Chapter VI

Transition to a market and entrepreneurship. The Systemic Factors and Policy Options.

1. Introduction

The political and ideological concerns aside, the fundamental economic argument in favor of postsocialist  transition to a market system has been a supposition that it will improve allocative efficiency and thus the competitiveness of the industries and standard of living of the households. It was believed that the shift of property rights from state to private  sector must facilitate such an improvement fast. Yet in the majority of cases -- even after the first decade of transition -- the economies have not returned to the path of sustainable growth. In 1999 a quarter of transition economies of East Central Europe (ECE) and the former Soviet Union (FSU) are still in or have returned to contraction.

The pre-transitional 1989 level of GDP has been recovered only in Poland in 1995, in Slovenia in 1998 and in Slovakia in 1999. In the remaining 25 countries of ECE and FSU as well as in Mongolia the output is still below the pre-transition level and on average for the whole transition economies region it is at a low 75 percent of the output registered in 1989 (EBRD 1999). In two biggest postsocialist countries, Russia and Ukraine, it remains around half and one third, respectively, of the pre-transition level. Still worse, it appears likely to continue shrinking in 1999-2000.  

Such a meager outcome from the early phases of transition stems much more from the fundamental mismanagement of the process of postsocialist changes than from the over-emphasized 'legacy of the past' (Kolodko 1999a).

 Neither the governments of the countries involved, nor the international community assisting the process of postsocialist transition assumed at any stage of the endeavor that the process would go along such an awkward way. After ten years of transition for majority of them it is a rather bitter surprise.

The policies implemented in the ECE and the FSU emerging markets have been based to a great extent on the early Washington Consensus.  It presupposed -- though was designed in the first place to address the structural crisis in Latin America, and not in the region of the formerly centrally planned economies -- that liberalization-cum-stabilization, together with fast privatization, if only supported by financial policy, must bring soon recovery and later sustained growth. Such a prognosis took for granted that this course of changes will secure improvement of allocative efficiency and automatically wipe out wasteful allocation typical for the distorted socialist economy. Yet for a number of reasons it has not occurred. The crucial cause for such disappointment has been the negligence of the institutional arrangements necessary for the successful performance of postsocialist economies (Poznanski 1996, Kolodko and Nuti 1997, North 1997, Stiglitz 1998, 1999).

The countries that are dealing more successfully with the issues of recovery and growth are these which were able to focus not only on de-nationalization of the state assets, but also on the development of venture entrepreneurship, mainly on the small scale. The grass-rooted development of especially small and medium enterprises has contributed significantly to overcoming the transitional depression and then to the recovery and fast growth. Yet accomplishing such a sequence requires that specific systemic and policy conditions must be met. Just the policy of liberalization-cum-stabilization and de-etatization is not sufficient. To facilitate the required path of development a proper institutional arrangements must be executed by the governments, a legal framework must be established and the government policies must support the rise and competitive performance of the SME. Liberalization in the broad sense of opening up market processes, is a prerequisite for the growth of this sector in transition economies, yet itself is not satisfactory.  

In this paper we discussed some of the fundamental features necessary for the take-off of SME in postsocialist economies in transition. The second section presents the conceptualization of the transition process, within which the SME development is discussed. In third section, the meaning of the legacy and the structural, as well as institutional and behavioral, characteristics inherited from the past are considered. Fourth, the significance of the removal of shortages, economic (price, trade, in-out business, capital flow) liberalization for entrepreneurship development and the demand factors are presented. Fifth, the role that the change in property rights plays in development of the SME is examined and the meaning of the legal measures and the new institutional arrangements are discussed. Sixth, the role that an emerging 'growth lobby' may play for the expansion of the SME is examined. And last, the policy conclusions which support the sustainability of development are drawn.  

2. Transition and the entrepreneurship

Transition to a market economy must be seen as a historical process of complex changes leading from the centrally planned economy based upon the dominance of bureaucratic coordination and state property to an open economy based upon market coordination and dominance of the private property. From such an angle the crucial factor in establishing of the market economy -- after the statist economy of the socialist, centrally planned type is abandoned -- is the development of the private sector. Yet privatization is far from sufficient to accomplish such a target.  

Transition consists of three parallel processes (Kolodko 1992). First, liberalization-cum-stabilization, second, institution building and, third, the microeconomic restructuring of the existing capacity.  

