Institutions and Entrepreneurship in Transition

1. Institutions and Entrepreneurship in Transition Saul Estrin, London School of Economics Slides for presentation at AISSEC conference, Perugia, June 2009 1

2. Outline • Entrepreneurship in a comparative perspective • Institutions and entrepreneurship • Institutions and entrepreneurship in transition economies • Institutions and Female Entrepreneurship • Entrepreneurship and the Credit Crunch 2

3. Entrepreneurship in a Comparative Perspective • New firm entry plays a critical role in a market economy: • Transfers resources in line with demand from industries with declining demand to industries with rising demand • Generates the variation in products and technologies from which market based selection of more profitable organisations can occur • In this way, generates innovation and the diffusion of new goods and production methods • Socialist planning systems suggest that innovation and “creative destruction” to raise productivity are hard to achieve in the absence of new firm entry and exit The “entrepreneur” is the individual agent who fulfils this function

4. Defining the Entrepreneur • We focus on individual entrepreneurs who • Perceive and create new market opportunities through innovative activity • Introduce their ideas in the face of uncertainty and other obstacles • Create viable business that contribute to the national economic growth and their own livelihood • Engage in this activity at the opportunity cost of pursuing other occupations

5. Significance of Entrepreneurship:Political and Social Factors • Political effects: freedom of entry and dispersion of economic power support political freedom • Entrepreneurship also has social effects: it may create the effective way out of poverty(De Soto; East Asia versus Latin America) • Social, political & economic effects may be related (outsiders-insiders; Acemoglu; Gerry & Mickiewicz; Buccellato & Mickiewicz) 5

6. Types of entrepreneurship / entry High aspiration Low aspiration Based on Estrin, Meyer, Bytchkova (2008) Genesis: push / necessity Appears in down cycle Goal: Survival / consumption Input: Labour Strategy: reactive, imitative Contracts: simple, informal Self-employment, own family Form: proprietorship Market: local Low tax or tax evading Genesis: pull / opportunity Appears in up cycle Goal: Accumulation Input: Combining resources Strategy: innovation, initiative Contracts: complex, formal Creates employment Form: incorporated, ltd liability Market: global Source of tax revenue 6

7. attitudes to entrepreneurship differ across nations: 7 Fear of failure is much higher in TE Source: GEM 2008

8. and some countries have more entrepreneurs than other... 8 Source: GEM 2007 There is less entrepreneurial entry in TE

9. Literature May 29th 2009 9 • General Institutional Theory – North (1990, 1997) • Role of entrepreneurs • Distinction between formal and informal institutions • Williamson (1987), Barzel (1997), Rodrik (2000), Acemoglu and Johnson (2005) • Property rights as backbone of market economy • restrictions e.g.. with respect to ownership rights, freedom of choice, mobility • Access to formal rights and role of informal sector (de Soto, 2001; Sonin, 2003; Estrin, Korosteleva, Mickiewicz, 2009) The role of formal institutions important for higher-value-added types of entrepreneurial activity

10. Institutions and Entrepreneurship May 29th 2009 • Baumol (1990) – the form of entrepreneurial activity depends on institutional context; weak institutions may increase net returns to non-productive or destructive entrepreneurship • Literature suggests three main institutions relevant for entrepreneurship: • Property rights (Harper, 2003; confirmed by Johnson et al, 2002, Aidis, Estrin, Mickiewicz, 2009, but not Dermigue-Kunt et al., 2006 nor Klapper et al., 2006) • State-sector (Baumol, 1990; de Soto, 1990; Verheul et al., 2001) • Financial sector (Gros and Steinherr, 2004), both formal and informal (Aidis, Estin, Mickiewicz, 2007; Korosteleva and Mickiewicz 2008)

11. Institutional Variables • In a variety of papers, we use two main measures of the institutional environment • Index of Economic Freedom (Heritage Foundation) – fifty independent variables grouped into ten sub-indices covering all aspects of the economic environment. Because of multicollinearity, we use an average of all then indices, the “economic freedom index”.

12. Institutional Variables 2 • Based on legal origin, La Porta et al. (1999) classify countries by legal environment. The categories are: English, French ,German, Scandinavian and Socialist (==Transition) To avoid low frequencies, we merge German and Scandinavian.

