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MOCT-MOST 11: 197-204, 2001. © 2001 Kluwer Academic Publishers. Printed in the Netherlands.

INTRODUCTION SME Development Policies in Different Stages of Transition by WILL BARTLETT* The preponderance of large firms and economic gigantism under the communist economic system, has been steadily reversed over the last decade in most transition economies. Typically, the largest proportion of the numbers of firms are now classified in the category of small and medium sized enterprises (SMEs). As one would expect, their contribution to employment and value added is of lesser importance, with the greater part of output still usually generated through large state or privatised firms. Yet the SME sector is of crucial importance in its role in producing intermediate goods for use by larger firms, often through subcontracting arrangements; in its opening up of the previously neglected services sector; and in creating a middle class and hence a constituency for the support for continuing social-democratic reforms. In addition it makes an important contribution in three key areas which support economic growth: job creation, innovation, and in the impetus it gives to the development of competition (Brezinski and Fritsch, 1996). This latter factor is particularly important in delayed-transition economies where the entry and growth of new SMEs challenges the established positions of existing large state or privatised companies which are often backed by, and connected to, powerful political elites. The conventional approach to economic transition, based upon neo-classical economic theory, has been that the development of the small and medium sized enterprises sector will occur spontaneously following a process of stabilisation, liberalisation, and privatisation. Blanchard (1997) in a major theoretical contribution to the economics of transition, has stressed the role of reallocation of resources from the old state sector to the new private sector, which must implicitly include a large contribution from newly created small firms. However, although many hundreds of thousands of SMEs have been established in the transition economies, they still face severe barriers which hinder their expansion and the realisation of their full potential. In one of the early critiques of the conventional view, Amsden et. al.(1994) argued that effective transition policies need to be backed up by the intervention of a “developmental state” to create the institutional framework needed to promote a market economy. The state should act in a complementary way to the market and push through the required pro-market reforms. As Amsden et al. pointed out, the success of the transition process depends on the emergence of institutions to support long-term investment and risk-taking. This approach can be characterised as a “top-down” method of economic development. The danger for countries in transition is that the strong state, necessary to implement the pro-market reforms, can easily become a clientelistic state in which the instruments of * School for Policy Studies, University of Bristol, UK

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economic power are used to serve the interests of a narrow elite, eliminate real competition, and protect the position of established large enterprises. The state then itself may become a key institution which generates barriers to SME development (Bartlett, 2000; Smallbone and Welter, 2001). Research on the development of the small business sector in the western economies has supplemented this approach by emphasising the importance of institutions below the level of the state including local government, but also non-state institutions such as business associations, and informal and formal groups and networks of firms (Cooke et al. 1998). The importance of the institutional environment and business culture can be observed in the Italian experience with “industrial districts” in which local economies based mainly upon SMEs have been able to generate rapid economic growth by combining elements of competition together with elements of inter-firm cooperation through local business networks (Pyke and Sengenberger, 1992). The development of network relations between SMEs, and between large and small firms, are important elements of successful market economies in other western economies. Franičević and Bartlett (2001) have explored the applicability of this approach in the transition economies of eastern Europe, and argued that it is only likely to be successful in a few cases where some preconditions have been met. In many other cases, the institutional environment is as yet too sparse to sustain inter-firm cooperation. Stark and Bruszt (1998) have nevertheless argued that the network paradigm may be an affective alternative institutional structure to the statist model of top-down development. This is the context in which local development coalitions, public-private sector partnerships, and decentralised regional innovation systems (Braczyk et al., 1998) have the potential to promote SME development more effectively than top-down state driven approaches.

Stages of transition The five papers in this volume cover a wide range of experiences with SME development at different stages of transition. Most of the countries in central eastern Europe are now in a late stage of transition, and are making rapid progress in transforming their economies and institutions with a view to accession to the European Union. Elsewhere, especially in the Balkans and in the former Soviet republics, transition remain blocked at an early stage, or at least lagging in various critical dimensions of development. Correspondingly appropriate policy instruments vary depending upon the stage of transition and the nature of the barriers to entry and growth which SMEs face in each country. The papers in this volume reflect this variety of development and transition stages, and the analyses point to distinctively different policy prescriptions for the further development of the SME sector in each case. The first four papers deal with economies where the transition has been delayed or stalled, and where the environment is often hostile to SME development. These papers, which tackle issues relating to SME development in delayed-transition economies, cover the Kyrgyz Republic (Anderson and Pomfret), two papers on Albania (Hashi, Muent et al.) and Belarus

