VIABILITY OF SMALL FIRMS AND ECONOMIC DEVELOPMENT:

THE CASE OF SMALL SAWMILLS XN ESTONIA

BY

Damon Zirnhelt

Submitted in partial M h e n t of the requirements for the degree of Master of Development Economics

Dalhousie University Halifax, Nova Scotia

June 2000

O copyright by Damon Zirnhelt

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DEDICATION

In loving rnemory of Hamet Zirnhelt and Robert Shaw

TABLE OF CONTENTS

LIST OF TABLES vii

ABSTRACT

CHAPTER ONE: INTRODUCTION 1.1 Background 1.2 Project Rationale 1.3 Thesis Question 1.4 Project Research 1.5 Synopsis

CHAPTER TWO: OVERVIEW 2.1 OveMew of National Economy 2.2 Overview of Forest Sector 2.3 O v e ~ e w of Estonia's Sawmill Industry 2.4 Small Sawmills in Estonia

Industry Structure Number ofSmal2 Sawmills TechnologrgrcaZ Level and Access to Credit Access to Raw Material Market Access and Market Knowledge Operating Costs Sumrnary

CHAPTER THREE: ANALYSIS OF INPUT MARKETS 3.1 Appropriate Technology and Access to Credit

Assessment Government Policy

3.2 Raw Material: Access and Costs Assessment Government Policy

3.3 Labour Assessrnent Government Policy

3.4 Electricity Costs Assessrnent Government Policy

3.5 Summary

CHAPTER FOUR: ANALYSIS OF OUTPUT RlARKETS 4.1. Introduction

4.2 Export Markets 4.3 Domestic Market 4.4 Govemment Policy

m o r t s Domestic Market

CHAP'I'ER FIVE: CONCLUSIONS AND POLICY IMPLICATIONS 5.1 Introduction 5.2 Input Markets 5.3 Output Markets 5.4 Industry Organization and Govemment Support

Development Agencies JO int- Use Facilities Georgia Wood Cooperutive: Lessons Learned

5.5 Final Remarks

LIST OF TABLES

TabIe 2.1 Importance of industrial production by branches, % of value-added

Table 2.2 Exports of wood-based products in Estonia 1994-97 (millions kroons)

Table 2.3 Estonian wood industry companies according to Type of activity

Table 2.4 Structure of the Estonian sawmill industry in 1995

Table 3.1 Cost cornparison of sawnwood production in Estonia and Finland

Table 3.2 Sawmills' Source of Roundwood

Table 3.3 Institutions providing Education and Training in Wood processing

vii

The potential of smaii and medium-sized enterprises (SMEs) to contribute to socioeconomic development has received widespread attention through research and policy. SMEs' contribution to national economies has been well documented. Their contribution to regional economic development within a country is fiequently defended on the grounds of equity or employment, rather than efficiency- In many cases, nevertheless, SMEs make significant contributions to economic efficiency. This thesis examines the mall sawmill sector of Estonia in the attempt to determine the extent to which these s d fkms are economically viable in the present or will be in the future. Soon after Estonia gained independence, many small sawmills were able to mcceed - including the inefficient ones - because prices of inputs did not reflect their tnie economic costs. As Estonia's market economy continues to develop, s m d sawmills fïnd it increasingly difficult to survive because of imperfections in key input markets and a lack of education about, and access to, output markets. While many costs, including raw material and labour prices, are rising, so are output pnces. This thesis finds that these small firms are potentially viable, but not under present conditions.

As is typical for srnail fhms in general, imperfections and biases in credit markets are serious problems. To compete and to be able to reach key output markets, these small fkms need financial capital so they can acquire the machinery necessary for producing better products more efficiently. Policy-makers must increase credit support for small sawmills. Access to raw material is a problem because of market power exercised by the large î ï m s that dominate this industry. This problem c m be overcome, if appropriate intervention improves access to raw material.

Although small &ms lack certain economies of scale and therefore cannot compete with big firms in certain markets, they have certain advantages among hem; in particular, flexibility and the capacity for specialization. These characteristics give them the ability to address the demand in niche markets. Certain sectors within the country such as the £biture industry have the potential to grow, but likely depend on a sufncient suppIy of specialized sawnwood f?om small sawmills. Further, even users of standard sawnwood products may benefit fkom the continued existence of small sawmiils that can produce small orders locally. Large firms do not necessarily cater to these needs.

If these market imperfections c m be overcome, the survivability of small sawmills will have a positive economic benefit on the country as a whole, and, more specifically, in regions of relative underdevelopment where they are located. Local ownership of small h s can make an important contribution to economic development because of the commitment and interest of business owners to the communities in which they live. In conclusion, this thesis gives examples, for M e r investigation, of ways in which govemment and industry can work to achieve this goal.

ACKNOWLEDGEMENTS

1 especially thank my supervisor, Dr. Barry Lesser, for a great deal of consultation, guidance, ideas and meticulousness. 1 also thank him for giving me the opportuniîy to take on this particular thesis project. 1 a m gratefid to Dr. Jeff Dayton- Johnson for putting so much time and thought into my thesis. His comments, interest in my work, insight and encouragement have been most helpfûl.

A special t h a ï ï to Carol and Alisdair Sinclair for al l their kindness and generosity. 1 am fortunate to have found a "home" in Halifax. 1 also thank Alisdair for reading my thesis. 1 am very gratefûl to Professor Ian McAUister for giving me the opportunity to study here. He has given me a lot of extra time and ideas, and, in doing so, has gone fa beyond the call of duty. 1 also thank Donna Lesser for her generosity.

In the Baltics, 1 am gratefiil to the following people, not only for their help in my research, but also for their hospitality: Ulle Puustusmaa, Kirsti Anipai and her family, the Albi family, Andns Sekacis, and Irena Rasirniene and her f d y - For their assistance, 1 also thank Svend Koonsdroom, Tonu Kull, Antii Pae, Maris Peilans, Professor M. Teder, Arvydas Lebedys, Stasys Mizaras, Katre ViljaIo, Krïstjian Tonnesson, Paavo Kaimre, Aavo Kummal, Juri Sakkeus, Jaak Maandi, Ene Padrik, Krista Kampus, Andrei Valentinov, and the faculty of the Department of Forestry at the Estonian Agricultural University.

Of course, to m y family: first, my mom, who has always given so much to her family and so little to herself - 1 am thankflll for her companionship and support while 1 worked on this project; my dad, for always thinking of his children, his enthusiasm and interest in my studies and his vigorous pursuit of new ideas; my brother Sam, a dear fiiend with whom 1 have shared many ideas and great experiences; and my brother Robin, also a dear fiend who, among other great things, has taken up the slack at home so that 1 could finish this project; he has done a tremendous job at "holding the fort." 1 am indebted to Joan, my close fiend and grandmother, who provided me with a place to work on this project. Her kindness and support over the years mean very much to me.

1 am gratefûl to my close fiends Dan and Melody for their support and for always showing an interest in me. Over the years, Dan has dso been a mentor and 1 appreciate his thoughts on certain aspects of this thesis

1 thank Chris MacDonald for thoroughly reading and comrnenting on my fïrst draft.

FinaiIy, 1 acknowledge those 1 have failed to mention for the various ways they have contributed to my studies and thesis.

CHAPTER ONE: INTRODUCTION

1.1 Background

The output of the forest industry of Estonia has been increasing both in total and

as a proportion of total exports. One product group of this industry, sawnwood', has

performed particularly well (Estonian Economy 1997-1 998: 44). At the beginning of

independence in 199 1, there existed many small sawmills2 and, compared to forest

industries in other countries, the proportion of the combined output of the small saWIIil11s

of total sawmill production capacity was (and still is) comparatively large. Even though

the technological level is obsolete and the product quality is inadequate by Western

standards, these h s were able to survive and grow in number for the first few years

after independence for severd reasons. They had no investment tied up in capital since

their machinery and related equipment was tumed over to them by the state through the

privatization process. Raw material pnces were very low by international standards, as

were pnces of other inputs such as labour and electricity. This was due to the Iack of _ 4'-

regdation of nahilai resources, undefïned property rights regarding natural resource

ownership and subsidized energy prices. Shce that tirne, as in other sectors of the

economy, the sawmilling industry in Estonia has undergone many changes. Factors

influencing markets, operating costs, technology requirements, raw materials and

government suppoa systems have al1 been changing at rapid rates.

ccSawnwood" is a term used synonymously with "lurnber."

