The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment

Armeanu, Dan; Istudor, Nicolae; Lache, Leonard Article The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment Amfiteatru Economic Journal Provided in Cooperation with: The Bucharest University of Economic Studies Suggested Citation: Armeanu, Dan; Istudor, Nicolae; Lache, Leonard (2015) : The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment, Amfiteatru Economic Journal, ISSN 2247-9104, The Bucharest University of Economic Studies, Bucharest, Vol. 17, Iss. 38, pp. 195-211 This Version is available at: https://hdl.handle.net/10419/168911 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Fostering Entrepreneurship in a Changing Business Environment AE Vol. 17 • No. 38 • February 2015 195 THE ROLE OF SMEs IN ASSESSING THE CONTRIBUTION OF ENTREPRENEURSHIP TO GDP IN THE ROMANIAN BUSINESS ENVIRONMENT Dan Armeanu1, Nicolae Istudor2 and Leonard Lache3 1)2)3)Bucharest University of Economic Studies, Romania Please cite this article as: Armeanu, D., Istudor, N. and Lache, L., 2015. The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment. Amfiteatru Economic, 17(38), pp. 195-211 Abstract Given the negative effects of the economic crisis on the Romanian economy, entrepreneurship represents one of the main pillars of economic recovery and the authorities need to act in support of private entrepreneurship initiative. Even though entrepreneurship does not equate to the small and medium-sized enterprises, there is strong support in literature regarding the importance of SMEs in national economies due to the authorities' potential of intervention and their contribution to gross value added. The fluctuating evolution of the Romanian business environment has led to a high volatility of its contribution to GDP, which is especially true in the case of SMEs due to their lack of technology and capital and difficult access to financing, as well as limited know-how compared to the large companies that control the Romanian market. Successful entrepreneurial initiative leads to sustainable businesses and ensures a smooth transition from business ideas to the creation of value added, thus supporting economic growth and the narrowing of macroeconomic gaps which have been generated during the economic recession. As a distinctive and dynamic component of Romanian entrepreneurship, the SME segment has a significant contribution to GDP. This study aims at assessing the contribution of entrepreneurship, through its SME segment, to Romania's GDP in the main economic sectors and, at the same time, the estimation of output gap at sectoral level, thus filling a gap in entrepreneurship-related domestic literature. Keywords: entrepreneurship, business environment, small and medium-sized enterprises, real GDP, potential GDP, output gap, production function JEL Classification: L26  Corresponding author, Dan Armeanu –– [email protected] AE The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment Amfiteatru Economic 196 Introduction Entrepreneurship initiative represents a cornerstone of market economy and its support by public authorities is a fundamental prerequisite of long-term economic welfare. Such supportive measures are ever more important in the context of an economy in transition to a fully-fledged market-based system. This is the case of Romania, where the slow and unconvincing progress has been a chief result of the lack of a stable, attractive and competitive business environment. Public policy has obviously lacked a structured and coherent approach to sustaining the local entrepreneurship environment, which in turn has affected subsequent economic growth. Since multinational corporations dominate the Romanian economic landscape, with limited potential for stimulative public intervention (i.e., tax benefits), significant attention must be paid to the small and medium-sized enterprise sector. In many economic sectors, SMEs are the main job creators, as well as the main contributors to GDP. Authorities have an array of tools available to support SMEs, such as tax and administrative facilities, counselling and assistance in EU funds absorption, support towards human capital development etc. The connection between entrepreneurship and SMEs in the Romanian business environment is well documented in literature – see, among others, Lafuente and Driga (2008, 2009), Lafuente and Rabetino (2007), Marchiş (2011) and Ciucan-Rusu and Szabo (2013). The authors demonstrate that entrepreneurial initiative in the Romanian economy has been relatively weak at creating value added and at orientation towards the customer and that deficiencies in human resources, financing and the institutional