19 July 2019 | Sebastian Benz
Lilian owns a small engineering firm in Melbourne, Australia that provides highly specialised advice to clients on how to minimise the environmental impact of water, waste, landfill and tailings management. While most of her firm’s business is with the domestic mining industry, their expertise is also in high demand in other resource-rich countries. Yet, regulations in some of those economies create significant barriers to the international growth of Lilian’s firm.
In fact, research at the OECD shows that regulatory barriers that affect trade in services often burden small- and medium-sized firms (SMEs) like Lilian’s much more than they weigh on larger companies. As such, many SMEs stay away from restrictive markets entirely, and when exporting at all, they often focus on economies where the laws and regulations resemble those of their home country. By contrast, larger competitors – and especially multinational enterprises – are more likely to thrive in foreign markets, even when local rules are different or more restrictive than at home.
Difficult business conditions for SMEs can represent a significant risk to economic growth and prosperity. According to the OECD Structural Business Statistics, micro and small enterprises with less than 50 employees account for 43% of all employment in the OECD, while medium-sized enterprises with between 50 and 250 workers employ an additional 16%. SMEs also were a significant driver of overall employment growth in the market services sector between 2010 and 2016, mainly reflecting the entry of new firms.
How services regulations can disadvantage SMEs
From a business perspective, many foreign laws and regulations represent a fixed cost. Research at the OECD using the Services Trade Restrictiveness Index (STRI) shows that these fixed export costs can represent up to 50% of total export revenue in the first year that a business starts exporting (Figure 1).
While all firms must learn about potential barriers to entry before exporting – from licensing requirements, to visa procedures, to local rules concerning professional liability insurance – the effort to understand and apply these rules generally translates into a higher fixed cost ratio for smaller firms than it does for larger firms, given the typical overall volume and scale of business. As such, exporting is more profitable for larger firms when fixed costs from regulatory barriers are high, as larger firms are more likely to conduct several projects at a time and to remain in a market over many years.
In addition, due to their size, larger firms have more options for foreign market entry. For example, a foreign office is only profitable when export sales are persistent and above a certain threshold. Larger players with deeper pockets can endure temporary losses, while SMEs often do not possess the financial means to support this type of longer-term investment.
As a case in point, Lilian’s engineering firm has two small offices in South America. Even though she has identified interesting opportunities in Africa and Asia, establishing a permanent office there could pose existential risks to her firm. In many countries, it is extremely costly and time-consuming to register a company. Often, locally qualified engineers must be recruited as managers instead of bringing in experienced personnel from existing offices. In some countries, a certain share of the staff must be citizens or permanent residents in the country. In order to avoid such requirements, SMEs often prefer to collaborate and share revenue with local partners rather than set up a foreign subsidiary.
How SMEs can benefit from services liberalisation
Clearly, these two factors can penalise SMEs relative to large firms. OECD research shows that SMEs suffer most from existing export barriers and differences in services regulations across countries. For smaller firms with an average annual revenue of EUR 500,000, an additional 21% of their revenue from export sales is eaten up by compliance costs imposed by moderate services trade restrictions. This is a significantly higher percentage than is seen for larger firms (Figure 2). These additional costs cut into export profits of SMEs, and often prevent them from exporting in the first place.
To mitigate this disadvantage and support small businesses, policy makers could take steps to lower or eliminate services trade restrictions where possible. Even modest reductions in services trade restrictions can lower export costs for the smallest firms by around 7.5 percentage points more than it reduces export costs of large firms.
Smart and determined action can stimulate inclusive growth
Services reforms can not only promote trade and raise aggregate welfare, but doing so also creates new international business opportunities for SMEs.
More than all others, small firms benefit from policies that promote competition and innovation through the reduction of entry barriers and elimination of red tape, facilitate the movement of people, ensure the independence of regulatory bodies, and increase transparency of necessary regulatory procedures. And for Lilian, smart liberalisation of services trade can help expand her business into new markets and contribute to making trade work for all.