Russian Federation and the IMF
Competition and Business Entry in Russia
Harry G. Broadman
Despite privatization, robust competition is still lacking in much of Russia's industrial sector, stifled by excessive concentration, vertical integration, and geographic segmentation. Many established firms enjoy protection from new (and potential) rivals. Reforming anticompetitive business structures and lowering barriers to entry are key to Russia's post-privatization reform program.
Since the start of reforms in 1992, significant progress has been made in many areas of the Russian economy. Price controls have been lifted on more than 90 percent of wholesale and retail goods, and most state-owned enterprises have been privatized, to varying degrees. But Russia has not yet restructured the dominant firms in its industrial sector (although some restructuring has taken place—especially in the import-substitution sector—since the devaluation of the ruble in 1998). Nor has it eliminated administrative barriers that hinder new domestic and foreign firms from entering the Russian market. Indeed, the scarcity of de novo private firms in Russia is particularly striking in comparison with other transition economies.
There remains considerable potential for abuse of market power, not only in Russia's infrastructure monopoly ("utility") sector (this potential is widely acknowledged, and the government's structural reform agenda includes policy initiatives designed to reduce it) but also in the manufacturing ("nonutility") sector. Many manufacturing firms are shielded from competition because of structural and institutional impediments, including significant seller and buyer concentration—"horizontal dominance"—in regional markets, a high degree of vertical integration and exclusive buyer-seller relationships in certain industrial sectors, geographic segmentation, interregional barriers to trade and investment, and policies that make entry difficult for new firms. These impediments are more pronounced in Russia than in other transition economies. Although the ownership of many enterprises has changed hands thanks to privatization, the industrial configuration established by administrative fiat and central planning during the Soviet era is still largely entrenched, and a new industrial sector in which competitive market forces determine corporate behavior has yet to emerge fully.
Excessive horizontal and vertical consolidation and high entry barriers in Russia's industrial sector have negative consequences for the Russian consumer, for rechanneling enterprise assets to more productive uses, and for the development of the Russian economy: (1) high prices, reduced output, and diminished product and service quality; (2) diminished incentives for transactions between regions, which hampers the development of a unified economic space; (3) reduced foreign investment in business; and (4) the stifling of innovation and technological advancement.
At the national level, the degree of concentration of industrial output in Russia does not indicate that the lack of competition is a structural problem. The four-firm concentration ratio—that is, the sum of the market shares of the top four producers—in many industries averages about 60 percent, which is similar to that in the United States, and the largest Russian manufacturing enterprises (measured by number of employees) are not unusually large, compared with U.S. firms. However, this aggregate-level analysis of structural dominance masks three underlying attributes of Russia's industrial landscape.
First, large Russian enterprises tend to be configured as single, integrated, multiplant establishments often located in or near the same city, whereas enterprises in industrial countries usually have multiple establishments at several different locations domestically and, often, abroad as well. Thus, the establishments of the largest Russian enterprises are, on average, significantly larger (in terms of number of employees) than their counterparts in other countries, including the United States. Because of the limits of conventional measures of national market share and concentration, the true extent of horizontal dominance in many Russian markets is probably understated. Data on a variety of Russian sectors suggest that, at the oblast (regional) level, the average market share for a typical firm is about 45 percent and the average four-firm concentration ratio is greater than 95 percent. Although the existing level of horizontal integration in Russian manufacturing is largely a legacy of Soviet central planning, such integration appears to be increasing. The increase is due not to new corporate expansion, however, but to mergers and acquisitions.
Second, many of the dominant enterprises in Russia are also highly vertically integrated (or have exclusive buyer-seller relationships). Forty-six percent of the firms participating in a recent survey indicated that their customers purchased supplies from only one or two suppliers and that 23 percent of the suppliers controlled more than 65 percent of the relevant input market. To be sure, putting successive stages of production under one corporate roof can result in economies of scale and reduce transaction costs, as in the case of continuous steel-casting: it would be economically inefficient—if not technologically impossible—to have three separate firms heating iron ore, rolling it into ingots, and then producing the finished steel products. But in most industries, such vertical efficiencies exist only up to a point. Indeed, in many product markets throughout the world, it is increasingly cheaper for a firm to buy inputs (or sell outputs) on the open market or through arm's-length contracts than to produce them internally. In Russia, because the enforceability of contracts still cannot be taken for granted, there are strong incentives for vertical integration. The uncertainties and chronic shortages of the old Soviet supply system encouraged a high degree of vertical integration, which has persisted, in part, because of inertia. Moreover, vertical integration, like horizontal dominance, is increasing—again, usually through mergers and acquisitions rather than expansion. Importantly, excessive vertical integration superimposed on horizontally concentrated product markets can foreclose the entry of rival firms.