In 1995, there were approxirnately 350 small sawmilIs operating in Estonia,

which together made up about 49% of the total output of the industry. However, the

number of small sawmills has been decreasing since 1995, even though sawmill

production on the whole has been increasing. Severd large sawmills have recently been

established with the help of foreign investment ("Review" 1996: 21). From an econornic

development perspective, the fûture of small sawmills in Estonia, as an example of small

finn development, has significant implications.

1.2 Project Rationale

If small sawmills were to largely disappear, and no other changes to the sawmill

industry were to occur, it is obvious that total output would fa11 dramatically. However, if

the output of the remaioing few large sawmills were to increase and actually replace the

lost output of small sawmills, then concems about production and total output rnight not

be so important. However, the total economic contribution of the sawmill industry might

change because of the change in industry structure and it is not clear whether such a

change in industry structure would be positive or negative for the overall economy.

The friture of small sawmills in Estonia is not clear, but is a relevant topic for a

thesis for several reasons. While Estonia has a large volume of forest resources per capita

For the purposes of this study, srna11 sawmills are defmed as those that produce under 2000 cubic metres per year, since it appean that beyond this sùe, the characteristics of the sawmill firm change significantly,

and its forest indu* makes a signincant contribution to the country's economy, the

rapid changes in the sawmilling industry raise questions about the suMval and economic

viability of s m d firms in general in natural resource-dependent economies at both

regional and national levels.

The potential for small and medium sized enterprises (SMEs) in generd to

contribute to socioeconomic development has received widespread attention through

research and policy. As Mukerji, et al. state, "It is universally accepted that the majority

of new jobs in the economy are created by small and medium sized enterprises (SMEs).

SMEs have received much attention in the literature because of their docuniented

contribution to a nation's economy. They contribute between 60-80% of a nation's total

employmenty' (Muke rji 1998: 1). While their contribution to regional economic

development within a country may sometimes be defended more on the grounds of

equity, rather than efficiency, it may be found that in many cases, SMEs, (in our case,

small sawmills), contribute significantly to the country's economy, even when the

alternative uses of al1 resources utilized by these firms are considered.

There is also a belief that small firms, owned and operated by people who live in

particular regions, contribute more to regional economic development, and in turn, to

overall development than large &ms, in part because there is a greater sense of

obligation to the general welfare of the local region or community. Policymakers are

paying more attention to SMES in terms of economic development potential and this rise

with respect to management practices, physical capital employed and general plant structure.

4 in interest in SME promotion is due in large part to the signincant economic

performance in sorne regions brought about by small firm development. In north-central

and north-eastem Italy, for example, studies ". . .find that, with a strong sense of

community, local producers often commit themselves to promoting the well-being of

their regional indu- and cooperate with one another through trade relations, collective

institutions, and other social relations, strengthening their ability to adopt new techniques

and flexibly adapt to econornic changes" (Izushi 1999: 740).

Large companies rnay enjoy economies of scaie with respect to marketing, mass

production and management. Smaii fïrms, on the other hand, typically face difficulties in

this respect. However, due to their s m d size, they dso exhibit certain characteristics that

may make them efficient in meeting certain demands in the economy. Small sawmill

fïrms certainly have advantages in terms of flexibility with respect to European and

domestic demand. This flexibility is key in accessing higher-value export market niches,

the increase in value-added being a desirable goal in terms of improvements in resource

use and in economic development in general. This flexibiiity is also important in that

other related industries, such as the furnitue industry in Estonia, may need suppliers of

sawnwood which have the flexibility to meet specific requirements. These requirements

may Vary in specification, quantity and quality. Large sawmills, due to their size and

production methods and marketing goals, are less effective at serving these needs.

Fuaher, small sawmills are regionally significant in terms of their proximity to, and

dispersion in, regions of underdeveloprnent.

In sumrnary, the smaii sawmill industry is economicaily significant for two

principal reasons:

1. The forest ïndustry rnakes a significant contribution to Estonia's economy. Within the forest indUSffYy the sawmill industry, primarily consisting of a large number of small sawmills, is economically significant.

2. With respect to regional disparities, the forest industry - and more specifically the s a d l indu- - is important in terms of a) the potential contribution of SMEs to the nation's economy and b) the potential economic benefit of srnail h s in underdeveloped regions endowed with significant volumes of forest resources.

1.3 Thesis Question

This thesis will attempt to answer the folIowing question:

To what extent are small sawmills in Estonia economicaliy viable at the present and to

what extent wrll they be economically viable in the future?

This thesis will attempt to demonstrate that small sawmills have the potential to be

economically viable if certain conditions are met. Essentiall y, imperfections in input

markets and lack of access to the nght output markets are the main constraints to the

survivability of small sawmills, rather than demand problems or insufficient fkn size. In

fact, reaching the right output markets necessitates srnall firm size. Further, fiom a policy

6 perspective, enswing their viability is important, given the govement's view that a)

regional development is a key goal and b) SME promotion is one way to attaùi this goal.

1.4 f roject Research

Most of the primary and secondary research for this project was carried out by the

author in Estonia in June and Jdy 1998. This involved interviews with individuals in

various government ministries, industry orgartizations and businesses. Some time was

spent at the Estonian Agricultural University (Department of Forestry) in Tartu.

Interviews of sawmill owners also included tours of production facilities. Since 1998,

there has been some attempt to update the information initially collected by means of

library and Internet research and ongoing electronic dialogue with individuals in Estonia.

Data on the Estonian sawmilling indwtry is extremely limited, making it

necessary to use qualitative information as welI as quantitative information-While this

limits quantitative analysis, it does, at least, allow one to make estimations based on

reasonable assumptions. The analysis in this thesis identifies and assesses key factors

that, together, determine the economic viability of small sawmills in Estonia.

1.5 Synopsis

Chapter Two is an overview of the small sawmill industry in Estonia Because of the

importance of understanding how this industry fits into the national economy, this

chapter consists fïrst of an oveMew of the national economy, focussing on the economic

contribution of industry. Withixi industry, the forest sector output and structure is then

outlined to provide a fiamework within which the sawmill industry c m be assessed.

Finally, there is an o v e ~ e w of the sawmill industry, which illustrates its industrial

structure and the history of its development. The remaining sections of the chapter

attempt to outiine the factors which affect this industry.

Chapter Three is an analysis of the input markets that are relevant in the functioning of

the small sawmill firm. Each input market is assessed in terms of existing market

imperfections and changes in, and resulting effects on, the industry. The effect of

government policy on each input market is aIso assessed.

Chapter Four is an analysis of output markets and the conditions which m u t be present

in order for small sawmilIs in Estonia to access them. Present and fûture export markets

are examined fïrst. The domestic market is then assessed. Finally, government policy is

considered as it applies to each of these huo markets.

8 Chapter Five consists of conclusions and policy impIications. First, evidence is provided

to support the conclusion that the smali sawmiU is, in general, a good example of the

challenges faced by s m d &ms and the challenges faced in reducing regional disparities.

The potentid of s m d h s ' contribution to economic development is explored- Second,

the analyses of each factor, as categorized and explored individually in Chapters Three

and Four, are considered in a cohesive or integrated way. That is, each factor is

considered in tems of its effect on the economic viabiiity of srnall sawmills on the

whole. The policy implications of addressing the market imperfections associated with

these input and output markets are explored. Third, several examples of ways in which

both government and industry can work to create organizations to overcome these

challenges are illustrated.