framework have not allowed SMEs to fully unlock their growth potential, thus limiting their contribution to GDP. The specificity of the institutional framework, the lack of management culture and entrepreneurial education*, as well as the inherent shortcomings of the local business environment (difficult access to financing for smaller companies, the high number of bankruptcies and the lack of fiscal transparency) have far outweighed the traditional advantages of SMEs – the potential to generate value added, the adaptability to ever changing markets, the rapid adoption of new technology and ability to produce managerial innovation. All of these aspects have obviously affected the contribution of SMEs to GDP. Given that domestic literature on the topic of entrepreneurship (and its SME sub-segment) is mainly focused on descriptive analysis and its qualitative dimension†, the objective of this study is to assess the capacity of entrepreneurship and SMEs to innovate and to generate value added. The proposed approach shall be based on the Cobb-Douglas production function with constant returns to scale and statistical filtering techniques and it shall estimate all of the model's inputs (capital, labour and labour elasticity of output) by specific techniques, using statistical data available for the Romanian economy over the 2000-2013 period. The model shall also be used to evaluate the output gap of the SME segment, as well as to determine the contribution of labour, capital and total factor productivity to economic growth in Romania's top six value added-generating sectors. The paper is structured as follows: the ensuing section is dedicated to a review of the main results of entrepreneurship- and SME-related literature, both in Romania and internationally. Next, the research methodology shall be described – the production function model, estimating input variables, applying the model and assessing its suitability given the peculiarities of the Romanian economy. The two following sections shall discuss model results and draw the necessary conclusions. * See Lafuente and Rabetino (2007). † See Lafuente and Driga (2007, 2009). Fostering Entrepreneurship in a Changing Business Environment AE Vol. 17 • No. 38 • February 2015 197 Review of the scientific literature Small and medium-sized enterprises, and more generally entrepreneurship, are widely considered to be a fundamental engine of economic development at global level. However, due to the institutional and market inefficiencies they face, public intervention is necessary in order to sustain growth in the SME sector (Pîslaru and Modreanu, 2012). According to The World Bank (1994, 2002, 2004) and Beck and Demirgüç-Kunt (2004), pro-SME policies are based on three main pillars: first and foremost, stimulating competition and entrepreneurship and thus promoting economic efficiency, innovation and the effective use of resources. Secondly, SMEs are widely believed to have the best potential of job creation, as large corporations are comparatively less reliant on labour. Thirdly, some authors (see, for instance, Ardic, Mylenko and Saltane, 2011; Cressy and Tovainen, 2001; Dietrich, 2010) consider SMEs to be more productive than large firms; however, their progress is slowed down by limited access to financing and several institutional barriers. As pointed out by Beck and Demirgüç-Kunt (2004, 2006), in spite of the growing interest towards fostering SME development at international level that has resulted in several multibillion dollar financial assistance programmes provided by The World Bank and EBRD, among others, pro-SME policies are subject to heavy criticism by authors who argue their efficiency. Some studies (Pagano and Schivardi, 2001) argue that large corporations enjoy significant competitive advantage that enables them to benefit from important scale economies, which in turn allows them to make significant investment in R&D that ultimately leads to increased productivity, as well as an improved ability to respond to the challenges of a continuously evolving international business environment (Maksimovic and Phillips, 2002). Other studies (Haltiwanger, Jarmin and Miranda, 2010) indicate that, in the medium term, SMEs are neither better job creators than large companies, nor are they more reliant on labor than large corporations. An interesting view is that of Ayyagari, Demirgüç-Kunt and Maksimovic (2011) and Beck and Demirgüç-Kunt (2006), who question the relationship between firm size and firm contribution to economic growth. As it turns out, this relationship is heavily influenced by factors as natural resource endowment, the direction and efficiency of economic policy, the