the ITU, Dr. Pekka Tarjanne, 1998.

118 Ure, 1995.

119 For another, subsidizing universal service from long distance service (as is done in the United States) is also a bad idea because it distorts pricing and economic incentives for network development.

120 A geographically averaged rate makes entry into urban areas quite profitable because it inflates prices for the urban areas.

121 Merrill Lynch, 1997; National Telecommunications Commission, 1997.

122 Braga, et al, 1999.

123 An example of how alternative arrangements for network expansion can help rural areas is the growth of microlending in Bangladesh for cellular telecommunications and Internet services that are organized by woman entrepreneurs in villages. Yunus, Muhammad with Alan Jolis, Banker to the Poor (London: Aurum Press, 1998).

124 Panzar and Wildman endorse the combination of vouchers with flexible pricing for local services.

125 Noam, 1995, p. 50.

126 European Union, 1998, pp. 16-18.

127 TeleGeograpy, 1999, p. 70 (on local termination rates).

128 We thank Mr. Brendan Gannon for his advice on the Philippine situation.

129 UK policy also selectively favors facilities networks providing local exchange services over those specializing in primarily in long distance services. The primary disadvantage of long distance networks is the failure of the UK to unbundle the network elements of the local loop. For example, the long distance carriers cannot easily co-locate DSL equipment (designed to upgrade some lines to high speed service) at the British Telecom switch. Given the UK’s strict price cap on private line access to the local loop for competitors, both long distance facilities networks and resellers have been able to compete without unbundling. Both equal access and unbundling will be introduced in the UK as a result of policies of the European Union.

130 While in the United States every government policy gets translated into "jobs" for the economy in order to give some immediacy to its impact, many developing countries emphasize the gains to investment and construction from reform. Resale may lower prices, improve network utilization and even stimulate creative product offerings. But this is far less politically compelling than laying in new fiber optic cables.

Another liability for resale is the fear that it could spoil the profitability of international services. The immense margins on international services are the dirty secret of the telecommunications world. Even in the United States they are very large indeed. Resale is a strategy well suited to quickly pursue customers who do the greatest amount of international calling. The resellers can still make ample margins after very large discounts to key customers. Losing these customers might not immensely damage the total market share of the incumbent carrier, but it can take a real chunk out of profitability. Operators investing heavily in network facilities, in contrast, may exercise more pricing restraint than resale carriers simply because they are more inclined to live cozily under the price umbrella of the dominant carrier while they try to improve cash flows.

131 Of course, national spectrum allocations would still comply with ITU obligations. Smith, 1997

132 Tarjanne, 1998.

133 Tarjanne, 1998.

134 Noll and Rosenbluth, 1995.

135 The authority of the FCC is tempered by federalism (state regulatory commissions are important for local telecommunications regulation) and the strong roles of Congress and the courts. In addition, in regard to legislative policy, management of government use of the spectrum, and foreign affairs there are prominent roles for the Departments of Commerce and State.

136 Quoted in Lapper, "Bullish Prospects."