Considering the point of departure towards a free market, i.e. a largely distorted price structure and financial disequilibria at the late stage of centrally planned economy, the liberalization process initially caused further financial destabilization, mainly initiating an inflationary process. Since inflation was repressed under the socialist economic regime, liberalization at first leads to acceleration of price (open) inflation and therefore calls for thorough stabilization policy. This in turn, requires though financial and monetary policies, what has particular implications for further structural reforms associated with transition to a market system.

Second, the core of transition is the process of institution building. The market does not mean just a liberal regulation (or de-regulation) and dominance of private property expanding fast due to ongoing privatization, i.e. de-nationalization of the existing assets. The market means both private property and liberal regulation AND the building of institutions. The institutions are the rules of the economic game and the organizations facilitating these rules as well as the links between them (North 1997). Thus the establishment of appropriate institutional arrangements is indispensable for the birth and growth of a market economy. The more this is the case in the postsocialist countries, where the old institutional regime is being dismantled and the new one must be developed almost from the scratch. Unlike liberalization-cum-stabilization, which may be (if the political circumstances permit) executed in a less or more radical manner, institution building in each case must be a gradual process.  It takes time and calls not only for new law and organization framework but also for lasting process of learning by doing.

Transition to a market makes sense only if it leads to the improvement of efficiency and thus relatively better overall economic performance. Hence, microeconomic restructuring, tied to the liberalization-cum-stabilization, on the one hand, and to the new institutional arrangements, on the other, must be seen as another indispensable part of the whole transitional endeavor. This process needs not only time, but first of all the capital, new investment and retraining as well as re-deployment of the labor. It is also very costly in the terms of both financial resources and the social costs. The new economic structure resulting from these changes contributes to upgrading industrial capacities and thus to higher competitiveness and, at the end, to rising standard of living. Microeconomic restructuring is linked to both the streamlining of existing capacities and to the creation of entirely new units facilitating the processes of producing the goods and delivering the services.    

Within such conceptual framework transition always is a gradual process. It can be managed better or worse, it can last a shorter or longer time, but in its complexity it is and must be by its very nature a gradual process. In these lights even in the countries most advanced in transition, e.g. these that have already joined the OECD or are negotiating their accession to the EU, the transition is far from over.

Therefore, the development of entrepreneurship in the postsocialist countries in transition should be seen through the prism of this three-dimensional gradual process. It also ought to be interesting to examine the systemic and policy implications for the development of the SME from such an angle.

One may claim that the main purpose for the whole transition exercise is the creation of entrepreneurship. Undoubtedly, liberalization and privatization are unleashing the entrepreneurship, yet these two processes are not sufficient to turn emerging activities in manufacturing, trade, financial and other services into a constructive force. As much as the final success of postsocialist transition in ECE and FSU and the reforms of the socialist system in China and Vietnam depend on the expansion of entrepreneurship in all sectors of the economy, the development of sound entrepreneurship is due to the proper design of certain other processes, firstly institution building.

Only the appropriate institutions can channel the emerging activities in postsocialist countries in such ways, that the new market-based entrepreneurship will contribute to growing competitiveness and sustained growth. Otherwise, it can turn against long-term growth and development, as it has happened, unfortunately, in some of transition economies, including Russia, the most important and the largest of them all.   

3. The legacy of reformed vs. unreformed economies for the SME development

Leaving aside the agriculture sector in some countries -- especially in Poland where as much as 80 percent of farm land was not neither nationalized nor collectivized -- and some positive examples, though only with minor meaning, from the service sector (e.g. retail trade, construction, transport, housekeeping, etc.) there almost were no SME in the old system. This single fact has the most significant implication for their expansion during transition period, since in majority cases they must be developed from the beginning. Yet there are some systemic and real differences between the countries under discussion.

The point of departure to postsocialist transition ten years ago was different in particular countries. On the one hand, we have had traditional, soviet-type, rigid economies of the FSU and some rather orthodox ECE. On the other hand, we have had reformed economies of ECE, especially Hungary, Poland and the former Yugoslavia. Yet among the remaining centrally planned economies of the ECE region there were from this point of view not negligible differences, too. Whereas in the GDR and to some extent in Bulgaria, there was a little bit more of a room for the SME, in countries like Albania and Romania the SME simply did not exist.