Third, significant political and economic power is wielded by regional authorities in Russia, a feature of other large transition economies, such as China. This is evident in the tight control of important economic activities within a region. Such control, in combination with vertical integration, helps freeze the high degree of structural autarky engendered under the Soviet system, when producing consumer goods was a local responsibility and enterprises served only local markets. Worse, it strengthens administrative—as opposed to economic—geographic market boundaries and fosters the regional segmentation of the Russian economy, hampering the establishment of a unified economic space, vigorous interregional competition, and natural economies of scale. Local authorities engage in a variety of practices to limit the interregional movement of goods and services, including charging duties on the "import" or "export" of certain alcoholic beverages; maintaining regional price controls on some agricultural products; imposing registration fees on workers from other oblasts; granting tax or credit preferences to support the building of local "business champions"; and supporting arbitrarily exclusive licensing. In this regard, it is telling that in recent years some of the most frequent violations dealt with by the Ministry of Antimonopoly Policy and Support for Entrepreneurship have been anticompetitive actions by local governments.
Barriers to new entrants
According to official estimates, in 2000 more than 70 percent of Russia's GDP came from the private sector, up from less than 10 percent just eight years earlier, at the start of reform. This is a remarkable achievement. But the expansion of Russia's private sector is due mainly to privatization of state-owned enterprises, not creation of new enterprises.
Most new entrants in Russia are owner-manager firms—mainly small and medium-sized enterprises. There are about one million registered small and medium-sized enterprises (generally defined as business establishments with fewer than 250 employees); they employ about 13 percent of the Russian labor force and produce about 12 percent of GDP. These figures, however, are likely to be inaccurate, because much small business activity is still in the informal economy and thus goes largely unreported. Nonetheless, in comparison with other transition countries, the growth of small and medium-sized enterprises in Russia has been exceptionally slow: the percentage of national employment accounted for by small and medium-sized enterprises is 37 percent in the Czech Republic, 58 percent in Georgia, and 37 percent in the former Yugoslav Republic of Macedonia. Importantly, the geographic distribution of small and medium-sized enterprises in Russia is highly skewed. Whereas Moscow and St. Petersburg account for 22 percent and 10 percent, respectively, of all small and medium-sized enterprises, 28 other regions account for only about 0.5 percent of the total each.
Evidence suggests that in many sectors, the principal constraints on entry by new private firms in Russia are the anticompetitive market structure and the anticompetitive conduct of existing dominant firms, which is often sanctioned or supported by local governments. In effect, incumbents do not leave enough structural economic space for new entrants to make a go of it.
Moreover, impediments to entry include the lack of competition in and poor quality of (state-owned or controlled) infrastructure services, as well as blocked access to warehousing and distribution channels; weak mechanisms for resolving commercial disputes; the lack of access to seed capital and competitively priced credit; the difficulty of obtaining suitable business premises and real estate; the absence of rules-based procedures for, and the complexity of, business licensing, registration, and inspections; and corruption and organized crime.
In the key infrastructure services—electricity, heating, natural gas supply and transmission, and rail transport—state-dominated monopolies still play a major role. In purchasing infrastructure inputs—if service hookups can even be arranged—manufacturing firms (particularly new, smaller ones) have little choice: there is usually only one supplier; pricing is not cost-based; and the quality of service is often poor. On the output side, manufacturing firms must deal with underdeveloped distribution or warehousing facilities outside the major Russian cities. The lack of refrigeration facilities is a particularly serious problem, making shipment of perishable products across regions extremely expensive. Many intercity roads are in poor condition, making long-haul trucking hazardous.
In Russia (as in most other transition economies), contracts are hard to verify and enforce. Private property rights are not secure and lack credibility. The lack of efficient methods for resolving commercial disputes substantially increases the cost of entry. Most businesspeople in Russia attempt to resolve differences among themselves rather than take cases to the overburdened courts. And if a company does go to court, enforcement of compensation for successful plaintiffs collecting debts is notoriously weak.
Persuading financial institutions to back start-up businesses can be challenging even in industrial countries; in transition economies, where capital market imperfections are pronounced and institutions that intermediate savings into investment capital are typically not yet fully developed, the problem is particularly acute. In Russia, bank loans for new businesses—if they are available at all—are short term (typically six months) and expensive. As a result, most start-ups of small and medium-sized enterprises are funded out of personal savings. According to the State Committee on Small Businesses, only 15 percent of small businesses in Russia have received bank credits in recent years.
Access to commercial real estate in Russia is often limited because of municipal administrations' monopoly ownership and control of urban land. In theory, enterprises have the right to privatize associated land plots; in practice, property rights and procedures are unclear. Less than 10 percent of the land under privatized enterprises has been privatized.
The average new business applicant in Russia must deal with a multitude of agencies at both the federal and the local levels and obtain approval of myriad registration and licensing forms. But new firms rarely consider these administrative barriers, however time consuming, to be the most problematic aspects of registering and licensing, conventional wisdom to the contrary. Indeed, firms that specialize in helping new businesses navigate the process have become a new growth industry. Far more onerous—although it has received much less attention—is the lack of uniformity in procedures and fees across regions, and the scope for discretionary conduct by licensing, registration, and inspection officials. In business surveys, it is typical to find that about one-third of questioned firms indicate they are forced to obtain a license that, in their opinion, was not legally required, and more than 10 percent indicate that they pay licensing and registration fees over the legal limit. It is therefore not surprising that the licensing and registration process is fertile ground for corruption. A not atypical anecdote has an entrepreneur paying the equivalent of $7,000 for a license, of which only $800 goes to the government.
