04.08.08

SMEs in Russia and China: A Comparison
by Max Bolotinsky and Hongda Jiang,
Market Analysts, Alinga Consulting Group

Russia and China are similar in many ways. Both are geographic giants with rapidly growing economies. Both are popular destinations for foreign investment and companies of all sizes looking for new markets. However, beyond these generalities, the two countries differ strongly on economic specifics.

The portion of Russia's GDP generated by small and medium enterprises (SMEs) is estimated at 13-17%. China's officially released data for 2005 (the most recent available) showed SMEs in that country accounting for 55% of its GDP. For comparison, in the USA this estimate is 50-60% and in the European Union, about 70%. What variables could account for Russia's pronounced lag in this economic sector – a sector often credited with granting national economies flexibility, diversity, and the strength to weather economic downturns?

This article will analyze specific factors affecting SMEs as they enter the Russian and Chinese markets. As we shall see, there are numerous challenges in both, but China is performing substantially better.

Russia's SME Environment

Russia's Minister of Economic Development, Elvira Nabiylina, recently made a bold projection that Russia's SME's share of GDP would reach 50% in the next 5-7 years. Russia's State Presidium proposed measures that it said would encourage 60-70% of population to become "involved in entrepreneurial activity" by 2020. President Medvedev has stated specifically that he will support SMEs and would work to make the federal government support rather than obstruct their activities.

Unfortunately, obstruction has so far been much more common than support. Despite the ambitious projections of Russia's government, the actual growth in the number of registered SMEs in Russia has only amounted to about 5% in each of the last several years.

An opinion poll conducted by the Levada Center in late 2007 showed that only 18% of Russians wanted to start their own business and that 69% thought it would be impossible for them to do so. Other studies have shown that 80% of all Russian businessmen were dissatisfied with their current rights, 88% were afraid they might lose their property at any time, and over 65% felt obstructed by government corruption.

Interestingly, the employment growth rate in this sector is 8 times higher than in the rest of the Russian economy – although this employment-to-GDP growth rate would actually imply a decreasing efficiency within the SME sector.
 

There are a few more hopeful statistics for Russia's SME sector. In October of 2007, there were 1.1 million officially registered small businesses and 3.5 million individually registered entrepreneurs. The annual growth rate in SME capital investment is estimated at least 30%. For the first half of this year, that investment has grown 40% over investment for the same period last year. This is in part thanks to improved legislation that went at the beginning of this year and known as “On Development of Small and Medium Entrepreneurship in the Russian Federation."

One major obstacle to growth is the rising cost of entering the market and maintaining a business in Russia. Rent prices have gone up substantially; locally produced market analysis has gotten more expensive; accounting costs and average wages have also grown. Excessive bureaucracy and corruption create other expenses. While graft demanded by organized criminal groups has greatly decreased in the past decade, bribes demanded by federal accreditation agencies, courts, police, and other official structures are still named by businessmen as a major problem they face.

The reforms that came into affect this year are supposed to better control the interactions between SMEs and the government.

The law establishes specific criteria that a business must meet to be considered an SME. The first is that the government, foreign companies, and non-SME companies collectively own no more than 25% of the company. Second, the company must employ fewer than 250 workers and earn less then one billion rubles per year. The earnings requirement was only recently clarified – and is to be reconsidered every five years. The law also makes divisions within the classification of SME: company with 0 – 15 employees, earning less than sixty million rubles is "micro;" those with 15-100 employees and between sixty million and four hindered million rubles are "small;" and those between that mark and the maximum are "medium."

Unfortunately, the government's plans to actually help SMEs, beyond defining them, are not quite as specific. The government, according to the new law, pledges to grant "equal consideration" to companies when distributing support programs (though what the support programs will be is not stated), and offers to let representatives from the SME sector participate in the legislative process and government projects that will affect SMEs. It has also pledged tax credits, loosened accounting rules, and assistance with property, financial support, IT support, consultation, and more. However, the details on how this help will actually be delivered to businesses are still unclear.

Another new law being considered by the Duma and expected to take effect with the start of 2009, does offer more specifics, though. Major emphasis is made on easing entry into the Russian market, on the limiting government inspections, and on doing away with many product certifications. Instead of obtaining numerous permits, entrepreneurs will simply need to declare (by submitting the proper documentation) to various federal agencies that they are conducting business and operating legally. This new procedure will apply to specific industries such as retail, food, hotel, transportation, consumer services.

Planned inspections by government agencies will be limited in occurrence to once every three years. Inspections of small businesses will additionally be limited to fifteen hours, and for medium-sized businesses – no more than seventy hours. The frequency of inspections is currently unregulated. Many businesses complain that inspections have nearly bankrupted them with the increased man-power and bribes they entail. Repeat inspections will only be allowed with a special approval by the Prosecutor General.

Product certification, which requires numerous signatures and often numerous bribes, is also set to be curtailed. Currently, Russia regulates nearly 85% of all products on the market. Europe, or comparison, regulates 15% of all products. The new legislation pledges to limit certification to only those products that could "harm life, health, or the environment" if not properly regulated.

Bureaucracy in Russia has always been legendary and with this recent reform push, there seems to have been a surge of human-interest articles with horrific stories of entrepreneurs forced to spend hours signing hundreds of documents a day, or the fact that it takes 250 different signatures from various officials and offices to open a restaurant in Moscow. While bureaucracy is a critical factor, with the growth and value of the markets, many businessmen still say that they almost guaranteed profits if they are well-funded and persistent.
 