13. Individual level data • GEM is an ongoing multinational project created to investigate the entrepreneurship both within and across countries • Data is generated by surveys, which rely on stratified samples of at least 2,000 individuals per country • The dataset includes a number of individual social and economic characteristics and perceptions • The key advantage of the methodology relates to the fact, that the sample is drawn from the whole working age population

14. Individual level data • We utilise all 2001 – 2005 surveys. Countries include: • Belgium, Denmark, France, Germany, Hungary, Finland, Ireland, Israel, Italy, Latvia, Netherlands, Norway, Poland, Portugal, Russia, Slovenia, Spain, Sweden, United Kingdom, • Canada, United States, • Australia, New Zealand, • India, Japan, Korea, Singapore, • Argentina, Brazil, Mexico, • South Africa,

15. Example of Estimation Framework May 29th 2009 15 Ententryijt = f(Strength of Property Rightsjt, Level of Welfare Provision and Taxationjt, Availability of Formal Financejt, Availability of Informal Financejt, GDP/capitajt, GDP growth ratejt, Individual Level Controlsjit,) Alternatively use legal origin as institutional variable Estimated using probit, reported with robust standard errors and allowing for possibility that observations are not independent for each country–year sample Estimated for entrepreneurial entry, high aspiration entrepreneurial entry, opportunities entrepreneurial entry and the structure of individual financing High aspiration and opportunity start up jointly estimated with likelihood of start up (bivariate probit)

16. Results on Entrepreneurship and Institutions Institutional features that encourage new firm entrepreneurship are: • “Rule of Law” and “Size of State Sector” - Two factors derived from Heritage Foundation measures • Rule of Law impact sensitive to level of development- effect tails off for richest 10-20% countries • Formal finance is less important at early stages of development and becomes more important later on

17. Types of Entrepreneurship and Institutional barriers; Main Results It is not direct business regulations but low quality of “higher order” formal institutions which is the most critical barrier, especially for more sophisticated forms of entrepreneurship: (Estrin, Korosteleva, Mickiewicz, 2009) Quality of property rights system matters most for HIGH ASPIRATION ENTREPRENEURSHIP, and is less relevant for LOW ASPIRATION ENTREPRENEURSHIP Underdeveloped financial systemdoes not necessarily hinder LOW ASPIRATION ENTREPRENEURSHIP; informal finance may substitute for it. But HIGH ASPIRATION ENTREPRENEURSHIP relies on more developed formal financial sector 17

18. For high-powered entrepreneurship that generates growth and change, formal institutions matter more: complex forms of economic activity require complex contracts, and those in turn are conditional on formal rules (empirical results: Estrin, Korosteleva, Mickiewicz, 2009) 18

19. The formal institutions that matter are ‘higher order institutions’: rule of law / protection of property rights (Note that those dimensions are not captured well neither by World Bank “Doing Business” indicators of government regulation nor by EBRD indicators...) which consists of two key elements: constraints on the executive branch of the government independent and well-functioning judicial system, free from corruption 19

20. Entrepreneurship and Transition: The heritage from planning is poor: • Need to reallocate resources e.g. industry to services • Absence of business to business relations • Need to restructure state owned enterprises (SOEs), so new firms less able to play leading role in reallocation

21. Barriers to Entrepreneurship • Key Barriers • Financial • Institutional • Human capital and socio-cultural factors • Weak cultural recognition of value of entrepreneurship

22. Financial Barriers • Usual sources of start-up capital not available at start of transition • Personal wealth could not be accumulated under communism • Financial markets almost non-existent at start of transition • Banks inexperienced in private sector lending and lack of organizational capacity to finance entrepreneurs

23. Institutional Barriers • Immature legal and institutional system • Outdated or no-existent commercial code • Laws needed to define key concepts of market economy • Legal system inexperienced • Weak protection of private property rights, especially investor rights • Enforcement of contracts sometimes relies on informal networks or threat of physical force

24. How Much entrepreneurship is there in transition economies Aidis, Estrin and Mickiewicz (2008) find: • Entrepreneurial activity is lower in transition economies than countries with other legal origins (La Porta et al) • Entrepreneurial activity in transition economies is lower than in other economies at a comparable level of development • This holds even controlling for differences in individual characteristics e.g. Skill, age, gender • Entrepreneurship levels are even lower in Russia than in the group of former socialist economies

25. While some transition economies may be more entrepreneurial than the others, the comparison with the rest of the world reveals a different story... GEM 98-05 averages

26. Yet there are differences between the TE

27. 27 (adopted from Mickiewicz (2009)

28. To some extent informal institutions may substitute for formal institutions.For example: China and Russia are characterised by both weak formal property rights and by financial repression. Both factors should imply little use of external finance by entrepreneurs and constraints to entrepreneurship. However China scores much higher on social capital indicators than most of the ex-Soviet countries Accordingly, China is one of the two countries in Global Enterprise Monitor dataset (the other being Thailand) with the widest availability of informal finance (between 6-7% prevalence rate); and the value of informal capital in China has been estimated to vary between 2%-5% of GDP in the early 2000s. In contrast, availability of external informal finance in Russia is low (between 1-2% prevalence rate). Results for other ex-Soviet TE are not much better. Korosteleva and Mickiewicz (2008) 28