degree of openness exhibited by the economy, the competitiveness of domestic products in international markets etc.. For example, economies that are relying on the export of products that incorporate substantial value added favour large corporations, as opposed to less open economies, and pro-SME policies can generate distortions at microeconomic level (Beck and Demirgüç-Kunt, 2004). However, it is worth noting that many studies question the higher presumed efficiency and productivity of SMEs compared to large corporations, as well as the contribution of SMEs to economic growth. As discussed in Beck and Demirgüç-Kunt (2004), this requires significant effort towards a business environment with few barriers to entry and exit, an efficient institutional framework and a transparent and predictable legal system and public policy that fosters private economic initiative and stimulates competition. The issues of SME efficiency and SME contribution to economic growth are ever more complicated in the case of emerging economies, where the lack of appropriate management culture, bureaucracy and institutional deficiencies discourage both entrepreneurial initiative and the internationalization of SMEs, thus directly affecting their development (Volchek, 2013). Regarding entrepreneurship in Romania, Ciucan-Rusu and Szabo (2013) identify an additional issue of the business environment and SMEs: the translation of already performed activities in the public sector into the SME segment, thus leading to a AE The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment Amfiteatru Economic 198 "nomenclature business" type of entrepreneurship, dominated by a large number of businesses with only one employee and with zero ability to innovate and create value for the client. The same study underlines the weak involvement of education in acknowledging the importance of entrepreneurship and entrepreneurial culture, idea backed by Lafuente and Rabetino (2007). Other studies (Lafuente and Driga, 2007; 2009, Marchiş, 2011, Pîslaru and Modreanu, 2012) contain descriptive analyses of entrepreneurship and SMEs and statistical information pertaining to SMEs, without attempting a quantitative assessment of the contribution of SMEs to GDP or a modelling of the sectoral output of SMEs and the related output gap. Such an endeavour is necessary as it permits correlations and simultaneous interpretations with similar analysis performed by the National Bank of Romanian and the European Commission at a macro level, thus providing policy makers with a valuable instrument. Research methodology The output model based on the Cobb-Douglas production function assumes the following equation of output:    1 K LA Y (1), where Y is potential GDP, L is potential labour input (the level of full employment), K is the potential capital stock, when labour input is at its potential level and α is the output elasticity of labour. As discussed in Konuki (2008), if salaries reflect the marginal productivity of labour, α shall be equal to the ratio of total labour earnings to gross domestic product. A formal derivation of this parameter in the particular case of the Romanian economy is discussed in the following sections. Estimating potential GDP on the basis of a production function approach involves the identification of potential levels of labour and capital, total factor productivity and the output elasticity of labour, α. The main advantage of this methodology is that it is backed by economic theory, while at the same time providing useful information about the drivers of equilibrium output, which is out of reach for purely statistical methods. However, as highlighted in Denis, Grenouilleau, McMorrow and Roger (2006), the robustness and the reliability of this approach is only as good as its inputs. As we shall see shortly, estimating potential levels of labour and capital poses a significant challenge in the case of volatile economies. In order to assess the labour trend, the following equation shall be used:   TNAIRUNL  1  (2), where L is the equilibrium level of labour (used for purposes of estimating potential GDP), N is active population (15-64 years old),  is the trend labour participation rate and the equilibrium unemployment rate (NAIRU) shall be determined based on the following equation (Ut is the actual unemployment rate): C ttt UNAIRUU  (3), in which C t U is cyclical unemployment (driven by the current state of the economy). T is the trend average number of hours worked weekly in the economy. Fostering Entrepreneurship in a Changing Business Environment AE Vol. 17 • No. 38 • February 2015 199 As regards the estimation of the parameters, some clarification needs