AND ENTREPRENEURSHIP IN A TRANSITION CONTEXT
2. TRANSITIONAL ENVIRONMENTS WITH MAJOR INSTITUTIONAL DEFICIENCIES
2.1. An Institutional Approach to Entrepreneurship in Early Stage Transition Economies
Evidence from several empirical surveys in former Soviet republics, such as Russia, Belarus and Ukraine and others such as the Baltic states, suggest that many enterprises are set up, survive and sometimes even grow despite government, because of the entrepreneurship of individuals in mobilising resources and their flexibility in adapting to hostile external environments (e.g., Aidis, 2003; Chepurenko, 1994, 1999;Chepurenko & Malieva, 2005;
Manolova & Yan, 2002; McIntyre & Dallago, 2003; Smallbone & Welter, 2001b; Smallbone, Welter, Isakova, & Slonimski, 2001;Yan & Manolova, 1998). The problem is that in these situations the number of firms remains small and their contribution to economic development in terms of jobs, innovation and external income generation is rather limited. Thus, in sit- uations where market reforms have been slow or only partially installed, the institutional context becomes a critical factor, since government still has to create the framework conditions for sustainable private sector development.
In such conditions, it has been suggested that the types of entrepreneur- ship that can be identified and the enterprise strategies adopted are heavily
influenced by the external environment in general (e.g., Hoskisson, Eden, Lau, & Wright, 2000;Oliver, 1991;Peng & Heath, 1996;Peng, 2000, 2003;
Radaev, 2001; Wright, Filatotchev, Hoskisson, & Peng, 2005) and the in- stitutional context in particular (e.g.,Manolova & Yan, 2002; Aidis, 2003;
Welter & Smallbone, 2003). In this regard, institutionalist theory offers a suitable interpretative frame of reference, since it emphasises the role of external political, economic and societal influences on individual behavi- our (cf. North, 1981, 1990, 1995, 1998, 2004; Williamson, 2000; Voigt &
Engerer, 2002). Douglass North understands ‘institutions’ as the rules of the game within a society, which structure individual behaviour, thereby reducing uncertainty, risk and transaction costs connected with each indi- vidual action. He distinguishes between formal institutions, which include political and economy-related rules and organisations, and informal insti- tutions, such as the codes of conduct, norms and values of society (North, 1990). An institutional framework to foster entrepreneurship consists of the fundamental political, social and legal rules, which set the basis for eco- nomic actions (Davis & North, 1971). In this regard, examples of formal institutions include the legal framework and the financial system. Informal rules refer to codes of conduct and interpretations of laws and regulations, which further regulate economic actions. Both formal and informal insti- tutions are a major influence on the nature and extent of any entrepreneurial activity, since they determine the scope for the actions and behaviour of (potential) entrepreneurs in practice.
In those transition economies, where progress with transformation to- wards a market economy is limited, effective formal institutions appropriate to emerging market conditions, are lacking. ‘Old’ (i.e., unchanged) informal rules predominate, resulting in an incompatible institutional framework, which further slows down the transformation process (Mummert, 1999).
In such situations, entrepreneurs solve the ‘normative dilemma’ of post- communism (Los, 1992) by resorting to learned behaviour, although this contradicts the new institutional framework. Such behaviour represents a form of path dependency, which plays a major role in explaining certain characteristics of entrepreneurship and enterprise behaviour in transition economies (Welter & Smallbone, 2003).
In addition, an inadequate and often hostile institutional environment in countries where market reforms have been slow, or only partially installed, further constrains the development of small businesses and entrepreneur- ship (Smallbone & Welter, 2001a, b;Aidis, 2003). In Belarus for example, the very slow pace of privatisation, combined with an increase in the reg- ulation of small enterprise activity after 1996, forced many small firms into
liquidation and others into operating abroad in countries, such as Poland, Russia, the Czech Republic, Latvia and the Ukraine (Smallbone et al., 2001). Methods used to restrict entrepreneurship included additional re- quirements for enterprises to obtain licences, and a more rigorous approach to the implementation of regulations by state officials (e.g., tax officials) towards private firms than towards state enterprises. By 1997, the effect of an increasingly hostile regulatory stance on the part of government towards the private sector resulted in 54% of all registered enterprises becoming illegal, or driven out of business, because of new registration rules, linked to higher minimum capital requirements (Zhuk & Cherevach, 2000).
