Kazakhstan’s Missing Middle

By: Ralph De Haas Senior Economist

By Ralph De Haas and Asel Isakova

Why do private equity funds have difficulties with finding interesting mid-sized investment opportunities in Kazakhstan? And why does economic diversification remain such an elusive policy goal for the Kazakh government?

These are complex questions to which the table below may provide a partial answer. It shows the contribution of small firms (less than 50 employees), medium-sized firms (50-250 employees), and large firms (>250 employees) to economic production in Kazakhstan.

Three observations stand out.

First, large firms have become more dominant since 2005. They now produce more than four-fifths of economic output. The role of small and medium-sized enterprises (SMEs) has gradually declined, mainly due to small firms’ shrinking production. This means that bottom-up economic diversification has been limited if not absent, which does not bode well for the level of product-market competition in Kazakhstan. Also note that the 2005-2007 period was characterised by a bank-lending boom.

While this is likely to have benefited firms of all sizes, Table 1 suggests that large companies – such as in the construction, telecom, and transport sectors – may have benefited most. Of course, large hydrocarbon companies also profited from the high oil price.

Table 1  Contribution of small and medium-sized enterprises (SMEs) to GDP (in %)

	2005	2006	2007	2008	H1 2009*
SMEs	41	36	35	31	17
– small firms	36	32	31	28	16
– medium-sized firms	4	4	4	3	1
Large firms	59	64	65	69	83

^* Preliminary data; first half of 2009 only. Small firms refer to legal entities and individuals involved in economic activity that do not employ more than 50 people. Medium-sized firms employ between 50 and 250 employees (Law on Private Entrepreneurship, 2006, No. 124-3). Source: Statistical Agency of the Republic of Kazakhstan.

Second, preliminary data for the first half of 2009 show that the crisis may have had a dramatic impact on SMEs, which saw their contribution to output fall from 31 to 17 per cent. This can partly be explained by the expanding economic influence of state-development organisation Samruk-Kazyna and the large companies under its mighty umbrella. Moreover, even in 2008, 40.2 per cent of all SME output was still construction and real estate related. These sectors were particularly vulnerable to the credit crunch and the bursting real estate bubbles in Almaty and Astana.

A third observation is that medium-sized companies contribute very little to economic output: about 4 per cent of GDP before the crisis. The output distribution follows an ‘hourglass shape’: small and (in particular) large companies produce most of GDP while medium-sized companies add just a little. In short: there is a ‘missing middle’ in Kazakhstan’s business sector. There are either very few mid-sized companies or they are relatively inefficient in producing output. This goes a long way to explain why a burgeoning private equity sector has so far been absent in Kazakhstan: there may simply not be that many firms to invest in.

The above leads of course to the question whether the ‘missing middle’ is typical for Kazakhstan or represents a broader phenomenon? Table 2 compares Kazakhstan with a number of European countries. The first two columns show that the contribution of small firms to Kazakh economic output (31 per cent) is comparable to Poland and Romania and not much below the EU27 average. However, the next columns show that the missing middle is quite unusual: whereas in Kazakhstan only 4 per cent of output is produced by medium-sized firms, this number is about 20 per cent throughout Europe. The joint contribution of Kazakh SMEs to economic output (35 per cent) is therefore about 40 per cent lower than in the EU 27 (58 per cent).

Table 2  Contribution of SMEs to GDP: benchmark countries

	Small firms		Medium-sized firms		SMEs
	2002	2007	2002	2007	2002	2007
Kazakhstan	n.a.	31	n.a.	4	n.a.	35
Austria	39	38	22	21	61	60
France	37	40	16	16	53	55
Germany	34	33	19	19	53	53
UK	34	34	17	17	52	51
Czech Republic	37	35	20	20	57	55
Hungary	34	34	19	18	53	52
Poland	27	30	21	22	48	52
Romania	25	30	20	19	45	49
EU27	39	40	18	18	57	58

(Source: European Commission, Directorate Enterprise and Industry and Statistical Agency of the Republic of Kazakhstan. Share of SMEs in total value added at factor cost. N.A.: not available.)

What does this mean for policy makers? To start with, entry barriers may not be the main problem in Kazakhstan. Rather, it seems that small firms are not able to grow organically and ‘graduate’ into the medium-sized category. Such dynamic growth is what people usually have in the back of their minds when they talk about the employment-generating impact of SMEs. The business environment should allow small firms to grow and reap economies of scale.

The latest round of the EBRD/World Bank Business Environment and Performance Survey (BEEPS) measures what firms perceive as the main obstacle to their growth prospects. Data for 2008 show that small and medium-sized firms in Kazakhstan share the same Top 3 of impediments: high tax rates, limited access to finance, and an inadequately educated work force. It is striking, however, that the latter two obstacles have a higher ‘complaint rate’ among medium-sized firms than among small firms: access to financial and human capital hurts more when firms grow. In policy terms, this means that the focus may need to shift from financing start-ups and micro-enterprises to allowing existing small and mid-cap companies to borrow and, especially in the post-crisis period, raise private or public equity.

Another way to help the development of medium-sized firms is to let them – and the wider Kazakh economy – profit more from the presence of large foreign-owned companies. Fostering backward linkages, by developing SMEs into partners that are ‘fit-to-supply’ foreign investors, will in many cases require technical and managerial upgrading. The recent EBRD Management, Organisation and Innovation (MOI) Survey shows that, among a peer group of eleven transition countries, medium-sized companies in Kazakhstan score below average in terms of management quality (only overtaking Belarus, Uzbekistan, Russia and Romania.) While the government has an important role to play by improving educational standards, foreign strategic investors also have a responsibility in upgrading local suppliers. This may also reduce the government’s inclination to use the ‘stick’ of mandatory local content requirements.

The next years will be crucial for Kazakhstan’s diversification efforts. The country is climbing out of its first recession in more than a decade and needs to redefine its financial system. This window of opportunity to improve the business environment for SMEs is narrow: around 2013 the Kashagan oilfield will come on stream. By that time, pressures on SMEs will start to mount further in the form of an appreciating exchange rate and even tougher competition from the oil sector for human capital.

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