CHAPTER IWO: OVERVIEW

2.1 O v e ~ e w of National Economy

For industry in generai, it appears that the economic conditions in Estunia have

recently been (and wiil continue to be) favourable. The economy has been growing

rapidly since the country gained independence, except for a recession in the early 1990s

and a slowdown following the Russian crisis of 1997-98. Many of the recent

developments have been innuenced significantly by the country's preparation for

accession to the European Union (EU). By July 1994, Estonia had already signed a fkee

trade agreement with the EU which meant al1 limitations on imports and exports of

industriaï goods with respect to EU countries were to be dropped (Rumpenun et al. 1997:

41). As a result, market conditions and government policy regarding the EU have

signifcantly af3ected those industries in Estonia involved in internationally-traded goods.

In fact, Estonia's success in gaining access to the EU depends on its adherence to policy

directions dictated by the EU.

M e r independence, GDP dropped significantly, but recovery began in 1993. By

1997, growth exceeded 10% ("Prospects" 1998: 3). Estonian indusûy in general has been

successful in recent years. In 1997, total industrial output increased by 13.4%, the major

reasons for this growth being:

... favourable property relations in industrial enterprises, investments made in eariier years, favourable economic conditions for foreign trade partners and the development of export production.

("Estonian Economy 1997-1998", 43).

2.2 O v e ~ e w of the Forest Sector

One of the fastest growing industries in Estonia has beedis the forest industry

(see Table 2.1). Fore. resources are one of Estonia's few naturai resources and forests

cover about 44 percent of the comtry's land area (Kallas 1996: 15). Thbe r growth rates

are impressive and the harvest rate, while still below its sustainable lirnits, has been

increasing rapidly ("Prospects" 1998: 7). In 1995, the wood processing industry was

growing at 20 percent while the processing industry in general was growing at ody 3 per

cent ("Estonian" 1997: 5). The forest and wood-working industries constitute the third

largest industrial sector, making up 13 per cent of total production value. In 1997,

production increased by 48 per cent - the highest growth rate in the industrial sector

("Prospects" 1998: 1).

11 Table 2.1 The importance of industrial production by branches, % of value-added

(Source: "Estornian Economy" 1998: 44)

Energy

Mining

Manufacturing

indushy inc,

Food industry

Lig b t industry

Forest Kndustry

Chernical industry

Construction

materials

Machine- and

apparatus indusîry

Printing,

publishing and

others

Estonia has undergone a major privatization process, now mostly complete. This

has included land restitution and the private take-over of the forest sector enterprises and

land previously held by the state. The changes that have accompanied these

developments have led to a large increase in the availability of raw matenal to fïrms.

Meanwhile, the annual harvest rate has been far below the annual allowable cut (AAC).

The AAC is the volume of timber in a given jurisdictidn that the governing body has

1992

11.0

4 3

1995

13.5

4.5

84.7

3 1.6

17.1

93

8.8

3 9

11.8

2 2

1 993

127

4.7

1994

14.7

4.6

1996

13.6

4 9

82.6

1997

122

5 2

80-7 81.5 820 82.6

27.0

11.4

12.5

8.7

3.7

3 7.7

9.9

8.3

7.6

3 -7

29.6

11.7

13.0

8.9

4 2

327

9 2

9.8

8.6

4.7

28.9

10.6

12.4

9 3

14.0

1.5

3.8

11.8

3 -6

1

12.5

3 2

12.5

4.5

13.6

4.6

12 determined to be the maximum volume that c m be harvested on a sustainable basis.

Up to this amount, the forest will grow at a rate greater than or equal to the amount that is

harvested through replanting and reforestation. The AAC is detennined scientifically and

is set by government. In 1996, the actud harvest rate was 50 per cent of the AAC and by

1997 it was 70% ("Prospects" 1998: 7). Provided that market conditions remain

favorable, there is substantiai potential for fürther expansion and growth of forest related

The wood industry, which has been defined in a report by the Estmian Fores-

Development Programme to include ". . .the various woodworking industries that produce

primary and secondary wood products chiefly for construction industry, interior

decorating, fumishing and so forth" ("Mechanicai" 1996: l), is broken down into the

following product groups :

Primary wood products - sawnwood - wood-based panels

- p l y o d -particleboard -fibreboard

Secondary wood products -Mer-processed sawnwood

-builders' j oinery -edge-glued panels

-furniture -prefabricated houses

("Mechanical" 1996: 1)

The wood industry is largely export-based and the decrease in trade with the

former USSR has been replaced with a dramatic increase in trade with European

countries, where two thirds of the present exports are shipped ( " ~ r o s ~ e c t s " 1998 : 2).

The forest industry has experienced a trade surpIus. (At the same time, however, the

country as a whole has expenenced a trade deficit, but this is not an unusual situation.)

Table 2.2 shows a breakdown of the value of wood-based exports by type of product.

Table 2.2 Exports of wood-based products in Estonia 1994-97 (miilions kroons)

particle board

I

total 1 1543.5 1 2072.3 1 2769.2 1 4477.7

fibreboard

(Source: "Prospects" 1998: 4)

37.2

56.3

148.6 172.1

146.3 I

213.6

79.6 118.2

14 As of 1994, there were apparently over 1200 companies in this industry, broken down

by product type as indicated in Table 2.3. (Note that it is possible that there may be some

double-counting, since some companies fall into more than one category and may be

counted in more than one category. If this is the case, the total number of companies may

not be as large as indicated.)

Table 2.3 Estonian Wood industry companies according to type of actÏvity

Main field of activity

sawnwood

veneer and plywood

particleboard

companies

368

1

1

- prefabricated houses 33

builders' joinery 196

other

(Source: "~echanicd " 1996: 1)

462

Total 1250

2.3 Overview of Esfonia's SawmiU Industry

During the Soviet era, the Estonian sawmill industry was developed to serve the

US SR market. h the 1 WOs, Exportles, the Soviet exporting organization, ceased its

exports of Baltic sawnwood3 outside the USSR. One commentator has d e n :

Between the mid-1970s and 199 1, Estonians lost al1 expenence and business contacts. European sawnwood use developed in that t h e but the Estonian sawmill industry remained unchanged.

The govemment forced the Estonian sawmill industry to meet the needs of the fümiture

industry, which served only the USSR market. Thus, al1 products were designed to meet

the requirements of the USSR economy ("Mechanical" 1996: 2). Many sawmills were

also built to meet the local needs of collective farms and agricultural cooperatives

(Martikainen et al. 1996: 16).

Since independence, the structure of the industry has changed dramatically. Most

of the previously existing operations have been privatized, some new fïrms have been

established through foreign investment, and many small circular sawmills have been

built. Some sawmill companies have undergone significant investments, including

nurnerous joint ventures (Martikainen et al. 1996: 16).

The quotation below implies that the products had been exported to countries outside the USSR, but presumably most of these exports were to COMECON countries, not Western Europe.

16 As iliustrated in Table 2.2, Baltic exports have increased dramatically over the

1 s t several years. The Baltic states' share of the UK &ber market jiimped fkom 0% in

199 1 to 10% in 1994. Martikainen et al. state that "British softwood mills are losing

market share due to sigd5ca.t volumes of softwood arriving fiom the Baltic States"

(1 996: 16). Nordic producers have also faced increasing export cornpetition fiom the

Baltic states, particularly in Germany:

German imports fiom the Baltic states increased by almost 180% between 1994 and 1995. As the total German sawnwood imports decreased by 14%, BaItic States' market share increased fiom 4% to 13%.

