Share prices of some of Russia's oil and gas giants jumped over 100% over the past year, while the Russian stock index rose over 60%. Will Russia's economy finally realize the potential that has eluded it for centuries? The answer is not only in the p/e ratios of big firms, but also in the overlooked realm of small business. For years, we've all heard about the challenges for small entrepreneurs in Russia , from fighting off the Mafia to spending weeks just to get a new business registered. But the real story is the resilience of Russian entrepreneurs in overcoming these problems.
A recent study by the European Commission's Tacis program estimated that Russian small- and medium-sized enterprises (SMEs) -- companies with up to 250 employees -- account for a surprisingly robust 40% of total Russian sales revenue and at least 45% of total employment. Since Russian entrepreneurialism has only been legal for 15 years, these figures compare favorably with those of the European Union, where SMEs account for 56.7% of total sales revenue and 65.8% of total employment.
Small business in Russia is bigger, and more important, than many people realize. The Russian Working Center for Economic Reform estimates that 35% of small business is in retail, including restaurants and bars, 21% in production and 21% in construction. About a third of Russian small businesses are located in Moscow and another 25% spread out in seven regions, with Samara and Nizhny Novgorod known as vibrant clusters.
Russia could yet see an even stronger boom in small business if the outstanding problems were tackled. Chief among them are high and inconsistently applied taxes, vulnerability to official and unofficial corruption, and lack of finance.
Taxation has been a headache for Russian business since the demise of communism. The SMEs were particularly vulnerable to the vagaries of tax collectors since, unlike the bigger firms, they lacked resources and expertise to ward them off. Russians often assume that bigger is better, so the authorities typically spent more time trying to revive Soviet era white elephants than helping the next generation of new businesses.
As a result, SMEs were left on their own. Responding rationally, the businesses minimized reportable income and paid whatever was needed to make the tax man go away. While this approach ensured survival, it impeded growth. By operating within the "gray economy," Russian SMEs couldn't get loans other than from equally gray money lenders. And because their tax contributions were small, Russian policy-makers continued to overlook them as a potential source of growth. The Tacis study estimates that SMEs account for only 10% of sales tax revenue, despite accounting for at least 40% of all sales.
It took President Vladimir Putin to try to break this cycle. On his initiative, the parliament just approved changes to the tax code that are designed to render taxation of SMEs simple, fair and transparent. SMEs with up to 100 employees and maximum annual revenue of 15 million rubles ($480,000) can now pay either a 15% flat profits tax or a 6% flat revenue tax.
The corruption headaches of SMEs are similar to those associated with taxation. Russian businesses, including SMEs, are subject to a bewildering array of required licenses, approvals and inspections. As in the case of taxation, SMEs are less well equipped than larger companies to make their way in this morass. As a result, they are more vulnerable to official corruption, in the form of government inspectors looking for extra income, as well as unofficial corruption in the form of local rackets offering protection in a manner that can't be refused. The Information for Democracy Foundation recently estimated that SMEs on average spend between $2,000 and $4,000 a year in bribing officials alone.
Improvements have been made in this area as well. The number of businesses for which licenses are required, from auditing to pharmaceutical manufacturing, has been reduced to 104 from 2,000. Since a recent study by the Center for Economic and Financial Research and the World Bank revealed that it takes 70 days on average to obtain a license in St. Petersburg (admittedly the worst case), fewer licenses will clearly be good for business. Efforts are currently underway to centralize inspection authority by creating a federal inspection agency that would streamline the process and reduce the scope for abuse.
The shortage of formal sources of finance remains a problem. However, Russian entrepreneurs are proving to be reliable borrowers. International Moscow Bank, one of Russia's largest and most prestigious banks, recently introduced a loan program for small businesses, while Sberbank, Russia's mammoth savings bank, already has a substantial small business loan portfolio. KMB Bank (The Bank for Small Business Lending), a bank established by the European Bank for Reconstruction and Development, has an SME loan portfolio of over $125 million. There is still plenty of room for other banks that want to diversify their client base; the Resource Center for Small Businesses estimates that fewer than half of small businesses have ever even applied for a formal loan.
What are the key obstacles still preventing Russian SMEs from catching up with their EU or Central European colleagues? Regulatory changes will have to be enforced consistently to change SME behavior. One-stop registration is still not a reality for many firms, while, according to the CEFR-World Bank report, limiting the number of planned inspections has led to an increase in unplanned inspections. For more financing to be made available, regulations for collateralized lending should be overhauled. Banks need to be able to obtain collateral more easily when they want it, but they also should not be forced to take collateral if they don't consider it necessary. Finally, the government should consider extending the new tax regime to larger small businesses. These businesses don't need special privileges, just less adversity.
The stakes aren't simply economic. In a recent survey conducted by Professor Timothy Frye of Ohio State University, managers of new private businesses were more likely to vote for market-oriented parties than managers in state-owned or privatized firms. As important for the future of Russian democracy, almost two-thirds of the new private business managers believed that elections should not be cancelled under any circumstances. So don't lose hope if the Russian stock market falls.
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