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and Ukraine (Smallbone and Welter). The Kyrgyz republic has had an active approach to privatisation with most of the former state firms now privatised, yet according to Anderson and Pomfret many areas of the market economy and supporting institutions remain poorly developed. The juxtaposition of two papers on Albania permits contrast over time in one country. The paper by Hashi reports on a survey carried out in 1997, the year of the pyramid scheme collapse, while the paper by Muent and his colleagues from the EBRD reports on a survey carried out two years later in 1999, by which time the Albanian economy had recovered from the economic downturn induced by the earlier events and, driven by the recovery of the SME sector, was powering along at an annual growth rate of 7% per annum. Belarus and Ukraine represent classic examples of stalled transition. In Ukraine, for example, privatisation has been characterised as “stop-start” (Estrin and Wright, 1999) while in Belarus, there has been little privatisation “with the government hostile to most forms of private businesses … unless the President and his supporters are involved” (Estrin and Wright, 1999: 396). The paper by Woodward reports on new research into experiences with SME development in Poland, arguably one of the success stories of transition in eastern Europe. The Polish transition has been characterised by the rapid growth of the SME sector which has not only been a driving force behind sustained growth but has also successfully absorbed much of the unemployment created by the shrinking of the state sector. The Poles have supported this by building an extensive institutional support network encompassing numerous small firm incubators, micro-credit schemes, and business support centres. Many of the critical barriers to SME development linked to provision of finance and the institutional framework for development have been removed. The challenge now is to raise the productivity level in SMEs by stimulating innovation and introducing improved working practices, especially in view of the prospect of accession to the European Union which will introduce far greater competitive pressures. Woodward argues that an essential component of this process is the development of policy instruments to support inter-firm linkages and cooperative networking between SMEs themselves and between SMEs and other local and regional institutions which can assist in technological advances, such as research centres and institutions. The facilitation of trust-based cooperation between SMEs is arguably just as important at this later stage of transition, as the promotion of fair competition and the creation of a level playing field is at the earlier stages.

Barriers to SME entry and growth If SMEs are of critical importance to the transition process, then factors which hinder their development (whether entry or growth) are key issues for economic policy research in the field. All five papers cast light on the barriers to SME development in the countries which they cover. One of the fundamental debates in recent years has related to the issue of the relative importance of financial barriers and institutional barriers. Pissarides (1998) has promoted the idea that financial barriers are the key problem holding back SME growth in transition

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economies where capital markets are imperfectly developed and the banking system is typically weak, and often focused still on financing large state or privatised firms than providing finance to newly established SMEs. The papers in this volume provide conditional support to this view. In the delayed-transition economies of Albania (Hashi, 2001), Belarus and Ukraine (Smallbone and Welter, 2001), research evidence from sample surveys indicates that finance is a highly significant barrier for SMEs. But in Poland, more advanced in transition, this barrier seems to have become less problematic in the mid 1990’s, according to Woodward (2001), as the banking system began to turn its attention to SME finance. In the case of the Kyrgyz Republic, the least developed economy, Anderson and Pomfret (2001) find that external finance is not a serious problem. The SME sector is based largely on micro-firms in the services sector, and most financing requirements can be easily met through self-financing and family sources of finance. It therefore appears that it is in the critical intermediate stages of transition that the finance barrier is of greatest importance for the newly emerging SMEs. But, others argue, finance alone is not enough. Throwing money at SMEs will produce little effect if the institutional structure is not sufficiently well developed. This argument takes several distinct forms. The most basic argument is that the critical dimensions of the institutional structure are the tax and legislative and regulatory environment within which firms operate. In examining this question, Smallbone (for Belarus and Ukraine) and Hashi (2001) (for Albania) find significant survey-based evidence that these factors are indeed perceived as critical barriers to development by entrepreneurs in those countries. Evidence that the institutional framework (bureaucracy, late payments, high taxes) together with financial barriers (such as a high cost of capital) are perceived as important impediments to growth even in the case of more advanced-transition Slovenia is presented by Bartlett and Bukvi cˇ (2001). Others emphasise the interactions between institutional development and other aspects of the economic and social system. The most direct evidence is provided by Muent et al. (2001) in the case of Albania. They observe the importance of unfair competition as by far and away the most severe barrier reported among their sample of 104 Albanian SMEs. This “new and important result” (their words) is explained by the existence of a large informal economy where entrepreneurs avoid paying taxes and hence undercut the prices of the firms in the formal economy. The loss of tax revenue to the state also impedes the potential developmental role of the state itself. But the state itself is largely to blame for this state of affairs, by levying unreasonably high taxes in the first place. Muent et al. (2001) call for a more nuanced approach to SME taxation based on selective tax incentives. The informal sector is also identified as a potential problem in the other delayed-transition economies studied here, including Belarus and Ukraine, Even more seriously, it is not just the existence of an informal sector, due to inappropriately high taxes and over-regulation (e.g. through licences) in many transition economies that presents barriers to growth. Rather it is the anti-competitive practices employed by both the larger firm sector and by the governing political elites themselves which often present the most serious barrier. Anderson and Pomfret (2001) paint a dismal picture of a state bent on exploiting and thus inhibiting the newly emerging SME sector