(Martikainen et al 1996: 16)

A joint project called "Baltic Suwmill Indusby to the Year 2000" was completed

in 1995 by the University of Helsinki and Tallinn Technical University. The results of

this survey were outlined in an article by the same researchers titled "Competitive

Strategies of the Baltic sawrnill indushy"which fïnds that "(w)hile the industrial output of

many sectors has sharply decreased since 1990, the sawrnill industry has showed the

syrnptoms of rapid recovery" (Martikainen 1996: 16). However, it also points out that

"...the competiveness of the Baitic sawmill industry is still quite unclear. For instance, the

small average size of sawmills is one of the fundamental problems in the Baltic states"

(Martikainen 1996: 16). A 1998 report called Prospects of the Wood Processing

Industries in Estonia states that "(t)he best performing branch of the wood processing

sector has so far been the sawmilling industry which, not being technically developed in

the early 1990s, has during the p s t few years upgraded its production facilities and

L7 quality in a remarkable manner" ("Prospects" 1998: 10). While these comments

indicate growth and progress, on the one hmd, they also indicate, or suggest, continuhg

uncertainties regarding technology and structure which could influence the fiiture of the

srnall sawmiii industry.

2.4 Small Sawmiiis in Estonia

Industry Structure

It is interesting to note that the previously-mentioned study of the Baitic sawmill

industry did not include in its survey smali sawmills (less than 2000 cubic metres per

year) even though, as indicated in Table 2.5, small sawmills constituted a significant

portion of the total output in the Estonian sawmill industry. Soon after independence,

most of the growth in number of firms came fiom those producing less than 2000 cubic

metres. Recently, this number has been decreasing. The number of large sawmills has not

increased significantly, but their production capacity has.

Table 2.4 Structure of the Estonian S a w m Industry in 1995

over 15000 m3

Sawmill size

* Estimate

compsnies Share (%)

328

II (Source: Mechanical " 1996: 4)

The sawmill industry is dispersed around the country and is therefore very significant for

regional employment because of the general concentration of other economic activity in

the capital, Tallinn ( "~echanical " 1996: 4). This is an important characteristic as it has

implications in terms of regional economic development and, in tum, general national

II development. As Danson sates, Over the last hvo decades there has been an increasing

realisation of the importance of small and medium enterprises (SMEs) to the

J I development and health of the national and regional economy ... (Danson 1996: 1).

Danson also explains that recent well-founded research indicates a connection between a

region s prosperity and the level of growth in owner occupation (Danson 1996: 14). The

small sawmills are basically Estonian-owned, while the large sawmills are centrally

located and are mainly foreign-owned. This characteristic has implications for this study

Capacity*

89

Share* ( O h )

(1000 cubic metres)

300 49

19 (to be explored in Chapter 3), since Estonia has experienced an increase in regional

disparities despite its ove rd rapid growth.

The survey previously mentioned is now four years old, which is a substantial

length of tirne for a country that has seen dramatic social, political and economic changes

in the short period since it gained independence. The general trend is that the number of

smdl sawmill firms is decreasing, fïrm size is increasing and the production capacity is

concentrating. Therefore, although these figures indicate that small sawmills made up

essentially halfof the total sawmill production capacity in 1995, it is clear that they do

not currently constitute the same portion. Antti Pae, the president of the Estonian Forest

Industry Assocation, confkms that the number of smdl sawmills is decreasing (Pae

1998). By 1998, the construction of three major sawmiils was underway, and it was

expected that once these were in production, the structure of the sawmill industry would

be such that 10% of the mills would account for over two thirds of the total output

C'Prospects" 1998: 11). However, although the number of small sawmills is decreasing,

the number appears to still be quite large.

Number of SmaZZ Sawmills

At the t h e of independence, and for severd years after, economic conditions

aiiowed for the successfid operation of a large number of small sawmills even though the

technology, most of it Russian in origin, was outdated. Prior to independence, this did not

20 matter, since the entire economy was based on this technology, there were no foreign

markets in which to compete, and prices of inputs and outputs did not necessarily reflect

the real economic values of the resources involved in sawmiiling. Factors influencing

markets, operating costs, technology requirements, raw materials and government support

systems are now al1 changing at rapid rates (Kilvits 1 997: 1 9). In the following sections,

the significance of these factors will be discussed.

TechnoIogical Level and Access to Credir

The Soviet-origin equipment commonly used is not adequate to produce the

quality required by European, and even the growing domestic, markets. Because of the

crudeness of the machinery, it is diacult to produce accurately sized lurnber. The only

way to overcome this problern is to acquire better equipment fiom Western Europe.

However, this is impossible for many small producers because they cannot get the

necessary riancial capital due to insufficient collateral. (Their existing equipment has

very little resale value.) In addition, even when they can get loans, the borrowing rates

are very high (Kull 1998), especially when compared to the lower rates available to n v d

finns in other coutries-

Access to capital is a problem addressed in the SME and credit market litirature.

In a study of English and Scottish small business and banks, Ennew and Binks find that

positive contributions of SMEs to a nation's economy are often constrained by

21 imperfections in capital markets (Ennew and Binks 1996: 81). In fact, the problems

with finance and capital encountered by SMEs exist throughout Europe. "Srnall fïrms

tend to borrow short-term hancing at one to two percentage points over the rates

charged to large businesses" (Mulhem 1995: 83). Emew and Binks argue that "The

efficient provision of finance to small h s has long been recognised as a key factor in

ensuring that these h s can grow and cornpete" (Ennew a n d Binks 1996: 82.) The

implications of imperfections in access to capital for srnail sawmill k s will be

examined in Chapter Tbree since this problem is a serious canstra.int.

A major drawback for these firms is that they are lirnited in their ability to supply

potential markets if they cannot kiln-dry lumber. By 1996, only about 30% of production

could be kih-dried. For most of the small firms, again because of credit diffculties,

acquiring kiln-drying equipment is often not possible ("Mechanical" 1996: 30). In certain

markets, this means that Estonian lumber cannot be sold at d l . Moreover, even when it

can be sold, the prices firms receive are signif icdy lower than for equivalent kiln-dned

products.

Finally, there are deficiencies in knowledge about production processes and

management practices. There are no common grading rules t o apply to either raw

materials (roundwood) or finished products. The lack of proper treatrnent of raw

materials and s a m o d decreases the prices received. In tuni, this contributes to the

generally poor reputation of Baltic sawnwood. As will be discussed in Chapter Three,

22 attitudes of some Estonian sawmill owners also can adversely affect the success of

their b s .

Access fo Raw Material

For sawmills in general, there are basically two sources of raw material: state

forests and private forests. The total forest area in the country is 2.0 million hectares. It is

expected that state forests will eventually occupy 48% of this area and private forests

52% ("Prospects" 1998: 6). Acquuing raw material has been a problem for s m d

sawmills, but the extent to which it will continue to be a problem is unclear. Relevant

changes in forest policy and land restitution will be examined in Chapter Three.

In general, timber fiom public land is sold through an auction system by the

government. One problem for small b s is that the timber is sold in large quantities,

which are often too large for the small £hm to purchase. Also, because of their small

scale, it is important that when they do buy timber, it is of the type and amount that they

can use in their production facilities. This auction system does not lend itself to satis*g

these needs as the liquidity of small firms is often hadequate for these purposes

("Mechanical" 1996: 12)

In the public auctions, market power constrains small sawmill firms. One small

sawmill owner cornplains that even when s m d firms try to compete, they are squeezed

23 out by the few large fïrms who dominate these auctions. Through predatory behaviour,

they argue that the large fïrms tend to drive up the prices until the small firms are forced

out of the bidding process (Kull1998). Once the small firms are discouraged fiom

participating, the prices f d back at least to where they staaed. While no direct evidence

to corroborate this argument was found, there is no question that the market is far fiom

perfect. As will be examined in Chapter Three, the structure and organization of the

systems implemented to allocate state timber are being changed, and it will be important

to assess how this will affect access to raw material for smaU sawmill firms.

