TRANSITION REPORT 2014 Innovation in Transition
Last year’s Transition Report, entitled Stuck in Transition?, examined the causes of the slow-down in income convergence between transition countries and more advanced market economies. It focused on country-level characteristics that continue to hamper economic development in large parts of the transition region – weak economic and political institutions, slow structural reforms, limited productivity growth and the daunting challenge of improving human capital and working towards equal opportunity. The report was a general reality check and, to some extent, a wake-up call.
Innovation in Transition – the title of this year’s Transition Report – tackles a similar set of issues from a completely different perspective. The report focuses, in considerable detail, on the individual firm in transition. Adopting this micro perspective is crucial to achieving a deeper understanding of why countries can become “stuck” in transition. More importantly, it also reveals the effect that individual firms can have on economy-wide productivity and the specific steps that can be taken to help boost productivity and reinvigorate economic growth. The challenge for policy-makers is discovering how to facilitate and encourage change at the firm level without intervening in decisions that are best left to firm owners and management.
We use the word “innovation”, with some hesitation, to describe what happens in individual firms. Innovation has associations with high tech and R&D, but innovation is something much broader and encompasses the introduction of any new products, services or production processes. This definition of innovation is particularly important in emerging economies because many productivity improvements, and ultimately economic growth, will come from imitation and adapting globally available technologies to local markets. Some of these changes will happen when new firms with novel ideas enter the market and when unproductive firms cease to produce, freeing up resources that can be used to realise better ideas. The economy also gains when efficient and fast-growing firms expand their market share while inefficient ones wither. Yet, most productivity improvements stem from within firms, particularly in emerging and developing economies.
The overriding question that the Transition Report 2014 aims to answer is why certain firms in the region innovate and grow while others become stuck in terms of their development. To answer this question, the report draws on a unique enterprise survey conducted across the region by the EBRD and the World Bank over the past three years – the fifth round of the Business Environment and Enterprise Performance Survey (BEEPS) – together with the Middle East and North Africa Enterprise Surveys (MENA ES) carried out by the World Bank, the EBRD and the European Investment Bank. The latest round of BEEPS includes, for the first time, a special module on firms’ innovation activities. This collates information about the new products and processes that firms have introduced in the recent past. The survey enables these activities to be related to a firm’s management practices, its performance and the business environment in which it operates.
The analysis also benefits from another major survey conducted by the EBRD in 2012, the second round of the Banking Environment and Performance Survey (BEPS II). The survey used face-to-face interviews with the CEOs of over 600 banks in the region to collect detailed information on their operations and business models. BEPS II also collected data on the locations of over 137,000 branches operated by these banks. This has provided a unique opportunity to gain additional insights into how firms and banks interact throughout the transition region and how these interactions may drive innovation in firms.
Through the analysis of these rich data it is possible to establish that firm innovation in the transition region entails much more than “frontier” innovation in the form of research and development (R&D) and the creation (and patenting) of products and services that are new to the global market. In many transition countries, firms innovate mainly by adopting existing products and technologies and adapting them to local circumstances.
Reaping these relatively easy returns remains an important driver of firm productivity across many transition countries and one that, unfortunately, is often overlooked by local policy-makers. As a result, innovative firms – much more so than non-innovative ones – continue to suffer from business constraints. These limitations take the form of widespread corruption, a lack of skilled labour, excessive customs and trade regulations and scarce funding options.
In countries still far removed from the technological frontier, policy-makers should focus more on improving the country’s capacity to absorb and benefit from technologies developed elsewhere. This requires, in particular, better primary and secondary education, better access to bank credit and an environment in which entrepreneurs are encouraged to improve the way they manage their firms.
As firms gradually close the gap between themselves and the global technological frontier and as the structure of the economy changes, economic institutions and policies supporting this change should also evolve. As an economy approaches the global frontier, the contributions made by innovative start-ups play an increasingly important role compared to improvements made within existing firms. The policy focus then needs to shift from facilitating investment and the transfer of technologies to nurturing creativity, providing highly specialised human capital and creating space for the entry of young, innovative firms as well as allowing the exit of firms that do not succeed. This requires that we pay more attention to flexible labour markets, better competition policies, good universities and sufficient access to venture capital and private equity for young start-up firms. It is the failure to successfully achieve such structural transformation that has left so many countries stuck in the “middle-income trap”.
While governments cannot directly make firms improve their performance, they can help them do so. They can achieve this by ensuring that economies are sufficiently open to trade and investment, by helping firms to learn about more efficient ways of doing business, by enabling workers to acquire the right skills and raising the general level of education and by safeguarding competition that rewards firms that transform themselves and puts pressure on laggards to improve. Importantly, as firms transform themselves, the structure of the economy and the economic institutions must also evolve. Government policies should adapt too; there is no one-size-fits-all innovation policy.
