Thursday, November 27, 2014

SME Performance in Georgia and Armenia: Part 1

The CRRC Caucasus Barometer (CB) survey results demonstrate that Georgians exhibit relatively high levels of interpersonal and institutional trust when compared to their Armenian neighbors. Trust is an important component of “social capital,” which is widely perceived to be a necessary condition for a thriving entrepreneurial class and small and medium enterprise (SME) sector. Scholars of social capital such as Francis Fukuyama (1996) and Robert Putnam (1993) have written extensively on the effect of social trust on economic development, of which the growth of SMEs is important, finding a connection between trust toward fellow citizens and formal institutions and successful entrepreneurship. Other scholars such as Knack and Keefer (1997) assert that “if entrepreneurs must devote more time to monitoring possible malfeasance by partners, employees, and suppliers, they have less time to devote to innovation in new products or processes,” while Bjornskov and Meon (2010) express the view that “trust allows entrepreneurs, who move the productive possibility frontier forward through process innovation, to have more impersonal contacts and rely more on the market process.”

This two-part series of blog posts provides a comparative analysis of the productivity of respective SME sectors in Georgia and Armenia in the context of social trust. While Georgians report higher levels of trust in other people and in formal institutions than their Armenian neighbors (possibly indicating higher levels of social capital), the performance of SMEs in Georgia is unproductive in comparison, suggesting that factors other than trust may be more salient to entrepreneurial success. 

Before providing analysis it is important to consider the different official definitions of an SME in each country. According to the Ministry of Finance, the term “SME” in Georgia refers to any firm generating annual turnover of less than GEL 1,500,000 (roughly $850,000 at the time of writing), regardless of the number of employees. By contrast, the Armenian authorities do not take turnover into account and, rather, define SME by number of employees, with different standards by sector: in industry an SME employs up to 100 people, in education and energy up to 50 people, and in services up to 30 people. Despite differences in definition the share of the workforce employed by SMEs in either country is similar; 31% of Georgia’s employed persons work in the SME sector, slightly larger than the 25% figure for Armenia.

While employment levels are similar, value added by SMEs is relatively smaller in Georgia than in Armenia, indicating a comparative lack of productivity in Georgia’s SME sector (productivity is measured as value added per employee). In 2012 value added produced by Georgian SMEs accounted for only 9.6% of the country’s GDP, compared to 27% for Armenia. Measuring the productivity of workers in the SME sector using the equation SME value added/GDP ÷ number of employees in SMEs/number of employees nationwide, we are left with the following coefficients as measurements of productivity: 1.08% for Armenian SMEs and .31% for Georgian SMEs. While the Georgian SME sector employs a slightly larger proportion of the workforce, the relative contribution of each employee to the country’s GDP is only one-third that of the contribution of employees in Armenian SMEs.

Giorgi Tsikolia, director of Georgia’s Entrepreneurship Development Agency, spoke of the poor performance of Georgia’s SME’s: “SMEs demonstrate low productivity and competitiveness as well as low sophistication. In many cases companies have poor management and employees lack knowledge and relevant skills.” In short, Georgia has no shortage of start-ups, but it has a shortage of successful entrepreneurs. The development of the sector has been plagued by persistent problems: proprietorships and small firms lack the capabilities and incentives to grow. Farmers often fail to progress from subsistence activities to producing for exchange, and small proprietorships struggle to achieve the productivity gains needed to become thriving medium-sized enterprises.

Can measures of social trust be useful tools for explaining the relative performance of SMEs in Georgia and Armenia? The CB asks respondents the following question: “Would you say that most people in the country can be trusted, or that you can't be too careful in dealing with people?” While this question doesn’t tell the whole story about interpersonal trust, it is designed to measure bridging social capital, a condition especially important for economic performance. The responses show Georgians to be much more trusting than Armenians, with 29% answering that “most people can be trusted” compared to 15% of Armenians. More importantly, 33% of Georgians responded that “you can’t be too careful,” compared to 53% of Armenians (values were re-coded from a 10-point scale used in the questionnaire to a three-point scale used in this text, with original values 1-4 corresponding with the response “you can’t be too careful,” 5-6 being “neutral,” and 7-10 corresponding with “most people can be trusted”).

Trust in formal government institutions is another measure of social capital. While a comprehensive assessment of the level of institutional trust in either country is not possible here, the observance of select indicators can provide valuable insight. In 2013 CB asked residents of both countries to assess how much they trust or distrust their country’s court system; 22% of Georgians reported to “fully trust” or “somewhat trust” the courts, compared to 15% of Armenians. Furthermore, Armenians were much more likely to express distrust, with 53% responding that they either “fully distrust” or “somewhat distrust” the courts, compared to only 19% of Georgians. This indicator has significant implications for the success of SMEs, as trust in the legal system to protect private property and impartially mediate disputes is an important condition for entrepreneurs to undertake costly investments. CB also asks respondents how much they trust or distrust their country’s Parliament. In 2013, 29% of Georgians responded that they either “fully trust” or “somewhat trust” the national Parliament, while only 11% of Armenians gave the same answer. Georgians were also much less likely to distrust their Parliament, with 19% percent indicating “distrust” or “fully distrust,” compared to a full two-thirds of Armenians.

Looking at social and institutional trust in a vacuum, one would expect Georgia to have a more successful SME sector than Armenia, but the opposite is true. So, it appears that other factors present in Georgia hamper the productivity of SMEs. Academic studies by Rudaz 2012 and Welton 2012 find significant impediments from the difficulty individuals face obtaining financing and the fragmentation of agricultural land, problems determined to be more pervasive in the Georgian case. Given that Georgians report higher levels of interpersonal and institutional trust than Armenians, it appears that tangible factors may have more profound effects on the productivity of small and medium enterprises in Georgia.

While this piece overviews the performance of SMEs in Georgia and Armenia in the context of social capital, the second blog in this series will explore more tangible factors affecting the performance of Georgian and Armenian SMEs, including problems in agriculture and financial markets. For more information about public opinion in Georgia and Armenia, consult CRRC’s online data analysis tool.

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