Corruption as a barrier to business entry in Russia—as in many other transition economies—is pervasive: virtually all firms pay bribes to tax inspectors, customs officers, and a host of local bureaucrats who visit firms several times a year. The result is that, often, firms must increase staffing simply to deal with inspectors—a nonproductive activity. In addition, most enterprises have to pay organized criminal groups to survive; these groups' levies commonly start at 5 percent of profits but are often higher and are usually collected as flat monthly fees.
Agenda for reform of competition policy
As Russia's fiscal stance improves (in part because of higher oil prices) and budget constraints harden economy-wide—that is, as firms and government agencies engage in cash transactions, bills are paid on time, and subsidies (including direct budgetary support and indirect subsidies such as tax arrears that are not penalized) are eliminated—inefficient large enterprises will likely continue to decline in importance. But proactive structural reforms are needed to foster enduring competition.
One set of competition policies should focus on reforming anticompetitive incumbent enterprises. The thrust of these policies should include more effective demonopolization and disintegration of anticompetitive dominant firms; prohibition of mergers and acquisitions that reduce the number of sellers and increase structural dominance; penalties for business practices—such as collusion, price fixing, and predatory pricing—designed to drive out competitors or deter entrants; and protection of consumers from unfair trade and false advertising practices. In the advanced countries, implementation of such policies is challenging and the track record is mixed. In transition economies as complex as Russia, their implementation is even more difficult because of protests from vested interests, and the significant political economy costs entailed by large restructurings mean they will take time. That does not make them any less necessary, however.
The other main prong of competition-enhancing reforms—measures to reduce barriers to entry—can be undertaken in the shorter run and should be implemented in parallel with policies dealing with incumbent firms. Even when existing firms have attained structural dominance, entry (indeed, just allowing for the credible threat of entry) can instill contestability and competitive performance, especially in markets where sunk costs are relatively small, thereby making exit easier should demand soften. Job creation by new firms will make it easier to restructure inefficient incumbent firms and lay off redundant workers. Greater openness to imports and foreign direct investment are also critical ingredients in engendering competition through the entry of new firms.
Russia's competition statutes are based on those in the industrial countries, including the European Union countries and the United States, and they are, for the most part, sound. The problem is implementation. The Ministry of Antimonopoly Policy and Support for Entrepreneurship is headed by a reformer, but the agency's budget has been drastically cut over the years, forcing it to retrench its regional branches, and skilled employees have been difficult to attract and retain. Competition policies in Russia, as in other transition economies, have focused on deterring anticompetitive conduct by incumbents rather than on correcting underlying imperfections in market structure, and steps to encourage entry have concentrated on providing financial support for small and medium-sized enterprises rather than on removing regulatory and institutional barriers and improving the overall business environment.
Competition policy toward incumbents. A more robust enforcement regime is needed in Russia to redress the substantial market imperfections that give incumbents a competitive advantage and to make their markets contestable. Countries that have made progress in this area emphasize dismantling excessive horizontal and vertical dominance; preventing anticompetitive mergers by implementing clearly defined and widely publicized merger guidelines that set parameters for distinguishing between procompetitive and anticompetitive mergers; establishing credible and sizable penalties for collusion and price fixing (cartels in the United States are subject to criminal sanctions); and ensuring that there is a strong, rules-based competition policy agency with political teeth and effective implementation capacity.
Competition policy toward entrants. In reducing barriers to entry, the priority is to deal first with markets where there is already significant structural dominance; other markets can be dealt with subsequently. Proactive policies to facilitate entry should concentrate on reforming infrastructure and distribution services; strengthening the judiciary and associated institutions for more efficient adjudication and enforcement of commercial disputes; enacting broad-based land reform; instituting uniform, rules-based procedures for licensing, registration, and inspections; and fighting corruption and organized crime.
Providing targeted support to small and medium-sized enterprises through government-subsidized lines of credit is likely to be counterproductive. Such support would undermine market-based reforms of the banking sector and nascent commercial intermediation by Russian banks. Worse, particularly in the context of weak property rights, it breeds corruption. Policies that could be helpful in this regard include strengthening the legal framework for venture capital and investment funds, supporting local banks that provide credit to small and medium-sized enterprises on commercial terms, and facilitating private cofinancing of projects by small and medium-sized enterprises and local banks.
Lowering entry barriers must focus not only on creating favorable conditions for potential rivals within a local market but also on enabling competitors based in other oblasts to sell or invest in the local market. This is critical to redressing Russia's regional market segmentation. It means that the federal government must have stronger enforcement authority to deal with the anticompetitive practices of local governments.
This article draws on Harry Broadman (ed.), 1999, Russian Enterprise Reform: Policies to Further the Transition (Washington: World Bank).