Typical feature of the development in the statist centrally planned economies was reliance on heavy industry. From the beginning of so-called 'socialist industrialization', that is from the 1950s in ECE, the heavy industries were provided with true priority as far as resources allocation was concerned. Such a pattern of development was based upon the long lasting and prevalent across the region conviction that the expansion of heavy industries in the long-run would be decisive for the economic efficiency and thus political supremacy. Later, even if such ill-advised conviction had evaporated, the way the industries had been managed facilitated the concentration of production. As long as there was centrally planned allocation of scarce resources there was also a natural inclination to concentrate the production within the large units. Actually, often according to the rules 'the larger, the better'.

So, there was not enough room for the development and performance of the SME. Even if they were allowed to function (formally true in most cases) and even if from time to time (when a reform-oriented mood was gaining momentum) they tried to fill the vacuum left by the large companies, there were to some degree actually discriminated against. A lack of proper supply of the means of production and limited access to other resources, often in short supply, made their existence still more problematic. If - as it had occurred periodically - there were the attempts to facilitate the development of SME, it did not last long and in the real struggle for the centrally distributed resources there were always the losers. The legal framework, which intentionally was introduced to support this part of the production and service sectors, was not strong enough to secure the smooth performance of SME, which  were always pushed into the shadows by big industrial units, that were much easier to be managed from the top of the state bureaucracy.  

Of course, the particular situation differed from country to country, yet such a course of evolution was rather typical for all of them. However, in those with lasting communist orthodoxy, the room for private SME performance was always a very narrow one, including the periods where in other countries there were certain attempts to exercise more flexible approach towards this sector.

Indeed, the way the management over the state sector in socialist economy was exercised was of a paramount importance for the evolution of the economic structure toward the concentration of economy into a few yet rather very large units. If it was quite understandable in the case of, say, steel mills or ship yards, it was a rather bizarre exercise in the instance of the factory making buckets or ropes. Yet even in the later cases - if it was difficult to organize the production just under one roof - special organizational units were created to bring the process of production and distribution under some form of the control of central bureaucracy.

In countries that tried to reform their institutional set-up and adjust the legal system towards the needs of a more flexible economy the SME did much better. In Hungary, Poland and the former Yugoslavia - somewhat like China in the 1990s - the sector of small companies employing just a few workers performed well together with the large firms. Yet the core problem was not the size of companies as such. What really mattered was the character of the property. Since they were socialist economies, they relied on state property and there were ideologically motivated constraints imposed upon the expansion of the SME. Whereas the state sector was inclined towards big units, since it was then easier to compete for centrally distributed means of production, the private sector's expansion was strictly limited. The small sector was doomed to remain indeed small, since there was a political limit imposed on its size. And not because of the concern about efficiency, but because of the general features of the old system.  

These orthodox limitations were somehow eased in the reform-oriented countries. Therefore, these economies were able to shift more resources and employment to the SME sector, which by the same time happened often to be the private one. The private sector was exclusively small, because there were not at all any private units among the large companies. The SME were allowed to perform especially in the light industries, agribusiness and traditional service sector. Later, the existence of such companies had an important meaning for the transition process for three reasons.

First, small and medium scale of production was more flexible and therefore, at the instant the liberalization had come, the supply response form the SME was much faster and better facilitating the market needs than the response from the more rigid large companies.

Second, the SME under the old system were mostly private enterprises, so it was the true root for the growth of private capital. Many SME, if only they were able to concentrate, invest and form new capital, become larger companies, thus contributing to sooner accomplished recovery and growth. This is an important part of the explanation why the transitional recession lasted several years less in Poland, Hungary or Slovenia - the only former Yugoslav republic that was able to escape the misfortune of the local military conflict, or its direct consequences as e.g. mass migration.  

However, there was many SME which had perished 'a day after' the economic liberalization arrived. A number of them was able to survive under the communist regime and accompanying it shortage environment, yet there were not able to manage at a free market. A bulk of the SME performing in the previous system was efficient, yet their management did focus mainly on procurement of the means of production, raw materials and other assets, and, of course, securing a labor. When the real market mechanism had begun to be introduced, the main difficulty became to sustain profitability when the market clearing mechanism was set in motion due to the price liberalization. This time the difficulty was to sell an output, not to acquire an input. Hence, many SME were not up to this challenged and had been wiped out of the emerging market.