As experience has shown, blindly copying the institutions of advanced economies is not the solution – the main challenge is establishing how to tailor institutions and policies to the needs of a particular country. Countries must engage in what Dani Rodrik and others have described as “self-discovery”. For such a process to result in the right policies, the private sector must be involved, probably even in a leading role. To prevent manipulation by special-interest groups the process must be transparent and independently governed.
As governments succeed in tackling the institutional challenges and are able to local build capacity they can become involved in more risky activities. These include targeting sector-specific technology or skills gaps and finding interesting ways of enhancing sector-specific skills with cross-cutting enabling technologies. Such so-called “smart specialisation” requires a basic implementation capacity in countries and an adequate quality of human capital, but it has the potential to create added value.
The overall message of this year’s Transition Report is a hopeful one. Last year’s report argued that change at the regional level within a country can eventually help to reform institutions and increase income. Likewise, as explained in this year’s edition, changes at the firm level can collectively transform an entire economy. Regardless of a country’s level of economic development or its progress along the transition path, individual firms can make a difference.
In all countries, no matter how difficult the business environment is or how weak the economic institutions may be, there are firms that enjoy high levels of productivity, on a par with those of their peers in advanced markets. The main difficulty for countries is the large number of less-productive firms. Managers in these firms can make decisions that have a profound impact on the productivity of their businesses. Governments can make it easier for them to implement these decisions and can increase the pool of talent from which they can draw. As firms move along their transition path, so will the countries in which they are based.
Eric Berglof, Chief Economist, EBRD
The EBRD seeks to foster the transition to an open market-oriented economy and to promote entrepreneurship in the countries where it works. To perform this task effectively, the Bank needs to analyse and understand the process of transition. The purpose of the Transition Report is to advance this understanding and to share our analysis with partners.
The responsibility for the content of the report is taken by the Office of the Chief Economist. The assessments and views expressed are not necessarily those of the EBRD. All assessments and data are based on information as of early October 2014.
Improvements in the overall productivity of an economy reflect many changes at the level of individual firms. When new firms with novel ideas enter the market and unproductive firms cease to operate, scarce resources are put to more productive use. Overall productivity also increases when highly productive firms and firms where productivity is growing fast increase their market share. However, most of the economy-wide productivity gains derive from productivity improvements within firms. These are the dynamics at the heart of this Transition Report.
READ MOREAcross the world, economies remain characterised by large differences in labour productivity between firms. The results of the Business Environment and Enterprise Performance (BEEPS) survey show that there are firms with high labour productivity in every transition country. However, in the less-advanced transition countries the share of firms with poor productivity is higher and the differences between the productivity levels of individual firms are larger too.
READ MORESuccessful firm innovation relies on a supportive business environment. A poor business environment can substantially increase the costs of developing new products and make returns to innovation much more uncertain, thus undermining firms’ incentives to innovate. The results of the BEEPS survey reveal that firms that innovate by introducing one or more new products are more sensitive to the quality of the business environment compared with non-innovating firms.
READ MOREIn the transition region, innovation often takes the form of adopting existing products and processes from more developed countries and adapting them to local conditions. The speed at which firms adopt new and existing technologies can explain up to a quarter of the differences in national income levels. However, technology adoption can be costly and firms may therefore need access to external finance.
READ MOREGovernments everywhere are keen to foster innovation. However, countries at various stages of development differ in terms of their capacity to use and create knowledge. These capacities are shaped by the quality of institutions, macroeconomic stability and the functioning of product, labour and financial markets. They are also influenced by specific conditions that underpin countries’ ability to access existing technologies, effectively absorb them and create new ones.
READ MOREEconomic growth has slowed down further in the transition region as a whole. By the time the eurozone’s recovery started to take hold in the second half of 2013, two major developments substantially affected the performance of the region’s economies.
READ MOREThe current political and economic situation in many countries continues to provide a challenging environment for reform. For the first time, this year’s assessment of progress in reform by sector contains more downgrades than upgrades. The downgrades are mainly concentrated in the financial sectors where a number of additional structural challenges have been revealed, even though the assessment of the institutional reforms has remained largely unchanged.
READ MOREEBRD Senior Economist Helena Schweiger
BEEPS is a joint initiative of the EBRD and the World Bank Group. “It is a face-to-face survey of enterprise managers and the key objective is to obtain an understanding of the business environment that firms face in their day-to-day operations. In the latest round, BEEPS V, 30 countries are covered, with around 16,000 interviews,” says EBRD Senior Economist Helena Schweiger. BEEPS V contains a new innovation module that covers product, process, organisational and marketing innovation as well as management practices in manufacturing firms. Read more about BEEPS.