to be made. For purposes of estimating NAIRU, two approaches can be used: on the one hand, dynamic models that explicitly incorporate macroeconomic drivers of NAIRU (such as inflation; see Altăr, Necula and Bobeică, 2010, Kuttner, 1994 and Denis, Grenouilleau, McMorrow and Roger, 2006 for a thorough discussion); on the other hand, statistical techniques for trend extraction can be used, the most popular being the Hodrick-Prescott and Kalman filters. In this paper we shall use the approach proposed by Ozbek and Ozlale (2005), with NAIRU being modelled using a random walk with drift model: NAIRU tttt zAIRUNNAIRU   1 (4), where the drift zt itself follows a random walk process: Estimating the cyclical component of unemployment poses some methodological challenges, as discussed in Altăr, Necula and Bobeică (2010). Due to the frequent structural breaks in time series pertaining to the Romanian economy and the resulting high volatility of macroeconomic variables and high sensitivity to phases of the economic cycle, we find that a legitimate choice for the cyclical component of unemployment is a AR(2) model with time-varying coefficients: C U t C tt C tt C tUUU    2211 (5), with the associated stationarity condition 1 21   tt   . Based on these equations of movement, we quarterly NAIRU shall be estimated using an extended Kalman filter applied to the seasonally adjusted time series. The trend labour participation rate  and average time worked T , shall be estimated by means of a standard Hodrick-Prescott filter instead of a consensus approach as suggested by Altăr, Necula and Bobeică (2010), which propose the simultaneous use of the HP and Kalman filters. This choice is motivated by the fact that the time series have exhibited not significant volatility over the relevant time frame, but a smooth evolution, which makes the HP filter an appropriate choice. The estimation of the labour input at sectoral level is done based on the same reasoning as in (2), accounting for the proportion of SME employees in the total number of employees at economic sector level, as follows:  TNAIRUw N N NL IMMS EC S S 1 _  (6), where: S L is the labour trend at sectoral level (only SME), S N is the labour trend in the economic sector S, estimated using a Hodrick-Prescott filter, EC N is the labour trend at the whole economy level, also estimated using a HP filter, and IMMS w_equals the weight of employees in the economic sector S attributable to SMEs. The output elasticity of labour α can be estimated using a variety of approaches, almost all based on some ratio of labour derived earnings to gross value added created in the economy (please see Guerriero, 2012, for a detailed analysis of the alternative approaches to AE The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment Amfiteatru Economic 200 determining the parameter). Estimates for the Romanian economy range from 0,65 (Altăr, Necula and Bobeică, 2010), to 0,68 (European Commission, using an estimation horizon between 1990 and 2006) and 0,69-0,70 (Guerriero, 2012). For purposes of this study, the following formula shall be used to estimate α, both at economy level and at sectoral level: GVA MIC    (7), in which C is the employee compensation, consisting of salaries and other assimilated income, MI equals mixed income, representing the proportion of gross operating surplus charged to entrepreneurial compensation and GVA is gross value added. Estimating α at sectoral level poses some challenges, as mixed income is not available at economic sector level. This is why we will make the assumption that mixed income is distributed at sectoral level directly proportional to the gross value added created in the respective sectors, as follows: S EC S ECS SGVA GVA GVA MIC    (8), Inherent in our approach is the assumption that the output elasticity of labour α is the same for both the economy as a whole and for the SME segment of the economy. The next important step in calibrating the production function is estimating the capital stock, which is not directly observable. A possible approach is proposed by Konuki (2008) and Altăr, Necula and Bobeică (2010), based on the permanent inventory method. According to this model, the capital stock at tine t is given by:   ttQtt GFCFdKK ,11 1    (9), where Kt is total capital at time t, dQ is the quarterly rate of depreciation of capital, with the link between the annual and quarterly rates of depreciation being given by  4/1 11 Aq dd  , and GFCFt – 1, t is the gross fixed capital formation (capital inflows) during period t. The application of the permanent inventory method can be done in two ways. One of them is to assume that the growth rate of capital is equal