Third, the skills of the managing staff of the SME was relatively more adequate for the needs of the emerging market economies. Despite the fact that the managers of these small units were far behind the qualifications of managers in advanced market system, they were more flexible and better prepared to undertake the risks that the operation at market economy has brought. Yet they were also oriented with their traditional skills, inherited from the old system, to manage the firm under the environment of the shortages. So, when the shortages were eliminated many of them were not ready to meet the new challenge brought by the transition, because their 'fine art' of management was rather the knowledge how to acquire the scare goods than how to sell a plenitude of them. However, the fact is that in those countries, which enjoyed the SME sector under the previous regime -- owing to the market reforms introduced before the transition took off -- the process of structural adjustment went much smoother. The institutional building was going faster, the recovery came sooner, the growth has become more robust.     

4.  Shortage removal and the demand factors

The common feature of the distorted socialist economy was the phenomenon of shortage. In addition to all its implications for the allocation of capital and behavior of the households sector, it had also an influence upon the SME. Even in the countries that did not introduced market oriented reforms prior to the systemic transition, e.g. Albania or Romania, in some sense there were SME as long as there was also an informal sector in the economy. Owing to the short supply, various economic activities had been undertaken in the 'shadow economy'.

Mostly it occurred in service sector but also in manufacturing at small scale in the industries not requiring either the scarce raw materials or sophisticated equipment. Such informal activities were exercised firstly in labor-intensive production, for example in garment industry in urban areas, or in food processing industry in rural areas. Depending on the attitude of the governments there were more or less restrictions imposed upon these types of activities. Yet in all cases --  as long as it was from the official point of view the informal sector - neither the flow of output from these unit, nor their overall numbers were registered. Thus we know that there were some SME under the economy of shortage, yet we don't know how actually big such a sector was.

A driving force behind the SME functioning under the shortage economy was the short supply of the goods and services, especially sought by the household sector at the consumers market. Therefore, the first feature of this activity was that the supply was addressed basically at the consumers market. Hence, these SME were able to sell their product in the shadow economy, which was linked entirely to the 'private' economy, i.e. to the households sector. They hardly operated in the investment or heavy industry sectors at all.  

The second fundamental feature of the SME under the economy of shortage was the syndrome 'easy sell, difficult buy'. Where the goods and services were in short supply, it was extremely easy to sell the products at the parallel market, since always -- and it was a systemic characteristic -- the aggregate demand was in excess over the aggregate supply (Kolodko and McMahon 1987). But for the SME it was also difficult to buy the means of production, since they were also - owing to the same systemic factors - in short supply. Since such SME were often informal, so the transaction of acquiring the raw materials, procurement goods, labor, etc., were often quasi-informal. Thus to buy inputs was difficult and to sell output was easy.

These foundations had changed significantly at the onset of transition. On the one hand, the SME that had operated up until then in the shadow economy emerged into the surface and tried to meet the new challenge and opportunities in the formal sector. On the other hand, the SME that were already performing in the formal sector, from then on had to meet another challenge, because instantly they found themselves in competition, a feature they were not familiar with. It explains why in reformed economies, e.g. Poland or Hungary, the pace of growth of SME was much higher than in non-reformed centrally planned economies. In countries with a relatively liberal financial regime, or even where the centrally planned allocation was actually abandoned during the reforms of the 1970s and 1980s, there were more SME in both the formal and informal sectors before the transition.

The paradox of this legacy for the expansion of the SME at the early stages of postsocialist transition was that in some cases (the best example is Poland) the shortage economy, together with the reforms aiming at limited liberalization, did contribute to faster expansion of the SME. If shortages were vast (as indeed was the case in Poland during the 1980s) and simultaneously the shadow economy was tolerated -- even if not facilitated by the actual government policies -- there was a greater potential accumulated for the take-off of the SME at the day true liberalization eventually arrived. And on the contrary; when the shortages were vast, but yet the supply response from the SME acting in the informal sector was repressed by the government policies - as, for instance, it occurred in Romania in the course of the 1980s - then the conditions for the SME growth at the onset of transition were very limited too.

Thus, when the process of transition was set in motion at the beginning of the 1990s the biggest chance for expansion came from the overall liberalization of economic activities and the cessation of numerous bureaucratic constraints imposed for a number of reasons under the previous institutional arrangements. The biggest challenge, in turn, stemmed from the fact that the end of shortages removed as well the easy way of being able too put the products and services on the market, disregarding their quality. It became necessary to compete not for access to the inputs, but for the sale of the output. Thus new expertise was needed, firstly the marketing skills and the ability to take care of the quality of output. The 'quantity drive' must be abandoned, the 'quality drive' was just born.