29. Significance of social capital (trust) for entrepreneurship “Sociability in ordinary civil affairs promotes a vigorous economic life as well, by schooling people in cooperation and self-organisation. People good at self-government are also likely to be good at combining for business purposes” (Fukuyama, 1995, p. 273) Level of trust is low in ex-Soviettransition economies. (Unlike China, the Soviet system left a heritage of highly individualistic, atomised societies (Fukuyama, 1995, p. 28). “Despotic governments broke asunder the civil associations that united the citizens, leaving them isolated and more genuinely individualistic”. (Fukuyama, 1995, p. 273) And informal institutions are persistent. Low social trust in TE is also reflected by low quality of government as represented by corruption. 29

30. Transition Economies did not follow one uniform development path • In some TE (eg. Russia, Ukraine), big players became entrenched while new entrants face obstacles to enter • Insider entrepreneurship: (Aidis, Estrin, Mickiewicz, 2008) • businesses more likely to be started by those already engaged in business activity, • entrepreneurs who closed down their businesses not likely to enter again, • characteristics such as age and gender play important role 30

31. Formal institutions, informal institutions and entrepreneurship interact in transition Weak ‘higher order institutions’ (lack of rule of law and weak property rights) created opportunities for entrepreneurial gains perceived as illegitimate in some TE as widespread corruption and weak property rights drove entrepreneurship towards unproductive activities Where economic gains were not perceived as legitimate, it created support for state intervention, re-nationalisation (amplifying anti-market attitudes inherited from the Soviet past) (Ireland et al., 2008) In turn, statist and anti-market policies led to entrenchment of strong incumbents (‘oligarchs’) that emerged from the early transition phase That results in low level of market-based and high aspiration- entrepreneurship, and low public support for entrepreneurship, which in turn makes the political-economic structure stable. 31

32. Low-entrepreneurship equilibrium supported by attitudes: an illustration Social attitudes towards entrepreneurship are important. At present Russian women rank entrepreneurs at the bottom of the list of men they would like to marry. 32

33. Female Entrepreneurship and Institutions • Current work; based on analysis of interactive terms between factors representing institutions and female gender • Wide variation in female entrepreneurship rates across countries • Results for males and females not the same

34. Figure 3 TE weak rule of law and weak female entry rates Chile – the opposite May 29th 2009 34

35. Figure 4 Small state & high female entry rates; Thailand, Peru; some rich English Legal Origin Countries The opposite: France, Sweden May 29th 2009 35

36. Figure 5 Developed Formal Finance & Relatively High female Entry Rate: United States The opposite:TE May 29th 2009 36

37. Figure 6 Informal Finance And Female Entry: Peru, Ecuador, Uganda The Opposite: Russia, Croatia... May 29th 2009 37

38. Summary of Results May 29th 2009 38 Controls confirm many findings in literature e.g.. probability of being an entrepreneur less in all countries for women, older people, less educated, less well networked Rule of law does not affect female entrepreneurship Female entrepreneurship is reduced by a large state sector. Holds for high aspiration and opportunity entrepreneurs No effect of formal finance on female entrepreneurship Informal finance is significant for female startup but not for high aspiration or opportunity female entrepreneurship Men more likely than women to rely on formal than informal finance

39. Entrepreneurship and the Credit Crunch • Entrepreneurship may be “recession pull” because opportunity cost of being an entrepreneur lower in a recession –necessity? • Alternatively, may be “prosperity pull” because of larger gains to e’ship in a boom – opportunity? • In our work, forces tend to offset or displays recession pull.

40. Conclusions The links between entrepreneurship, economic performance, formal institutions and informal institutions are complex. The place to start is the judicial system. Yet eliminating judicial corruption is not easy; it requires changing both formal rules and informal culture. In many TEs, corruption is still widespread and entrepreneurship is weak. Yet, as they are reaching the mature post-transition stage, weak entrepreneurship will affect economic performance more. 40

41. Key References • R. Aidis, S. Estrin, T. Mickiewicz (2007a), “Entrepreneurship, Institutions and the Level of Development”, Tiger Working Paper No 103. • R. Aidis, S. Estrin, T. Mickiewicz (2007b), “Entrepreneurship in Emerging Markets: Which Institutions Matter?”, CSESCE Working Paper No 81. • R. Aidis, S. Estrin, T. Mickiewicz (2008), “Institutions and Entrepreneurship Development in Russia: A Comparative Perspective”, Journal of Business Venturing, 23, 653-672. • S. Estrin, K. Meyer, M. Bytchkova (2008), “Entrepreneurship in Transition Economies”, in M. Casson et al. Oxford Handbook of Entrepreneurship(Oxford: Oxford University Press). • S. Estrin, J. Korosteleva, T. Mickiewicz (2009), “High-Growth Aspiration Entrepreneurship”, mimeo. • S. Estrin and T. Mickiewicz (2008), “Do Institutions have a Greater Effect on Female Entrepreneurs?”, World Bank 2009