Most small sawmill fkms purchase raw material (timber) fiom private land

owners ("Mechanical" 1996: 11). In many cases, these land owners are farmers who own

small parcels of land, some of which is forested. Because of the general small scale,

sawmill firms can purchase timber in small enough quantities to meet their needs (Albi

1998). Farmers are also limited in the amount they can harvest, because of the limited

size of their land holdings and the small scale equipment they use ( m d y fixa tractors)

to harvest their forests. The author's visual observation of severd smdl sawmill

operations indicated that even though this source of timber does exist, small h s often

do not seem to have adequate amounts of raw material inventory in stock. Although the

scale of the operation dictates that large inventories cannot be held, it struck the author as

surprising that £ïrms held such Limited quantities of raw material Uiventory. In tum, this

could mean that mills are very limited in their ability to meet a range of customer

demands with respect to quality, size and species specifications. Larger inventories of

raw material might be a possibility if better access to timber of appropriate

specincations was possible, as weii as fïnancing to cover the additional costs of

inventory.

It is not clear that private forests will continue to be a sustainabIe source of raw

material for srna11 sawmil1s. Now that the land restitution process is for the most part

complete, owners are fiee to do as they choose with their land. In some cases this means

s e h g it to large forest companies who are looking for a long t e m supply of raw

material which they cm control. Ruth Albi, who works for a large forest Company cdled

maa &talu, says that over the next few yem, %e big will eat the srnall" (Albi 1998). As

a result of the land restitution process, some new owners are people whose ancestors

(who previously owned the land) may have been famiers, but who are currently not tied

to the land in any way, either economically or emotionally. A significant number of these

people are therefore willing to sel1 their land to the few large companies who wish to

purchase it.

State regulations have a strong influence on the availability of raw material. The

govemment has developed legislation designed to ensure environmental sustainability of

the resource. It has established d e s so that harvesting is undertaken in an

environmentally sensitive manner. It is highly probable that much of the development of

this legislation was guided by member countries and organizations in the European

Union. It is also likely that the govemment of Estonia intends to enforce its guidelines,

25 since a fdure to do so could threaten its chances of accession to the EU. That said, the

actuai harvesting rates in state forests have been far beiow the detennined sustainable

yield (AAC). On the other hand, legal restrictions on the cutting volume for private

forests are to be abolished ("Developmenty' 1997: 58), which may act to improve the

overall availability of raw material to small sawrniils, since private timber has been, and

is, a major source for the small sawmills . It can be concluded that forest resources exist

in sufficient quantities that such legislation will likely not affect small sawmill f%ms in a

negative way. A s will be examined in Chapter Three, the critical factors affecting raw

material inputs are availability and price.

Market Access and Market KnowIedge

Typical of small firms in general, marketing the product is a major challenge. For

small operations, the time required to learn about potential markets through extensive

research is a daunting task and the necessary resources are often too costiy. Refemng to

Estonia's forest sector in general, a 1998 SWOT analysis concludes:

The weaknesses of the sector are mainly related to the lack of modem management skills =d unfamiliarity with marketing and export markets. Establishment of a solid foothold in foreign markets is effectively hampered by the small capacity of individual enterprises, and the problem is aggravated by lack of cooperation and information between them. Individual marketing efiorts have often led to excessive dependence on too few buyers. The importance of quality and quality control is still not M y recognized by al1 manufacturers.

("Prospects" 1998: 17-1 8).

26 There rnay be an argument that small fïrms cannot access markets because they lack

the necessary economies of scaie to compete, and that it is this characteristic that leads to

their fdure. However, there is growing evidence that some difficulties in accessing and

learning about markets are due to imperfections in those markets rather than firm size.

But the small sawmills clearly have more of a problem than the bigger fïrms. Chapter

Three will include an examination of existing and potential markets (both domestic and

export) and the necessary attributes small h s must have to access them.

Comparatively low operating costs have been beneficial to small sawrnills,

couteracting other shortcomings characteristic of the industry. The fact that wages have

been traditionaily low compared to those in nearby Western European is important

because of the high level of labour intensity characteristic of these firms. However, at a

macroeconornic Level, wages are rising, and as will be examined in the following chapter,

labour mobility wiWdoes affect the viability of small sawmills. Also important when

considering labour inputs are social issues. It has been said that finding decent labour, let

alone well-trained labour, is difficult Morde is low, alcoholism is high and the general

work ethic is not conducive to high levels of productivity or efficiency (Koonsdroom

1998). One individual told the author that the result of social and economic problems in

rural areas is that attitudes are poor and that people are not willing to work. He pointed

out that it is in the areas of highest unemployment that the demand for labour is the

27 highest (Maandi 1998). No M e r evidence has been found which supports the latter

opinion, but the poht is that suitable labour is a real problem.

The degree of c o d t that problems related to labour inputs will exert wiH

depend on generd trends in socioeconomic devetopment in the region. There is an

interesthg dichotomy that &ses when examining labour input. On the one hand, low

wages reduce operating costs and help to offset other constraints facing smdl firms.

However, low wages are associated with poverty and poor socioeconomic conditions

which may adversely affect the viability of small h s and economic development in

general. Thus, low labour costs may be only a superficial advantage for smail sawmills.

Large, foreign-owned firms, on the other hand, may not feel the effects of poor

socioeconomic conditions in quite the same way, thereby putting the small firms at a

disadvantage. The problem is compounded by the fact that small f m s are more labour-

intensive than large firms.

Electricity prices are also low because of subsidization policies that have been in

effect since independence. However, electncity prices are expected to rise, as the

subsidies are expected to disappear. An analysis of operating costs, including labour and

electricity, will be more Mly explored in Chapter Three.

To assess the economic viability of smaii sawmills, it is necessary to determine

the extent to which the characteristics and constraints outlined in this chapter are due to

imperfections in the various input and output markets versus an unreaiistically large

number of small firms, meaning that there are simply too many sawmills that are too

srnall to compete, even in the absence of imperfections. Chapter Three addresses these

questions,

CHAPTER TEIREE: ANALYSIS OF INPUT MARKETS

3.1 Appropriate Technology and Access to Credit

As described in Chapter Two, obtaining better equipment is often not possible, yet

it is a necessary prerequisite for long term survivability. However, the presumption that

cornpetitive potential c m only be realized by obtahing the most modem equipment (that

which is comparable to the equipment used by similar sized firms in Nordic countries, for

example,) may be incorrect. First, this equipment is entirely inaccessible for the firms

that cannot acquire credit at dl. Moreover, even if they could finance the equipment, the

credit is probably so costly that a net positive rate of return on investment in equipment

would be hard to achieve. Instead, it may be more economical to purchase equipment that

is not brand new but which is more affordable. This would enable firms to acquire

equipment which makes it possible for them to produce the necessary quality to reach

potential lumber markets, be they foreign or domestic, but at a more modest cost than the

most modem, newest equipment.

This dated equipment may not be as efficient as that used by cornpetitors in other

countries, but this would be compensated by other costs which are comparably lower. For

example, even if energy pices and wages are rising, it is unlikely that they will soon

30 reach the levels of nearby western European corntries. It follows that it may not be the

best shategy to bear the costs of high levels of financing to purchase the most modem

equipment, when somewhat older, and more aordable, equipment would allow h s to

improve their products with less debt servicing. In this case, the fïrm would be making

intensive use of the factors in which it has a comparative advantage (labour, raw

materials, and electrîcity) to make up for the factor in which it has a comparative

disadvantage, capital, due to its credit problems. Finally, the used equipment probably

produces at the same level of quality as the most modem sawmill equipment, only it is

less capital-intensive. As wiIi be discussed in Chapter Five, the ability to access markets

depends in large part on whether small k s can kiln-dry their lurnber. There are

numerous well-built, small-scale kilns available. In fact, they can be built quite easily and

can be fueled with waste wood, which is a byproduct of al1 sawmills. However, obtaining

drying facilities means that adequate hancial credit mut be available.