2.2. The Environment for Entrepreneurship in Early Stage Transition Countries
In many transition countries, where the pace of reform has been slow, the legal frameworkis still the main barrier for the development of small busi- ness and entrepreneurship. Creating an adequate legal framework involves laws relating to property, bankruptcy, contracts, commercial activities and taxes, but it also involves developing an institutional framework with the capacity to implement these laws, which has major implications for staffing.
In practice, and referring again to the Belarussian context, this requires the establishment of specialised economic courts; a private legal profession and effective enforcement mechanisms, which are still lacking for the most part, which goes hand in hand with a typical lack of adequate personnel in gov- ernment administration. The reasons include low public sector salaries, combined with a lack of education and training opportunities. All this pre- vents the proper implementation of new laws and regulations, with negative implications for the business environment and organizations. In addition, frequent changes in tax regulations and other commercial laws, which are characteristics of the early years of transition, require a constant adjustment of knowledge by small business managers as well as by those in government administration. Other problems include a rather uncertain attitude, or even arbitrariness, on the part of public officials regarding law enforcement, which is not helped by a typical lack of specificity in the drafting of laws.
Fundamentally, these institutional deficiencies reflect a lack of political commitment to facilitate private enterprise development. Belarus, under President Lukashenko, may be one of the worst examples, but the issues exist to varying degrees in most of the other former Soviet republics. Political considerations with respect to the enforcement of laws can aggravate the
situation, resulting in the fostering of‘old’ networks between former state- owned firms and government, as also happened in the early stages of transition in those former transition countries, which joined the EU in 2004 (for Hungary cf. Voszka, 1991, 1994). In some transition countries these networks seem to be one of the major problems (cf.Kuznetsov, 1997), which impede the establishment of independent juridical institutions and the im- partial enforcement of a legal framework required for market economies.
Another major barrier to small business development in transition coun- tries, where market reform has remained slow is the financial infrastructure (Welter, 1997;Zecchini, 1997). While stock exchanges developed quickly in the more advanced transition countries, in most former Soviet republics, national risk capital markets are virtually non-existent and the banking system is still highly inadequate (Zecchini, 1997; Frydman, Murphy, &
Rapaczynski, 1998). Banks under central planning were mere accounting agencies without an active role in the financial transactions of households or enterprises. In less advanced transition economies, the majority of banks still experience difficulties in mastering the task of guiding savings towards capital investment in private enterprises, especially small businesses. The extension of credits to small businesses has also been hampered by the fact that newly created or privatised banks often face liquidity constraints, re- sulting from insufficient equity capital provision, inherited liabilities from the central planning era and/or from massive repayment delays. In addition, banks have typically followed a conservative strategy with respect to the financing of private enterprises. As a consequence, most banks in less advanced transition countries, such as Ukraine and Belarus, lack the willingness to finance small businesses, reinforced by a lack of expertise and know-how with this new clientele, as well as a shortage of collateral on the side of the enterprises. In these circumstances, informal institutions and practices may compensate for some of the deficiencies in formal market institutions, although not without implications for the types of strategies adopted by entrepreneurs to set up and develop businesses (Peng, 2000, 2003).
2.3. Entrepreneurial Behaviour in an Early Stage Transition Environment All these factors can contribute to a negative attitude on the part of small businesses towards government and regulations, which was a common phe- nomenon in the early years of transition particularly, and across all transition countries. It typically results in the widespread use of types of enterprise strategy which represent an adaptation by entrepreneurs to a
specific set of environmental and institutional conditions (Oliver, 1991).