to the rate of growth of real GDP. In this case, the real capital stock at the end of year n is determined as follows (see Gălăţescu, Rădulescu and Copaciu, 2007): AA n ndr GFCF K  (10), where rA is the annual rate of growth of capital formation. This approach has one significant drawback, which is the need to reliably estimate the annual growth rate of capital inflows, with different assumptions yielding different results, as discussed in Konuki (2008). The other approach starts with a predetermined level of the initial capital-to-output ratio and subsequently estimates the capital stock using the recursive relationship (9). Fostering Entrepreneurship in a Changing Business Environment AE Vol. 17 • No. 38 • February 2015 201 In their study, Altăr, Necula and Bobeică (2010) start with a capital-to-output ratio equal to 2,0 in 1995; however, this is not consistent with the IMF country report of 2003 which proposes a capital-to-output ratio of 1,3 in 1992. Considering the capital obsolescence in the Romanian economy in the first years of transition to a market economy system (implying high depreciation rates), we consider that a capital-to-output ratio of 2.17 in 2000 is appropriate, which corresponds to a capital-to-gross value added ratio of 2,44 in the same year. This value has been estimated using equation (9), considering an average annual growth rate of real GDP of 3.59% and annual depreciation rate of capital of 5% over the 2000-2013 horizon. The annual depreciation rate is consistent with the studies of Altăr, Necula and Bobeică (2010) and Gălăţescu, Rădulescu and Copaciu (2007). In order to evaluate the capital stock in the SME segment of the economy at sectoral level, we shall start from the capital-to-gross value added ratio determined for year 2000, as follows: SEC SSME GVAKSSME GVA GVA wGVAK , , 2000,,20002000,,  (11), The estimation of capital stock for subsequent periods is done based on the assumption that the capital stock of SMEs will grow at a quarterly rate equal to the growth rate of the total capital stock in the economy. For purposes of modelling potential GDP, there are solid arguments (Denis, Grenouilleau, McMorrow and Roger, 2006), Konuki, 2008, IMF, 2003 and 2012 etc.) regarding the use of the actual capital stock in the economy as a proxy for the trend stock of capital ( TT KK ). The last step in model calibration is estimating total factor productivity (TFP). In this respect, implied TFP shall be first determined using actual real GDP and trend labour and capital determined using the methodology previously described:   1 K L Y Aimplied (12), where L and K represent actual inputs of capital and labour. For the trend input of labour, formula (6) will be used, replacing trend values of variables with the actual quarterly observations, while trend capital is given by (17). Once the series of implied TFP has been derived, a Hodrick-Prescott filter shall be applied in order to estimate trend TFP. In our opinion, the model's strength lies in the simultaneous identification of factor and productivity contributions to sectoral, SME-produced GDP, as well as output gap at sectoral level. As it shall be seen, the model's results allow for a better understanding of Romania's macroeconomic gaps (the overheating of the economy in 2004-2008 and the subsequent contraction) and, at the same time, an appraisal of SME performance during the crisis and the ensuing economic recovery. By identifying the winners and the losers of the economic crisis, we shall have a clear image of the ability of local entrepreneurship to adapt to new economic conditions and contribute to economic growth through innovation and increased productivity. Results and discussion The first step in our research effort is to estimate the output elasticity of labour α. The estimation has been performed for both the economy as a whole and for the six economic sectors taken into consideration based on their contribution to total gross value added AE The Role of SMEs in Assessing the Contribution of Entrepreneurship to GDP in the Romanian Business Environment Amfiteatru Economic 202 created in the economy. The estimation methodology has been described in the previous section and the data cover a 14-year time horizon (2000-2013). The results are presented in table no. 1 below: Table no. 1: Output elasticities of labour Economy Industry Trade IT&C Real Estate Construction Agriculture 0,6261 0,6374 0,6932 0,5739 0,2349 0,5109 0,4348 Source: authors’ calculations At this point, an important clarification must be made concerning the contribution of the SME segment to gross value added and the proportion of employees in the SME segment in the total number