It may not even be possible to purchase equipment (neither the most modern or

slightly dated) if financing is not available at al1 or is too expensive. Small sawmill

owner Tonu Kull, for example, says that high interest rates make it very mcult to

borrow capital. He says that in 1998, borrowulg rates were as hi& as 14% (Ku11 1998). Lf

rates were lower, making credit more accessible, small sawrnills might be better able to

acquire the necessary equipment. As will be addressed in the following sections, if the

other factors that influence the viability of small sawmills are expected to continue to be

impedùnents to their success, then better access to credit for the purpose of getting better

3 1 equipment wili not on its own make small sawmills more successful. But, if those other

factors are not entirely insurmountable, then the credit issue becomes much more

important.

In the discussion of appropriate technology, we must also consider fïrm size

(economies of scale) and its socio-economic implications. This is important for the thesis

question because of the specific focus on the smdl sawmill industry. This focus suggests

that there may be economic signincance in, first, whether a sawmill industry exists at d l

and second, whether it matters if it is made up of small or large fïrms. Even though

sawmilis al l produce sawnwood, the size of the sawmiil affects what type of product they

can produce. There is a wide range of sawnwood product markets. The new, large

sawmills in Estonia are designed for the mass production of sawnwood products which

are basically commodities. Because of the nature of commodities, mechanization and

mass production are key ingredients to their success. These large mills and their products

are probably very similar to those in North Amenca and Western Europe. These

sawnwood products do not add a lot of value on a per unit basis to the raw material

utilized to produce it. Total employment in one of these large mills is large, but it is

centralized and, M e r , the employment per mi t of raw material (roundwood) consumed

is comparatively lower than for smaller sawmills. Moreover, large mius of this kind are

not flexible in the range of products they produce, so they cater to only a few, albeit

large, markets.

As wiIl be argued in Chapter Four, there may be markets in which small

sawmills are more appropriate than large sawmills in terms of aimensions, grade

specfications and changing requirements on the part of customers. in this respect, foreign

markets may be reachabie but so may the domestic sawnwood markets, which are

expanding at impressive rates. Moreover, the potentid for smali savmïlis to effectively

adapt to meet the needs of the growing domestic secondary wood products industry has

implications which bring to light the economic development potential of small scale

fhms. While a more thorough discussion of markets will occur in Chapter Four, it is

important to demonstrate why small sawmills exist in any industrialized country.

Smdi sawmill technology is not necessarily inefficient, but it can be. When

people in the West think of small sawmills, they picture old, family-nui operations, since

many of them did exist between the 1940s and 1970s in Noah America. Technologically,

they were probably comparable in many ways to the Soviet-era equipment currently used

in Estonia. As in Estonia, they probably survived because they did not have to pay the

full cost of the resources used4. Many of them have disapperared and the ones that still

have the mechanical ability to fiinction are either used for non-commercial use (personal)

or during periods when there is residual demand for them to fill. Referring to Europe as a

whole, Prim states that "In the sawrnilling industry, there are many thousands of old,

small, often family-nui sawmills that are not really cornpetitive with more modern units,

but which still produce small volumes during penods of strong demand" Pr im 1997: 4).

These miils typically have high levels of waste, because of the thickness of the blades

used, and the product is of poor quajity and not kiln-drïed.

There is a growing manufachiring industry that produces small scale sawmill

technology in the industrialized world. This technology is often Iabour intensive

(compared to larger sawmills), but it is efficient in ternis of raw material waste and

minimal power actually required to cut the wood. Moreover, the dimensions of the

individual pieces of lumber can be produced accurately. Some small firms have been able

to obtain used Finnish and Swedish equipment (Kull 1998). This equipment allows the

smali h to produce the quality required, with minimal waste. They are labour intensive

compared to Large sawmills, but this is not necessarily a negative attribute. First, the

higher labour intensity may be a necessary ingredient when attempting to serve small,

specialty and changing markets. Even though small sawmills lack economies of scaie in

production, their small size may be beneficial in that the current and potential growth of

value-added sectors of the forest industry might depend on a small sawmill sector which

can respond to their varying needs. The fact that the small fïrm technology allows other

firms at later stages of the value chah of forest products to succeed provides m e r

evidence for the argument that an industry of small sawmills provides economic benefits

including regional employment, regional control over resources and livelihoods, value-

added nahual resource manufacturing and, therefore, an increase in the range of areas in

which the country can develop a comparative advantage.

4 This means that the price they had to pay for tirnber was artificially low, misrepresenting the real opportunity cost of employing these resources. Also, famiIy businesses often pay low (implicit) wages to

Tied directly to the issue of appropriate technology, the credit problem is mical

for small fhns in general and it is weii-recognized. Even in industrialized countries,

SMEs M e r fiom imperfections in capital and credit markets. Referring to Europe in

general, Mulhem finds that smail firms tend to borrow short-term kancing at one or two

percentage points higher than the rates at which large fïrms are able to borrow (Mulhern

1995). Mason and Harrison (2993) explain that the supposed spatial variations in

availability of finance are debatable; their review of evidence fkds no clear pattern.

However, they conçai that access to finance is particularly problernatic for smail b s

(Mason and Harrision 1993: 133). In industrialized countries, hast al1 capital raised by

small businesses is obtained locally fiom banks. Often, there are biases due to

asymmetries in information. Moreover, it is generally recognized that small fhns suffer

fkom lack of information and that credit rationing universally has adverse affects on srnaIl

films.

Estonia is adversely affected by the credit probIem especially because of the high

degree of uncerhinty and imperfections in Estonia's own capital markets. Before

discussing how govemment policy ought to address the credit issue, it is useful to

consider the characteristics and comtraints of the credit or capital markets. As described

in Chapter Two, lack of collateral is a major problem for small sawmills. Mason and

Harrison point to a study that stresses that 'Vhe higher the collateral required, at a given

interest rate, the higher the cost of hance, on a risk adjusted basis, to the nrm" (1 993 :

35 133). In Credit Rationing in Markets with Impe~ect Information, Stiglitz and Weiss

demonstrate that often fïrms cannot get loans at the going interest rate, particularly when

they ïack adequate collateral. Fuaher, the number of loans is too low, meaning that

intervention wili increase allocative efficiency in the credit market (Stiglitz and Weiss

198 l), and in turn, in the economy as a whole.

Emew and Binks (1 996: 82-3) effectively summarize the allocative implications

of imperfections in credit or capital markets as follows:

If businesses experience difficdties in obtaining debt finance for commercially justifiable projects then they may forgo potentially viable growth. Such difficulties do not refer simply to the fact that some fvms cannot obtain b d s through the banking system. Indeed, it would be expected that many applications for funds would be rejected as part of a rational commercial process. Genuine difficulties occur, e s t , in situations in which a project which is viable and profitable at prevailing hterest rates is not undertaken because the l5-m is un- able to obtain appropriate fùnding, and second, in situations in which viable projects can only obtain funding on apparently disadvantageous terms. Restricted access to h a n c e is not necessarily attributable di.- ectly to size, but rather to the costs and difticulties associated with the collection of uiformation for project evaluation and monitoring. These costs and difficulties are considerably higher for smaller projects and smaller firms and, as a consequence, the potential for h a n c e gaps is higher among this group of businesses.

(Ennew & Binks 1992: 82-3)

To deterrnine with any precision the effect that improved access to credit will have on the

viability of small sawmills, one would require data that shows the number of small

s a 6 U businesses that have been able to obtain credit with government support. Related

to this, it is important to consider how many of those fïrxns are viable, even if they

receive credit Even though there were many small sawmills operating soon after the

country gained independence, one must not assume that dl, or even many, of them were

or continue to be viable. Prices were very distorted, which may have allowed some fïrms

to survive when perhaps they would not have under more competitive conditions. If it

can be shown that small sawmiIls can survive in the emerging market economy if they

are abte to obtain credit, at reasonable rates, then improved access to credit is one way to

ensure that otherwise viable businesses are able to survive.