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through high taxation, licence requirement, extortion, violence and the breakdown of law and order. They point to the rich image of the “grabbing hand” of the state, popularised by Frye and Schleifer (1997). The wide-spread experience of low level petty bureaucratic corruption is pervasive in eastern Europe following the breakdown of communist strong state. A similar picture, if less dramatic, is painted for the cases of Belarus, Ukraine and Albania by the respective authors on those countries. Clearly there is a more pervasive social dynamic at work here, which was identified early on by writers such as Baumol (1990) who distinguished between societies where entrepreneurship was drawn into productive activities and those where perverse incentives encouraged unproductive and even destructive forms of entrepreneurship to be practised. Smallbone picks up on this line of argument in his discussion of the perverse role of the state in Belarus and Ukraine. Similarly, Miller et al. (2001) report that petty corruption in the Ukraine has lead to a reduction in business activity due to increased risk and uncertainty of doing business there. Hashi (2001) points to similar effects in Albania which offer opportunities for local bureaucrats to engage in rent-seeking, petty corruption and the collection of bribes, all of which hinders the effective development of formalisation of the SME sector.

Policy debates The creation of new (sometimes called de novo) businesses has been an essential feature of reformist policies in the former communist countries since the onset of transition in the early nineties. Early measures typically included the introduction of new company laws permitting the setting up of private businesses with limited liability. Further general measures were undertaken to liberalise the economic environment for private business. In most cases this led to an explosion of entry activity and the creation of thousands of new small firms. Much remains to be done especially in the delayed-transition economies, although as Hashi (2001) shows for Albania and Anderson and Pomfret (2001) for the Kyrgyz Republic, even in the most hostile environments, the newly established or privatised SMEs have become the backbone of those economies. In some countries, such as Belarus and Ukraine, there is still a need for further actions to liberalise the economy and create a level playing field where, as Smallbone and Welter (2001) argue, the government still has a role to play in creating the broad institutional conditions in which SMEs can fulfil their potential. In particular the adverse effect of the informal sector is a serious problem in many late start transition economies, and the resulting high level of unfair competition has emerged as a major constraint on the development of legitimate business activity. In these countries, the creation of a level playing field, the removal of unfair competition due to the existence of the informal economy remains one of the most problematic feature of transition. This is vividly illustrated by the findings of the research on the Albanian case reported in the papers presented in this volume where the essential need is for basic reforms in the legal system,