Frequent changes in the legal system, combined with a prohibitive tax level, an unpredictable behaviour of state officials in applying legal and tax reg- ulations, and inadequate access to external capital, encourage entrepreneurs to use evasion strategies (Feige, 1997; Leitzel, 1997). These‘evasion’ strat- egies allow private entrepreneurship to exist and survive in an environment where government typically considers private businesses to be mainly a source of tax revenue and where inadequate public law enforcement leads to arbitrariness and corruption.
‘Typical’ evasion strategies included combining legal and informal pro- duction; setting up a ‘fictitious’ enterprise; and making cash payments to employees. For example, evidence drawn from a study of employment be- haviour in Russian small businesses, indicates a predominance of unofficial payment strategies to workers in order to reduce social security contribu- tions (Welter & Smallbone, 2003). As the owner of a publishing house in Russia put it, ‘‘In a trading business the wage actually paid is several times greater than the officially calculated pay’’ (Welter & Smallbone, 2003).
Survey data from the same project in Russia also indicated widespread violation of the labour law, thus providing further examples of evasion strategies being used as part of ‘normal’ enterprise behaviour, although entrepreneurs were naturally cautious about admitting this openly. Exam- ples included the use of verbal labour contracts, or the socialist practice of
‘enrollment on order’ (i.e., the enterprise management issues an order to employ a particular employee), thereby violating the labour law. In addi- tion, only-one third included the legally required provisions for labour pro- tection in the conditions of employment. Consequently, in two-thirds of the surveyed Russian enterprises, the labour contracts were not valid legally (Welter & Smallbone, 2003).
Moreover, evidence from various studies across different transition coun- tries confirm these results (e.g., Frye & Shleifer, 1997; Gustafson, 1999;
Hendley, Murrel, & Ryterman, 2000;Peng, 2000;Radaev, 2001;Manolova &
Yan, 2002). Weakly specified regulations, combined with inadequate law enforcement, encourage corruption, not only when an entrepreneur is first registering a company, but also in everyday economic transactions. As a result, an inadequate legal framework contributes to forms of enterprise behaviour, which although rational from an individual entrepreneur’s point of view, is non-productive from the economy’s standpoint, falling into the category of unproductive entrepreneurship (Baumol, 1990). This behaviour is considered unproductive because it diverts resources that could otherwise be put to productive use, into dealing with some of the unnecessary costs
associated with an institutional context in which the framework conditions for sustainable entrepreneurship have still to be established. Institutional deficiencies lead to mistrust on behalf of the entrepreneur, towards state officials and society more generally (e.g., Raiser, 1999; Rose-Ackerman, 2001; Tonoyan, 2005). This can lead to a potentially vicious circle of mis- trust fostering further evasion behaviour of entrepreneurs, which in turn fosters further mistrust and corruption practices (for country-specific ex- amples, see Raiser, Haerpfer, Nowotny, & Wallace, 2001; Service, 2002;
Satter, 2003; Welter, Kautonen, Chepurenko, Malieva, & Venesaar, 2004;
Chepurenko & Malieva, 2005;Radaev, 2005).
As a consequence, in conditions that pertain in countries such as Belarus and Ukraine, policy needs to focus on the overall institutional framework for entrepreneurial activities, in order to facilitate the development of pro- ductive entrepreneurship and minimise unproductive forms of entrepre- neurial behaviour. In this context, it is important to recognise that the cost of compliance with regulations and other statutory requirements includes opportunity costs for businesses with respect to the resources devoted to compliance, as well direct money payments in some cases. Improving the quality of laws and regulations are key elements in establishing the frame- work conditions that are necessary for economic and democratic develop- ment. Regulations that are overly burdensome, complex or impractical may reduce business competitiveness by contributing to higher administrative and compliance costs, as well as to a diminution of the rule of law when non-compliance becomes rife. Greater recognition also needs to be given to the fact that policy recommendations for small business support are often connected to specific political and cultural contexts, while conditions and legacies can vary considerably between countries.