SME Performance in Georgia and Armenia: Part 2

As discussed in the first blog post of this series, the results of the CRRC Caucasus Barometer (CB) survey show that Georgians demonstrate higher levels of interpersonal and institutional trust than Armenians.  These types of trust are important indicators of social capital, which is often taken as a necessary condition for the presence of a robust, productive entrepreneurial class and small and medium enterprise (SME) sector. While Georgians express higher levels of trust in their fellow citizens as well as in formal institutions such as the judiciary and Parliament, economic data shows that the country’s SME sector suffers from a dearth of productivity. This blog post looks at survey data shedding light on economic conditions in Georgia and Armenia as well as policy research on the state of SMEs in each country, finding impediments to rural development and the high cost of financing to be potential causes for the relative lack of productivity by Georgian SMEs.

Productivity of the SME sector (defined as value added per employee) is significantly lower in Georgia when compared to Armenia. Emblematic of the lack of productivity in Georgian SMEs is the preponderance of small-scale agriculture. Many legally designated “small enterprises” are in fact subsistence agriculture proprietorships with little or zero cash turnover, a situation which Rudaz 2012 refers to as “entrepreneurship by default.” A report from the International Fund for Agricultural Development found that as late as 2005, 83% of rural households were dependent entirely on subsistence agriculture and that a “typical” rural household consumed 73% of what it produced. By 2013, however, the CB found that 59% of rural Georgians reported receiving household income from the sale of agricultural products, indicating an existence at least slightly above subsistence level agricultural production.  On the other hand, 27% of Georgia’s rural inhabitants reported no household income from salaries or sales of agricultural products. Rural Armenians are somewhat less likely to sell agricultural products (50% reported household income from this source), but more likely to receive salaries. However, 25% percent of rural Armenians responded “no” to their households having received income from either source. Thus one cannot decisively discern from the data at hand whether rural Armenians are more likely to receive cash income than rural Georgians.

The first blog post of this series determined that available measures of social capital appear to be insufficient to explain differences in SME productivity between the two countries. So, what are possible causes for the lack of productivity gains in Georgia’s SME sector? With regards to agricultural SMEs, a potential culprit mentioned in the previous installment of this series is the fragmentation of agricultural land, with the average private holding in the country being only 1.25 hectares. The consolidation of small plots into larger and more efficient commercial farms has been impeded by an inefficient system of land registration and poorly defined property rights. Restrictions on the purchase of agricultural land by foreigners and foreign-owned businesses have also precluded potentially productive investment in the sector. While the Constitutional Court struck down a law banning land purchases by foreigners in June, 2014, a new draft of the law will allow private foreign persons and foreign companies established in Georgia to purchase plots of up to 100 hectares. Fragmentation is a problem in Georgia, but it also bears mentioning that the average private plot in Armenia consists of 1.3 hectares, scantly larger than in Georgia. Land fragmentation appears to be an obstacle to the growth of Georgia’s SME sector, but it doesn’t appear to be a decisive one. 

As for palpable factors which may explain the lack of growth by both Georgia’s agricultural and non-agricultural SMEs, the difficulty of obtaining financing should not be overlooked. The average interest rate spread in Georgia (the difference between the interest paid on deposits and the interest charged on loans) is 11.3%, the highest spread of the former Soviet republics and significantly higher than the average spread of 7.3% in Armenia. This means that the cost of borrowing outstrips the incentive to save, with the result being that an entrepreneur in need of financing to buy land and equipment or hire employees is faced with very high borrowing costs. In Armenia, this problem occurs but on a smaller scale.

The high cost of financing stems in part from the lack of collateral held by SMEs, which discourages lending. Rudaz also reports the existence of a “law giving tax authorities the right to use the collateral of tax payers who owe money to fiscal authorities,” which allowed the tax authorities to seize the collateral of those owing back taxes. To be more specific, in cases in which a person has outstanding debts to both the tax authorities and a financial institution, the claims of the tax authorities take precedence. This interpretation was corroborated by Eka Gigauri of Transparency International Georgia. As a result, domestic financial institutions face higher financing costs when borrowing from abroad, and banks have become reluctant to accept collateral. There is also a general sentiment of political risk associated with Georgia; the country has a moderate-to-low credit rating of BB-, which hampers the ability of banks to procure external funding. These developments translate into higher borrowing costs for households and businesses.

To summarize, academic studies produced by Knack and Keefer (1997) and Bjornskov and Meon (2010) emphasize the importance of social capital on the success of entrepreneurship, and CB survey data show that Georgians exhibit significantly higher levels of social and institutional trust (which are among important indicators of social capital) than Armenians. Social trust is often taken as a necessary condition for economic growth. However, it is not a sufficient condition, as indicated by measurements of productivity (SME turnover per employee) being much higher in Armenia than in Georgia. This indicates that more palpable factors are inhibiting the growth of Georgia’s SMEs, with agricultural land fragmentation and the difficulty in obtaining financing being possible explanations. However, it must be conceded that none of the factors presented in this study, when viewed in a vacuum, appear sufficient for explaining the divergent performances of SME sectors in Georgia and Armenia. A more comprehensive study is necessary to reach solid conclusions.

For more information about public opinion in the South Caucasus, including data pertaining to social capital and the economic situation, refer to the CRRC online data analysis tool. If you have some criticisms, evidence or insights to add to the discussion, please feel free to contribute comments.