Another issue, however, arises with financing. In early 2005, a survey by Opora Rossii of 4350 SMEs showed that financing ranked third in importance among their problems, after "administrative problems" and finding suitable real estate. In that same year, banks operating in Russia had approximately one billion dollars (or about a fifth of all bank financing available in Russia) offered in the form of microcredits – ranging from $300-$10,000. At the same time, market analysts estimated that the demand for such loans, however, was 5-7 billion dollars.

Finding the loan is not the only problem. Most banks in Russia consider such loans to be high-risk and charge interest of between 16-17%, about twice what many businesses in Europe and America pay. Banks defend this, saying that recovery is very difficult in case of bankruptcy and that collection agencies charge as much as 25% commission.

Sberbank is Russia's leader in business lending with about 34% of the market. KMB and Vneshtorgbank are in second and third place. Last year, banks in Russia for the first time announced that loans to SMEs were growing faster than corporate and retail loans. However, growth continues to be impeded by the lack of a system to back SME loans with government money, as is common in many other countries.

One final issue is piracy and trademark infringement. As a party to the Intellectual Property Rights Agreement, Russian authorities have promised to meet international standards. In the recent past, companies who have gone to court to protect their trademarks or products have generally won their cases. However, all businesses should receive full patents for their products from the Russia's official agency, Rospatent, and the company trademark should also be registered before entering the Russian market.

The SME Environment in China

In sharp contrast to Russia, China boasts strong performances from SMEs and programs to support their financing. As of 2005, SMEs accounted for over 55% of the GDP, as well as 60% of industrial output, 75% of new employment, and 75% of employment in urban areas. SMEs seeking to establish a presence in China could continue to expect a largely favorable environment, government support, and increased attention from foreign financial institutions. However, significant pitfalls remain, especially with regards to weak enforcement of intellectual property rights (IPR) laws.

The Chinese government is acutely aware of the importance of SMEs. Throughout the 90s, Chinese state owned enterprises (SOE) were significantly downsized and many were privatized, helping to make the enterprises and economy more efficient and profitable. However, by some estimates, more than 53 million jobs were lost in the public sector (mainly through lay-offs and early retirement) as a result.

These major job losses are a potential source of social instability and so China has made encouraging the growth of SMEs a priority - in order to absorb the excess former SOE workforce. The Chinese government has taken various measures to stimulate SME growth. They implemented a one-stop registration and approval process to streamline and accelerate company formation; established a special fund through which SMEs can obtain low interest loans, as well as loan repayment subsidies of up to 2 million yuan (over $290,000) for qualified businesses.

In addition to government support, SMEs can also expect assistance from foreign financiers. Recently, Citibank established a specialized department to service SMEs in China with loans, trade services, financial services, and cash management. Standard Charter Bank is also experimenting with small loans for SMEs in Shanghai and Shenzhen, providing loans of 500,000 yuan without mortgage for a maximum of two years. Chinese SMEs (like all SMEs everywhere) can also take advantage of the new “NYSE Arca,” which allows SMEs to be listed in a special category until they can satisfy all traditional listing rules.

However, while financing is more widely available in China, SMEs should be careful about where they borrow from. Corruption in China is still a major problem, and is negatively affecting China's financial system. There are ample stories of corrupt bank managers and employees pilfering millions fleeing abroad. Banks hold a total of $204 billion in bad loans. Many banks have been bailed out only with help of government assessment from China's sizable foreign exchange reserves. It is hard to imagine that SME using such a shaky financial system can adequately secure their funds.

Corruption is so widespread that the CPC leadership has openly labeled it as the top threat to the continued governance of the Communist Party. Bribery is common and adds risks and costs to doing business in China, even for SMEs, who find that bribes are needed to secure contracts and grow. Corruption among government functionaries, particularly those at low levels that deal directly with businesses, is also common.

Much like Russia, China has plenty of laws against such activities but inadequate enforcement to make them effective. Despite strengthening law enforcement, and a new "name and shame" policy begun in 2006, where companies convicted of corruption have their names placed on an online list, corruption will be a hindrance in the foreseeable future. In the opening address of 17th Party Congress, Hu Jintao himself labeled the fight against corruption as one of a “long term nature.”

Another significant problem for foreign SMEs seeking entry into the Chinese market is the lack of adequate protection for IPR. Despite repeated crackdowns, many companies hoping to enter the Chinese market may find that cheaper counterfeits of their products are already being produced and sold there. Larger multinationals can often afford the legal costs to combat the counterfeiters, but most SMEs cannot.

On a positive note, given the prevalence of the IPR violations in China, western SMEs with interests in China can often expect some assistance from their governments on this issue. The US Department of Commerce helped established the “SME China IPR Advisory Program,” which provides free consultations to American SMEs in an effort to help them develop IPR protection strategies, resolve IPR disputes, and receive education on IPR issues. The EU also established a similar agency, called the “China IPR SME Helpdesk."

Two Countries, Two Markets

While Russia attempts to diversify its economy and find ways to significantly raise the participation of SMEs, China has already got that process underway. 

The overall environment for SME growth and development in China remains positive. The Chinese government, recognizing the importance of SMEs in creating jobs, has actively supported their development through specific programs. Furthermore, financing for SMEs in China, while not perfect, is at least adequately supporting development.

Russia, with its decreasing population and over-dependence on resource extraction and export, has not supported SMEs as effectively. While its growing markets are themselves an incentive for SMEs to invest in Russia, the Russian government would do well to recognize the importance of this sector and pass specific legislation to streamline bureaucracy and create a more positive environment to lenders servicing SMEs, perhaps through loan guarantee programs. While IPR infringements and corruption are problems in both Russia and China, China has done more to assist this valuable sector, and has the successful SME market to show for it. Russia still has a long way to go before its numbers will match that of its southern neighbor.

Read More about Opening Businesses in Russia