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EBRD Transition Report 2014 – BOX 1.3. Political connections and firm-level dynamics: the SEMED region

TRANSITION REPORT 2014 Innovation in Transition

BOX 1.3. Political connections and firm-level dynamics: the SEMED region

When markets are distorted, various drivers of aggregate productivity growth may cease to work properly, resulting in a stagnant economy. Such distortions often arise from the misuse of political connections.

Political connections can take various forms, ranging from direct ownership, management or control of a firm by political leaders or their relatives to close relationships between the state and the corporate sector, leading to favours being exchanged between politicians and firms (for instance, with firms receiving favourable treatment in return for funding political campaigns).

Politically connected firms may prevent new players from entering the market, which enables them to remain in business despite poor productivity. Shielded from the threat posed by new entrants, such firms will have fewer incentives to innovate and seek efficiency improvements.27 They may also stifle competition, thereby denying market share to more productive and faster-growing firms through the abuse of regulations or non-transparent contracts. Political connections can also help firms to obtain public bailouts in the event of financial difficulties, reduce their tax bills, benefit from favourable import licensing arrangements or, in some cases, gain preferential access to finance.28

Recent evidence shows that political connections have played a major role in limiting the growth of firms in the SEMED region. This may begin to explain why these economies have been struggling to absorb new labour market entrants, while many economies in south east Asia have managed to use their young and fast-growing populations to their advantage.

For instance, while in Egypt the informal economy has grown over the past 20 years, few firms have entered or exited the market and the average firm size is relatively small. In other words, small firms are failing to grow and challenge large incumbents.29 A recent study shows that trade protection, large energy subsidies and bias in favour of politically connected firms in the enforcement of rules have all played a major role in stifling firms’ growth.30

According to this study, in 2010 politically connected firms in Egypt accounted for 60 per cent of net profit in the economy, while their share of employment was only 11 per cent. Over 70 per cent of politically connected firms were protected by at least three non-tariff measures, compared with only 3 per cent of other firms. Meanwhile, more than a third of them operated in highly energy-intensive sectors, compared with a national average of just 8 per cent. Overall, around 20 per cent of the market value of these politically connected firms was attributable to their political connections. Strikingly, these differences between the profitability of politically connected and non-connected firms disappeared after the “Arab Spring” revolution of 2011.

In Tunisia the 220 firms that used to be owned by the Ben Ali family (which were confiscated in the aftermath of the country’s revolution) were responsible for 21 per cent of all net private-sector profits, despite accounting for only 3 per cent of private-sector output, according to a recent study.31 These politically connected firms outperformed their peers, particularly in regulated sectors. Political connections added an average of 6.3 percentage points to each firm’s market share, relative to the market share of a non-connected firm with similar characteristics. As in the case of Egypt, political connections were exploited in order to secure beneficial regulations, particularly when it came to preventing firms from entering the market.

All in all, cronyism significantly reduces entrepreneurs’ incentives to create new companies and existing firms’ incentives to innovate, with negative consequences for the growth rate of the private sector.

Politically connected firms are not the only factor that is distorting markets and impeding structural change in the SEMED region. Other important factors include a potential bias towards investment in capital-intensive – rather than labour-intensive – industries (which is being fuelled by large energy subsidies), cumbersome business regulations, weak and unpredictable enforcement of rules, restrictive trade regimes and pro-cyclical policies undermining macroeconomic stability.32