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respect for the rule of law, and the creation of the institutional conditions to support the growth of greater formal sector SME activity. In addition Muent et al. (2001) call for specific measures such as selective tax incentives to deal with this problem. But in most transition countries, by the end of the 1990s, the problem was rather how to improve the growth performance of an existing large number of small firms, and develop the best of them into medium sized companies, the fast-growth job-generators which could play a role as the dynamic core of sustainable growth. In transition economies where this issue has been addressed seriously, a number of direct support measures have been introduced to promote the more rapid and effective development of small firms. The extent and coverage of these institutions varies from country to country and even from region to region within countries. Often they are supported by outside agencies, with time-limited funding. Woodward (2001) points to the difficulties which this raises in Poland, echoing a more general critique developed by Bateman (1999) on the limited sustainability and hence lack of real impact of this approach. Yet in countries such as Poland the large number of local initiatives is beginning to develop an institutional thickness which is often perceived as an important component of successful local development practices in the Western economies (Cooke et al., 1998). Some institutions have been designed specifically to address the issue of financial barriers, including micro-credit institutions and mutual guarantee funds, and the case studies described by Woodward (2001) indicate that some real achievements have been realised in Poland at the local level. The banking system often discriminates against SMEs, especially where banks are still subsidising large loss making firms, and where banks lending practices remain strongly influenced by the political and economic elites. Nevertheless, perceptions of this problem can be exaggerated, and for the case of Albania, Muent et al. (2001) provide evidence which indicates that small and large firms have equal chances of securing bank finance. The real discriminating factor is whether the small firms apply for bank loans in the first place. In the delayed-transition economies, the institutional structure of SME support is invariably less well developed. All the authors in this volume which deal with the late developers point to the need for a more sustained effort to set up such supporting institutions. Smallbone and Welter (2001) in their discussion of policy measures for Belarus and the Ukraine, and Hashi (2001) for Albania, each emphasise the critical importance of such direct support measures. As both Woodward (2001) and Smallbone and Welter emphasise, these policy instruments are often more effective when designed and set up in the context of locally decentralised public administrations. Yet in delayed-transition economies in particular, the danger of rent seeking and corruption by bureaucrats is all too apparent. Anderson and Pomfret (2001) amply demonstrate the negative impact of petty corruption, violence and extortion on the development of small businesses. This suggests that the reform of local administration should be high up on the agenda in these countries and should precede measures which rely heavily on local government as a custodian of SME development policies. Finally Woodward (2001) points to the importance of policy instruments designed to

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support inter-firm cooperation and business networking among SMEs. A number of critics have dismissed the potential contribution of SMEs to the transition process on two main grounds. Scase (1997) has argued that many small business owners in transition economies are proprietors rather than true entrepreneurs, preferring to consume rather than reinvest their profits for growth (a critique not unheard of in western economies also – see Storey, 1994). Others have criticised the phenomenon of “too many, too small” pointing to the isolation and lack of economies of scale of many small firms in Hungary. Woodward (2001) argues persuasively that the answer to both these problems is the promotion of interfirm networking and collaboration, both to encourage an entrepreneurial culture, and to enable SMEs to gain advantages of scale economies in critical functions such as purchasing, marketing and R&D. Clearly this approach is more readily applicable at a later stage of transition when the basic institutional framework of a market economy has been established, and social norms have stabilised. In the early stages of transition where conditions for the development of trust-based cooperation between SMEs are sparse, the main areas for policy attention remain the need to reduce unfair competition associated with the existence of a significant informal economy, to reduce the impositions of the state on the formal economy, to ensure a level playing field for small firms, and to develop basic business support services which SMEs can access in an atmosphere free of corruption and the threat of violence.

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Miller, W.L., Grødeland, Å.B., Koshechkina, T.Y.: 2001, A Culture of Corruption? Coping With Government in Post-communist Europe, CEU Press, Budapest. Muent, H., Pissarides, F. and Sanfey, P.: 2001, Taxes, competition and finance for Albanian enterprises: evidence from a field study, MOCT-MOST, (this volume). Pissarides, F.: 1998, “Is lack of funds the main obstacle to growth? The EBRD’s experience with small and medium-sized businesses in central and eastern Europe”, EBRD Working Paper 33, European Bank for Reconstruction and Development, London. Pyke F. and Sengenberger, W. (eds.): 1992, Industrial Districts and Local Economic Regeneration, International Institute for Labour Studies, Geneva. Scase, R.: 1997, The role of small business in the economic transformation of eastern Europe: real but relatively unimportant, International Small Business Journal 16, 113-121. Smallbone, D. and Welter, F.: 2001, The contribution of small and medium enterprises to economic development in Ukraine and Belarus: some policy perspectives, MOCT-MOST, (this volume). Stark, D. and Bruszt, L.: 1998, Post-Socialist Pathways: Transforming Politics and Property in East Central Europe, Cambridge University Press, Cambridge. Storey, D.: 1994, Understanding the Small Business Sector, Routledge, London. Woodward, R.: 2001, SME support in post-communist countries: moving from individual to cooperative approaches (reflections on the Polish case), MOCT-MOST, (this volume).