of employees in the Romanian economy. As previously discussed, these are necessary in order to estimate the labour and capital inputs in equation (9). For purposes of this study, a five-year average (2008-2012) has been considered with the exception of agriculture, for which data are not available and a proportion of 90% has been considered for both gross value added and the number of employees for the SME segment. The results are given in table no. 2 and 3: Table no. 2: The contribution of SMEs to total gross value added created in different sectors of the Romanian economy, 2008-2012 Gross value added at factor prices, billion RON Industry Trade IT&C Real Estate Construction Year Total % SME Total % SME Total % SME Total % SME Total % SME 08 85,7 31,7 65,4 68,1 15,9 30,1 6,8 95,3 26,7 68,3 09 75,1 32,6 55,9 68,1 14,8 28,8 5,0 94,9 21,9 72,9 10 83,9 31,0 56,6 64,1 14,8 31,7 4,9 95,8 19,8 71,1 11 88,2 30,8 59,8 62,2 14,8 33,1 5,0 95,4 19,5 68,5 12 95,4 30,3 61,6 63,0 15,8 36,0 5,8 96,7 18,5 73,4 Σ 428,3 31,3 299,2 65,1 75,9 31,9 27,4 95,6 106,4 70,8 Source: INSSE data, authors’ calculations. Table no. 3: Number of employees in the Romanian economy, 2008-2012 Number of employees (thousands persons) Industry Trade IT&C Real Estate Construction Year Total % SME Total % SME Total % SME Total % SME Total % SME 08 1.644 49,5 1.543 76,7 145 58,2 47 89,3 554 77,2 09 1.423 50,4 1.410 75,9 135 59,7 43 89,3 469 79,1 10 1.346 50,1 1.330 76,1 130 59,3 41 88,4 393 78,1 11 1.387 50,9 1.362 77,0 134 59,0 41 87,8 418 79,7 12 1.381 50,2 1.369 76,2 137 58,9 40 88,2 400 80,9 Σ 7.181 50,2 7.013 76,4 681 59,0 211 88,6 2.235 79,0 Source: INSSE data. Before we proceed to the discussion of the estimation results in respect of potential GDP and output gap for the Romanian business environment, we shall briefly analyse the contribution of production factors to economic growth in Romania over the 2001-2013 time frame. The subsequent figure no. 1 exhibits the results. Fostering Entrepreneurship in a Changing Business Environment AE Vol. 17 • No. 38 • February 2015 209 to a healthy growth potential cannot happen in the absence of significant investment by the business environment (especially in the case of SMEs, who contribute significantly to the creation of value added in these sectors) and in the absence of EU funds absorption. The same can be said about the information and communication sector. As concerns the real estate transactions and construction sectors, which had important contributions to pre-crisis economic growth, they exhibited severe contraction during the recession due to worsening labour productivity and TFP. In the real estate sector this led to a natural reduction in the number of employees, while in the construction sector the return to sound growth levels depends on the recovery of the overall economy. The significant fluctuations in the agricultural sector are due to weak productivity and obsolete infrastructure and require significant investment in order to increase productivity and enter a sustainable growth path. The model gives a clear message: Romanian entrepreneurship has been severely affected by the economic crisis and the productivity of SMEs in the six main economic sectors has significantly slowed down as a result. This is a direct result of the SMEs' low capacity to innovate, their concentration in low value added-generating sectors, limited access to financing and weak management. It is worrisome that even after the end of the recession the SME segment is still operating below potential in almost all sectors (with the sole exception of trade, which is normal considering the recovery in aggregate demand). Considering that the output gap is expected to close in 2013/14, this highlights the competitive advantage that large companies that control the market have over SMEs, which has allowed the former to better weather the economic crisis and to return to growth rates near pre-crisis levels. In order to achieve this, entrepreneurs in the SME segment need to increase their potential to innovate. In order to support entrepreneurship in Romania, it is imperative that authorities act to promote competitiveness and the attractiveness of the Romanian business environment, by means of institutional and legal reform and by increasing the transparency and stability of the fiscal system; however, entrepreneurial education is also paramount, as it has a direct impact on employed human capital. References Altăr, M., Necula, C. and Bobeică, G., 2010. Estimating Potential GDP for the Romanian Economy. An Eclectic Approach. Romanian Journal of Economic Forecasting, 3/2010, pp.5-25. 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