Because a s igdcan t portion of sawnwood is exported, firms in Estonia must

compete with &ms in the same industry in other European coutries. For example, if a

small sawmill in Finland enjoys lower interest rates and better access to credit than a

similar fïrm in Estonia, this market imperfection puts the small Estonian sawmill at a

disadvantage. The high interest rates in Estonia symbolize, in part, the uncertainties that

go dong with rapid transition. It follows that there may be some justification for

government support of small sawmills with respect to credit, at least until the transition

process is f i shed , not only in terms of access but dso in terms of the price.

While there is theoretical debate about the extent of biases in capital markets

against small businesses, policymakers appear to believe they exist and that programmes

37 must be created to assist srnaIl businesses (Zoltan et al. 1999: 18.) Government

suppoa may help smail businesses redize their potentiai, but there is also the risk that

non-viable businesses will continue to survive because of subsidized interest rates or

eom grants that they should not have received. If government is to succeed in making up

for imperfections in the credit market, it must ensure that oniy potentiaily viable

businesses receive support. However, it is important to identie those businesses that are

not viable for other reasons such as poor management, those with too high a

concentration of firms in a s m d area, and those that experience other costs that are

higher and which will continue to make them not viable, even if credit is obtainable for

the purposes of acquiring new equipment. In considering the development of SMEs in a

transition economy, it is interesting to note that the SME sector in Poland has

experienced rapid and signiscant growth. This is said to be partly due to the role of SME

aid programmes, where part of the rationale of such programmes is based on the fact that

large financial instititutions are not interested in fhancing SMEs, due to high fixed costs,

limited profit opportunities and low money volume (Konopielko and Bell 1998: 290-1).

Thus, these SME aid programmes attempt to overcome the limitations of seIf-kanchg,

so that productivity and competitiveness in the European market improve because of

attributes other than low labour costs (Konopielko and Bell 1998: 291). In other words,

the actual experience of Poland confjrms the potential validity of the arguments we have

been making regarding the Estonian small sawmill sector.

38 Some govemment assistance is available to small and medium sized businesses

in Estonia The Estonian goveniment has emphasized (at the macroeconomic level) that

the country is open to business and that protective policies such as subsidies are not

objectives. However, the govemment also has recognized regional disparities as a serious

problem. This is relevant for small sawmills, given that they tend to be located in the

poorer regions of the country. There is evidence that the goveniment believes it has an

important role to play in addressing regionai problems. In Awiculture and Rural

DeveZo~ment: - Overview 199 7, Viik explains that ".-.in many rural areas, maintainhg the

population and retaining production activities are serious problems" (Vick 1998: 89).

The govemment has dso recently established the Regional Development Agency,

following the Regional Policy of Estonia, which is aimed at creating the conditions

necessary for balanced socio-economic growth of all regions of the country, considering

both regional as well as national interests ("Regional" 1998: 8). As a subset of this

agency, the Business Support Systern of the Regional Development Agency is a project

established in 1998. Its mission is to:

....( support) micro-, small and medium-shed businesses and the formation of new viable businesses in the entire territory of Estonia, in order to contribute to long-term stable economic growth of Estonia, following at the same tirne the principles of sustainable development.

("Business" 1997: 3 )

The project has the following specific objective:

To suppoa the development of microenterprises, small and medium- sized enterprises (SMEs) and the formation of new enterprises with information, advisory services, start-up financing and risk financing.

("Business" 1997: 3)

The following enterprises are preferred (in terms of the focus of support):

1. SMEs oriented toward exports 2. SMEs operating in the fields of activities priorïtized by the Regional

Development Agency ("Regional" 1 998: 2-3).

The Regional Development Agency has as one of its goals, to realize the economic

growth potential of al1 regions ("Regional" 2998: 9). More specifically, the Business

Support System of the Regional Development Agency of Estonia, States:

It is important for the society to support the creation of an environment favorable to entrepreneurship, and the enterprising mentality that will create the conditions for business development and emergence of new enterprises. Microenterprises and small and medium-sized enterprises play a decisive role in job creation, but at the same thne their problem lies in their limited resources due to their small size, which serves as an obstacle in spending on research work, introduction of new technology, also in the marketing of products and buying business advisory services. Support to micro-, small, and medium-sized businesses presumes the acknowledgement of the role of these enterprises in the society, more efficient CO-ordination of seMces oriented to the enterprises of the target group on the one hand and public sources on t!4e other hand, also more focused activities in the conditions of limited resources (more precisely defined target group, various measures).

Efforts to assist srnail business development in the regions are symbolized by the

establishment of programmes like this. Given the difficulty small businesses

(specifically, in our case, small sawmills) have in acquiring credit, government

programmes could offer loans at lower interest rates or back loans so that banks would be

more willing to lend at reasonable rates, given that the risk would be lower. The author

has been unable to determine, however, whether this programme (now in place), related

programmes under different ministries, and general support to business have had an

impact on the credit problem.

The Estonian government has aiso made some moves towards support to

businesses in rural areas. In the agriculture sector, the Agriculture and Rural Life Credit

Fund (&CF) has been established to provide agriculture and m a l Life credits

(Noorkoiv 1998: 78). By January 1998, the balance of the ARLCF was EEK 499.9

million and its loan portfolio was EEK 420 million. According to Bank of Estonia data,

loans given to legal entities in agriculture, hmting and forestry totalled EEK 284.4

million fkom April 1 to December 1, 1997 (Noorkoiv 1998: 78). However, it is not clear

which entities in the forest sector received loans.

The Rural Life Credit Guarantee Fund (RLCGF) was created in 1997 to offer

additional guarantees to famers and rural entrepreneurs who do not qualiS for bank

loans due to Iack of necesary collateral or hi& risk Furthemore, the RLCGF has made

cooperative agreements with seven commercial banks. This has involved the

41 establishment of guarantee contracts in 1997 to d o w for the creation of long term

credits nom commercial banks (Noorkoiv 1998: 78).

It is likely that most srnail sawmili businesses fdl under the coverage of these

programmes, as most sawmills are located in rurai areas and they do face relatively high

interest rates. In many cases, moreover, they cannot get loans because of a lack of

collateral. If the magnitude and number of resources such as the RLCGF continue to

increase, if rural development continues to be a priority for the govemment and if the

state's budget continues to expand, then access to favourable credit for small sawmill

owners wiU likely increase. If this occurs, then we can Say that th is constraint, one of the

most serious facing small sawmills, will be alleviated to some extent.

3.2 Raw Material: Access and Costs

Assessrnent

Roundwood market pnces constitute a major portion of sawrnill operating costs

and the economic value of roundwood m u t be considered in light of possible alternative

uses. As Pearce explains:

It is the usefirlness of forests that make them vaiuable economic resources. The more value in final goods and services that can be generated fiom a tract of forest the more valuable the forest itself.

(Pearce 1990: 4).

There is a growing recognition that forests have economic uses other than as raw material

used for mdac tur ing . Besides various use values, such as pulp and paper and

sawnwood products, there are also non-use values, such as environmental reserves, that

must be considered. To assess the economic value of forest resources in any complexity

would be beyond the scope of this project. In this thesis, world roundwood prices are

assumed to reflect the economic value of roundwood in Estonia, even though these pnces

may reflect many market imperfections, and might not exactly reflect economic scarcity.

Catinel points out that market imperfections relating to market power, extemalities,

information problems and unanticipated shocks can alter the effects of scarcity (Catinel

1996: 5). However, market prices are the best indicator available, at least within the

scope of this study. Since the demand for roundwood is derived kom the demand for an

array of forest products, if supply is relatively constant, then world timber prices cm be

used as an indicator of what people are willing to pay for the use of tirnber resources.

Further, as is illustrated in other sections of this thesis, it is assumed that Estonian forests

will be harvested at a sustainable yield. This dso indicates that world timber prices

generally reflect the net present value of the forest resources. At sustainable levels of

harvesting, there is a recognition of future value of the resource. If there are local

deviations fiom world roundwood prices, these would reflect market imperfections in

Estonia's forest industry.