The responsibility for the content of the publication is taken by the Office of the Chief Economist. The assessments and views expressed are not necessarily those of the EBRD. All assessments and data are based on information as of early October 2014.
Improvements in the overall productivity of an economy reflect many changes at the level of individual firms. When new firms with novel ideas enter the market and unproductive firms cease to operate, scarce resources are put to more productive use. Overall productivity also increases when highly productive firms and firms where productivity is growing fast increase their market share. However, most of the economy-wide productivity gains derive from productivity improvements within firms. These are the dynamics at the heart of this Transition Report. Such improvements are often driven by firm innovations in the form of the introduction of new products, the implementation of new production processes or the use of new organisational practices or marketing innovations.
Only a small number of these innovations are new to international markets and advance the global technological frontier. Instead, across the transition region most innovative activities involve the adoption of existing technologies by firms. This is a direct reflection of the fact that there is still substantial scope for catching up with the global technological frontier.
Some new products and processes are developed as a result of in-house R&D activities while others require no R&D efforts. This chapter shows that many firms in the transition region “buy” rather than “make” knowledge; they outsource R&D to other firms or purchase or rent patents, licences or technological know-how. The mix of strategies for the acquisition of external knowledge varies by country. Firms in higher-income countries tend to spend more on in-house R&D relative to purchases of external knowledge.
At the country level, this section of the report shows how over the last two decades, exports from the transition region have become more innovation-intensive. Innovation through the adoption of existing state-of-the-art technologies has played an increasingly important role.
Across the world, economies remain characterised by large differences in labour productivity between firms. The results of the Business Environment and Enterprise Performance (BEEPS) survey show that there are firms with high labour productivity in every transition country. However, in the less-advanced transition countries the share of firms with poor productivity is higher and the differences between the productivity levels of individual firms are larger too.
One way firms in these countries can become more productive is by introducing new products and processes or new approaches to marketing. Returns to all these types of innovation are sizeable even when they are not innovations at the global frontier but products and processes that are simply new to the firm. This chapter illustrates how firms in all sectors can benefit from innovation. In fact, returns to the introduction of new products are particularly high in low-tech manufacturing sectors where firms tend to innovate less.
For some firms, innovation may still be a step too far. Many can still boost their productivity by improving the way in which they are managed. In countries where the quality of management is generally weak, improvements in management practices deliver high returns while returns to process innovation tend to be lower. This suggests that management practices need to be improved before new processes can yield substantial productivity gains. On the other hand, in countries where management practices are on average better – in south-eastern Europe and in central Europe and the Baltic states – the introduction of new processes results in more benefits than further management improvements.
This section of the report ends with a cross-country analysis which suggests that exports from industries with a higher innovation component tend to grow faster, provided that the business environment is favourable and firms have sufficient access to finance. In these countries, innovation-intensive industries can thus become the engines of economic growth.
Successful firm innovation relies on a supportive business environment. A poor business environment can substantially increase the costs of developing new products and make returns to innovation much more uncertain, thus undermining firms’ incentives to innovate. The results of the BEEPS survey reveal that firms that innovate by introducing one or more new products are more sensitive to the quality of the business environment compared with non-innovating firms. These differences in the perception of the business environment by firms that innovate and those that do not are particularly large when firms are asked to assess the importance of corruption, workforce skills and customs and trade regulations. They are also greater in Central Asia, eastern Europe and the Caucasus and Russia, while in central Europe and the Baltic states they are smaller. The findings suggest that the overall environment in these countries may be more supportive of innovation.
Firm-level and cross-country analyses of the drivers of innovation also show that firms innovate more predominantly in countries that have better core economic institutions, such as an environment of low corruption and a strong rule of law, countries that are more open to trade and investment and countries that benefit from a highly skilled workforce. Better access to finance and higher-quality information and communication technology infrastructure also helps firms to innovate.
Innovative start-ups are relatively scarce in the transition region. Unlike in countries such as Israel, innovations by young, small firms are also less likely to target the global technological frontier than those of large firms. Moreover, many successful R&D start-ups tend to quite rapidly migrate to other countries such as the United States, causing an “innovation drain”.
In the transition region, innovation often takes the form of adopting existing products and processes from more developed countries and adapting them to local conditions. The speed at which firms adopt new and existing technologies can explain up to a quarter of the differences in national income levels. However, technology adoption can be costly and firms may therefore need access to external finance.
