Small Business Vanishes

Ovanes Oganisian, Analyst / Renaissance Capital

There are all kinds of small business owners in Russia. Some of them operate clubs and restaurants, some run Western-style advertisement, IT or legal consulting businesses, some are fixing teeth or noses, some are building homes, some repair cars, some grow tomatoes and wheat and many operate retail shops selling food, clothing, cars, antiques, or detergent. Some even sell bizarre things on local commuter trains.

In addition, they are working like galley slaves for their clients and are subject to myriad legal obstacles outlined in various codes, laws, instructions and standards. Very frequently, the day-to-day life of a small business operator in Russia includes negotiating with bureaucrats, police, customs officials, gangsters, firemen and tax inspectors.

The risk with small business in Russia sometimes is over the limit. The shipment of goods can be arrested in customs at anytime. Police can come and arrest your Tajik workers. The electricity to your building can be cut off. The sanitary authorities or fire marshal find an obscure reason to shut you off for a month. The favorable rent contract with local administration can get taken away. The mafia can steal your business or the prosecutor’s office can shut it down for good.

With these kinds of draconian business conditions, in addition to very little bank support and looming corruption problems, small businesses are also under pressure to compete with larger and growing domestic competitors and established multinational business opening up in Russia.

Though after a few years of struggling, Russian small business can generate up to a 40 percent return on equity, it is still hard to compete with Gazprom or Uralkali, who post 60 percent EBITDA margins. Russia is a small business laggard because its workforce has very low productivity and opportunity is stifled by the bureaucracy. It is much more profitable to make existing an Soviet enterprise more efficient then to start a small business.

In the United States, the government supports privately owned businesses by making sure 27 percent of the federal budget is allocated with small firms. The Russian government does no such thing. The large share of small business in developed economies provide enough fuel for continued renovation of business bringing out new ideas. In the U.S. and other developed countries, the government makes sure that entire sectors of the economy — such as the Internet, telecoms, construction and agriculture — become available for small businesses.

In the U.S., small business is flush with financing. It is a source of constant renovation for the economy, providing new ideas and energy. Ninety-nine percent of enterprises in the U.S. employ 500 people or less, while 52 percent of all workers are employed at a small business. In Russia 40 percent of people are employed in the top 30 largest companies, most of which are owned by the state. Another 30 percent work in the budget sphere as teachers, doctors, etc.

Around 1994, under Yeltsin’s economic policy, small business was flushed with credit and flourished, though not all the money that was thrown at small business did stick.  This is how Victor Pelevin described in his “Generation P” : Businessmen would go to the bank to get credit. On the way back from the bank, they bought a fax machine and a case of vodka. They would also meet with copywriters and order them to design a logo and a motto for their new firm. Three days later, they were found shot dead, near a dozen empty bottles of Vodka, with all the credit money stolen by the mafia.

But Yeltsin’s policy had an effect. We estimate that back in 1997, small- and medium-sized business equaled roughly 40 percent of GDP. That number fell to just 5 percent in 2008 — this despite the economy growing by almost 6 times since 1998 due to rising oil prices. We estimate that the nominal contribution  of small business in the Russian is $120 billion in 2009 — roughly what it was in 1997.

The biggest advantage of small business is that it provides a means of diversifying the economy. In spite of this, small businesses — which often did not pay taxes — was not able to save the Russian economy from collapsing when the oil price fell to $12 in 1998. In an act of desperation, former finance minister Boris Fyodorov ran around the Cherkizovsky market, trying to physically collect taxes in the weeks that preceded the default. He did not succeed. The state purse was left empty and the ruble fell victim to dropping oil prices, taking its share of small businessmen with it.

Another reason why small business is good is that small business invests in Russia, whereas large business invests in places where EV/EBITDA is smaller. Look at the Russian steel sector: in the last 5 years they all doubled their capacities, but almost none of the capacity was built in Russia, all of it was acquired in other countries. However owners of Yevroset, Rostik’s, or Kroshka Kartoshka kept opening their outlets in town after town on the banks of the Volga River and in other place throughout the country.

Small businesses sometimes fail, sometimes stay small, but frequently have a chance to become big businesses. Examples include M.Video, Technosila, Eldorado, Dixy, Yandex, RBC, Rambler, Yevroset, and Rostik’s, all of whom were once small but grew larger with time. 

However, small business will not help Russia with its strategic ambitions. Russia cannot afford having 50 percent of its workforce involved in some not very serious activity which transforms Russian cities into Arab-type Medinas. Small business owners are not able to connect Yamal and Europe with a pipeline, they cannot build a highway from Moscow to St. Petersburg, they cannot produce any significant amounts of oil in eastern Siberia. They are not able to produce rockets or turbines or any of the ambitious Russian projects that can easily be achieved in Gulag-type of working conditions or by semi-jailed engineers.

In Russia, the government places a priority on making inherited Soviet-type businesses more efficient. The government spends years solving problems of how to make AvtoVAZ or Russian aircraft producers or the Russian military complex more productive. The easiest solution the government usually finds is either consolidation or protectionism. Though Russia has a flat tax of 13 percent, indirect taxation is enormous. Due to high customs tariffs, Russians overpay by anywhere from 20-100 percent for most goods, whether they are imported or locally produced. Given that Russian consumption is at average 70 percent of monthly total income, Russians are indirectly taxed an additional 20-40 percent, making the actual overall tax rate 25-38 percent — far from a 13 percent flat tax. 

The government might also dislike small business owners because they are more independent, less easily fooled and less inclined to believe government rhetoric. At large state-owned firms will need little convincing in order to support government policies.

Small businesses are frequently criticized because they employ such a high number of ethnic non-Russians, a fact that xenophobes say drives deprives Russian citizens of jobs and brings various diseases into the country.

When the crisis hit, Russian leaders, realizing how depressed small business was, rushed to make promises to help and develop the sector into a force able to resist the crisis. Since then they closed down all Moscow casinos, shut down Cherkizovsky — the biggest retail market in Europe — haunted the country’s largest small business owner, Yevgeny Chichvarkin, and virtually bankrupted a firm called Arbat Prestige. Clearly closing casinos in Moscow is a noble cause, and so is shutting down a customs tax evasion scheme in Cherkizovsky that was a source of corruption for the whole Moscow district. But no one would thought of offering any substitute to save businesses and jobs.

Some professions easily yield small businessman. Doctors, dentists, pharmacists, lawyers, and tax consultants, for example. Most of the time, the skills required to run a small business are very demanding, but the government doesn’t think of any comprehensive program to develop them. Without those skills it is only possible to be a robot in Sberbank or Gazprom.

One of the symbols of the ’90s is a very independent, patriotic young guy, slightly overweight, bizarrely dressed and the owner of a restaurant or electronics boutique, or perhaps an importer or shop owner. This character was a locomotive force behind the Russian economy of that time. A few more Pikalyovos, and he just may reappear.