Yet one more paradox of development of the SME has emerged. Despite the removal of short supply of the needed inputs for the SME, which could be bought now in the liberalized markets, and despite de-regulation coming as an indispensable part of transition, the shadow economy persists. Moreover, in a number of the countries, especially those of the FSU that are less advanced in the transition, the parallel sector is much greater than ever before. Leaving aside the pathologies - like organized crime activities in Russia, that take a large share of all resources and creates a large part of the informal sector, and especially operates in the large companies and big business (Satter 1998, Ermarth 1998, Economist 1999) - usually the informal sector is composed basically of the SME.

Yet this time the cause is not the shortage, since this malaise of the centrally planned economy has been removed together with the entire old institutional set-up. This time the reason is a temptation to avoid taxes. The reluctance to pay due taxes, even if not necessary the highest ones, is quite strong in the emerging markets. It is not only a matter of weak tax administration, which must be streamlined in a gradual way as transition process progresses, but also the matter of the luck of proper fiscal culture and underdeveloped institutions in the postsocialist economies (Tanzi 1992).  

Another feature of the SME which stems from the shortage-removal effect is their real structure in the transition economies. To a much larger degree than in the developed countries and advanced market economies, the SME in ECE and FSU perform mainly in trade. Trade liberalization and the hunger for consumer goods, including the imported ones, have contributed to the mushrooming of SME in the trade sector, especially in retail trade. It happens - at least at the early stages of liberalization - that it is much easier to establish a small scale endeavor in retail trade than in manufacturing.

From this perspective any evaluation of the number of so-called SME must be analyzed carefully, since it is obvious that these numbers are simply the function of the magnitude of the country and the number of its population, on the one hand, and of the manner the trade is organized, on the other hand. Later - when the process of concentration is coming also to the private business in the trade sector and the SME in retail trade are being replaced by the system of super- and hyper-markets - the number of the SME starts to decline. This is simply the result of the technological progress in the trade industry.

Therefore, both the range and the characteristics of the reforms of the centrally planned economies, as well as the specific features of the shortage economy, have had a significant impact upon the development of the SME during transition to a market system. If the quantity and the quality of this sector of emerging postsocialist economy at the onset of transition was given by the legacy of the outgoing system, its evolution and contribution to the performance of the postsocialist economies was basically resulting from the policies executed already during transition. Both liberalization-cum-stabilization policy and the policy of institutional building, i.e. systemic policy, do matter a lot for the expansion and performance of the SME sector.

If the combination of these policies has been a fortunate one and its design has addressed the specific needs of the SME in an appropriate way, then this sector has not only expanded faster than the large companies, but also has been integrated deeper into the formal economy. Since its output is registered, it shows better results as far as the recovery and growth are concerned, too. Yet it is not only a statistical point, since these small firms not only have begun to operate at the formal, registered market, but also they did expand -- and sometimes significantly -- the range and scope of their activities.

There is also a link between the aggregate demand's shifts and the supply response that has been delivered by the SME sector. Initially -- owing to the stabilization attempts following liberalization -- the aggregate demand was contained by a significant margin. Thus, it caused transitional contraction, which lasted in certain countries for several years. Later, when the economies have been put back on the path of recovery and growth, the growing aggregate demand was another driving force behind the expansion of the SME. This time, due to liberal regulation and easy access to freed markets, they were able to react and there was a positive supply response to increasing demand of both the households and the firms sectors.  

Yet in certain cases and periods it has occurred that the aggregate demand was on the decline again. The resurgence of recession in some countries (e.g. Czech Republic in 1997-1999, Russia in 1998-99, Albania in 1997-98), or remarkable slowdown in some others (e.g. Poland in 1998-1999 ) had led also the slowing down the process of expansion of the SME. Whatever was the actual cause of triggering the policies aiming at the containment of the rate of growth -- was it a concern about too fast and too much growing current account deficit, as for instance in Estonia and Hungary, or was it the reaction for the fallout from the Russian crisis, as for instance in Slovakia and Moldova -- the resulting downward shift in aggregate demand must led to slower than otherwise expansion of the SME sector.