Against this background, this section of the report first studies how differences in local banking conditions across cities and towns in the transition region have an impact on firms’ access to credit. In light of the fact that small business banking remains largely a local affair, the chapter finds that local banking systems which enable the formation of long-term lending relationships tend to boost access to credit. At the same time, the presence of foreign-owned banks locally also tends to be beneficial to firms’ access to credit.
This section of the report then goes on to show that better access to bank loans has a significant positive impact on technology adoption across the region. Moreover, these new products and processes are often also new to the firm’s markets; hence they set an example for competitors in terms of technology uptake. In addition, firms use bank loans not only to purchase external licences and know-how to adopt new technologies, but also to cooperate with their suppliers and clients to develop business solutions. Therefore, local banking markets that increase access to finance can encourage firms to learn from each other and lead to the intra-national diffusion of technology. In the medium term, this has the potential to reduce regional growth disparities.
Bank financing remains the dominant source of external capital for firms across the transition region. Can banks alone carry the burden of funding innovative activity? The analysis in this chapter finds that additional sources of risk capital may be necessary to induce firms to carry out original R&D. In particular, a discussion about private equity and venture capital industries in the transition region reveals a large equity-funding gap. This gap arises as a result of underdeveloped stock markets in the region, as well as insufficient human capital, which limit the flow of private equity funding into the region.
Governments everywhere are keen to foster innovation. However, countries at various stages of development differ in terms of their capacity to use and create knowledge. These capacities are shaped by the quality of institutions, macroeconomic stability and the functioning of product, labour and financial markets. They are also influenced by specific conditions that underpin countries’ ability to access existing technologies, effectively absorb them and create new ones.
Transition countries perform reasonably well in terms of access to technology, but lag behind advanced economies and many emerging markets when it comes to absorptive and creative capacity. The analysis of national innovation policies reveals that they appear surprisingly similar, despite the underlying differences in countries’ levels of development and strategies pursued by firms to acquire knowledge (through in-house research or by purchasing patents, licences or know-how). In particular, the innovation policies in the region tend to follow trends set by countries at the global technological frontier and focus on the creation of technologies.
However, a one-size-fits-all approach such as this may not suit the circumstances of many of the transition countries. Given that these countries are yet to close the gap with the technological frontier, policies need to prioritise improvements in countries’ absorptive capacity. Such improvements can be achieved through better secondary education and professional training, better management practices and policies that alleviate credit constraints. While innovation systems should imitate the governance and general design of advanced countries’ innovation policies, policy instruments and priority areas need to be tailored to reflect an individual country’s specific conditions.
As countries develop and approach the technological frontier, innovation policies must evolve. They need to place greater emphasis on helping firms improve their capacity to create knowledge – by facilitating the supply of specialised skills and specialised finance, strengthening competition and facilitating the entry and exit of firms.
Vertical innovation policies that offer support for particular sectors require high standards of governance to be effective and may not suit the circumstances of many transition countries. If pursued, such policies should make effective use of private-sector participation, which provides for an independent check on the commercial viability of projects selected to receive preferential treatment.
Economic growth has slowed down further in the transition region as a whole. By the time the eurozone’s recovery started to take hold in the second half of 2013, two major developments substantially affected the performance of the region’s economies. First, regional growth has been affected negatively by the events in Ukraine since late 2013. These developments and the resulting rounds of economic sanctions made the growth outlook significantly more uncertain. Second, similar to numerous emerging markets, many of the transition countries had already been affected by the expectations of a tapering of quantitative easing in the United States and monetary tightening in advanced economies more generally.
Faster economic growth in south-eastern Europe was more than offset by a deceleration of growth in Russia and Turkey, and the recovery in the southern and eastern Mediterranean (SEMED) region has remained slow. Thus average growth in this region is likely to remain below 3 per cent for three consecutive years (2012-14). Regional growth is projected to accelerate only slightly in 2015.
The current political and economic situation in many countries continues to provide a challenging environment for reform. For the first time, this year’s assessment of progress in reform by sector contains more downgrades than upgrades. The downgrades are mainly concentrated in the financial sectors where a number of additional structural challenges have been revealed, even though the assessment of the institutional reforms has remained largely unchanged. Downgrades in non-financial sectors are concentrated in European Union countries. In several cases, disproportionate government interference across different sectors has had a negative effect on the functioning of markets.
Positive developments are evident in the infrastructure sector, where commercially based mechanisms have been successfully introduced, ensuring the efficient delivery of services. In addition, small improvements in access to finance for small and medium-sized enterprises (SMEs) have led to upgrades of related financial-sector indicators. Two countries have been upgraded in one of the traditional country-level indicators – competition policy. But the region’s largest economy, Russia, has been downgraded on trade and foreign-exchange liberalisation as a result of the restrictions on trade and the activities of foreign companies in the country.