Finally, if it can be done efficiently, it is better to process the raw material rather

than to export it. This assumes fist that the country is not at a comparative disadvantage

in tems of technical and human resources and, second, that M e r rnanufacturïng of

wood products depends on an adequate and suitable supply of sawnwood. A study

published by the Institute of Development Studies clarifies this point:

... whether a country with extensive natural resources can produce and export processed primary products depends on the skills of its worldorce. If the level of skill per worker is hi& [relative to other countries], the country will have a comparative advantage in primary processing; if the level of skill is low [relative to other countries], its exports will be concentrated on narrowly d e h e d (unprocessed or less processed) pri- mary products.

(Owens and Wood May 1995: 28).

In Estonia's case, for the first few years after independence, raw material (unprocessed

timber) was exported in large quantities. That trend is changing, but due to some

negative attributes and significant market imperfections, it is not clear that small sawmills

will establish a comparative advantage in forest products and become part of this trend if

some changes do not occur relatively soon.

A 1996 report outlines the costs of producing sawnwood in Estonia and Finland,

summarized below in Table 3.1 :

Table 3.1 Cost Cornparison of sawnwood production in Estonia and Finland

Cost item

wood I I I

Estonia

EEW unit uni&/

Wages

Salaries

Total 1 - I I Other

USD/

unit

48.90

3 500

11 400

Elecîricity k W 80 0.35

*

*

-

Finland

uni&/

m3

1.9

18

(Source: "Mechanical" 1996: 39)

36

6

These figures were derived fiom information obtained fiom Larger companies and

therefore some of the costs may not accurately reffect those of srnail sawmills. This

information is not current either, as the survey undertaken to collect this information was

carried out in 1995. However, even if current costs of small sawmills deviate somewhat

39 O00

128

O00

45 fiom this (either up or down), roundwood costs are stïil a major portion of total costs.

Roundwood prices for different assortments have been approximately 3 O-4O% below the

world market level but have gradually increased dong with the improvement of local

processing capacity ("Prospects" 1998: 7). As Estonia continues its process of accession

to the EU, it is expected that its roundwood prices will continue to nse to world levels. If

this occurs, operating cos& will increase significantly. A 1997 article in Forest Products

Journal states that one of the conclusions of European Timber Trends: Into the 21st

Century (Ems is that pnces in real terms for roundwood (as well as for forest

products) will remain relatively constant over the long term (Prins 1997: 18). Therefore,

using roundwood costs in Finland as proxies for world prices, Estonian sawmills' overall

operating costs may increase by approximately 52.00 USD per cubic metre. This would

be an increase in overall operating costs of about 30%. If normal profits are assumed to

prevail in the industry before such an increase, then ceteris paribus, some sawmills would

exit the industry. However, output prices are also changing. Sawnwood prices in Estonia

rose fiorn about 55% of those in Finland in 1994 to almost 70% in 1997 ("Prospects"

1998: 9). If both input prices and output prices rise together, then viability is not

necessarily disproven. These prices must be assessed before final conclusions about their

economic viability can be made. The product pnces used for the analysis wi!l depend on

the product mixes that small sawmill companies are, and will be, able to produce.

As explained in Chapter Two, access to raw material is a problem. Small sawmill

companies suffer fiom a lack of suitable timber both in size and quality, while large

companies are generally satisfied with the current availability ("Mechanical" 1996: 1 1).

The government has recognized these problems and, according to its 1997 report,

Development Plan for Estonian Forest Sector 1997-2000, has attempted to address them.

One of the plan's two objectives is:

To increase stability in the roundwood market and to secure the fimction- ing of the market mechanism in a manner which ensures the rational utilization of raw material, an increase in local processing volume and high value added of exported products (64).

In the above-mentioned development plan, the Estonian government states that it plans to

complement the current auction system with long-term supply contracts and sales by

assortmentss. If long term supply contracts and sales by assortments continue to consist

of large volumes, it IikeIy would continue to be difficult for small producers to secure a

roundwood supply fiom state forests for the same reason they cano t acquire expensive

equiprnent. However, if some roundwood is to be sold also in small volumes, by

assortment, access to raw material fiom state forests will improve for small operators.

The term "assortments" refers to roundwood that has been grouped together according to species, size and quality. This method enhances the value that can be extracted fiom the resource because high-value roundwood can be sold at a much higher price, if it is not mixed with roundwood of lower quality. It also makes it easier for small producers to purchase exactly the type of wood they need, without having to deal with excess wood that they would have to purchase and then sort through to £ïnd the specific material tley need.

47 But even if sales continue to be large, there may be other ways to alleviate this

problem. It may be possible to design a system where large assortments are sold to a

body (such as a producer cooperative) which then allocates the timber in small volumes

to individual companies according to their specific requirements. Organizational

structures of this nature exist in other countries, and the potential to adopt one, or part of

one, of these systerns will be explored in Chapter Five-

To be sure that the problerns relating to access to raw material are addressed, even

if methods of allocating state timber are changed, it would be preferabIe to estimate two

things. First, it would be usefid to estimate the total amount of raw material available

fiom state forests. State forests account for approximately 60% of the total timber

resources in the country that can be utilized by sawmills ("Prospects" 1998: 6). It is

stated that the m u a l allowable cut in state forests is approximately 3.5 million cubic

metres. Actuai harvesting rates have been far below this limit but have been increasing.

By 1996, the harvest rate had increased to 7040% of the AAC. It is expected that in the

next several years, the harvest rate will reach the AAC ("Development" 1997: 19). If this

expected trend occurs, then, combined with irnprovements to the allocative systems of

state timber, small sawmills will more easily obtain suficient quantities and types of

roundwood to meet their production needs. However, this will depend, in part, on what

happens to the demand for roundwood by the larger companies in the meantirne. Since

this analysis is based on world roundwood prices, then the potential effects of larger

companies acting like cartels, thereby strategically bidding up prices to discourage entry

48 of smaller fïrms, should be minimized. It would seem that there wouid be no reason, in

the long te=, for the large companies to bid the price up beyond the world market price.

This will depend, however, on whether the world market is depressed at the tirne, which

might give them more potential to go higher without hwting normal profits as much.

Further, it will also depend on how long the higher pnce has to be sustained. At the very

least, world price plus transport cost to Estonia, is the replacement cost for the small

sawmi11s and hence the limit on the domestic price.

Roundwood fiorn private forests has been, and will continue to be, an important

source of supply for small firms. As indicated in Table 3.2, as of 1995, private forests

constituted a major portion of their supply.

Table 3.2 SawmiIls9 Sources of Roundwood

Roundwood Source

Srare forests

Agricultural forests

Private forests

Imported fkom Russia

Other

Total

Production (%)

less than 5000m3

57.4

2.0

38.0

0.6

2.0

100.0

greater than 5000m3

68.0

1 -4

28.6

2.0

0.0

100.0

Source: "Mechanical" 1 9!

Total

61.5

1.8

34.5

1.2

1 .O

100.0

i: 11

In private forests, the actual harvest rate has been even farther below the sustainable

harvest level in state forests. In 1996, it was approximately one third of the sustainable

level ('Development" 1996: 19). However, the rate of harvest is increasing, in large part

because of the land restitution process. In the Developrnent Plan for Estonian Forest

Sector 1997-2001, it is stated that the legal restrictions on cutting volume on private land

wiI1 be abolished ("Devel~prnent~~ 1996: 58-9). It is hard to predict the Iong-term

ramifications of this deregdation, if in fact it has by now taken place. This move by

government is somewhat puzzling since the actual cutting rate is not yet close to this

level and there does not seem to be a good reason to abolish cutting limits. Further, it

wodd not be surprising if the EU reacts negatively to this change. If overcutting

eventually occurs, the long-term ramifications on roundwood supply might be in

question. Whatever the final outcome, the effect of the land restitution process (which is

now mostly complete) is a potential increase in supply of pnvate roundwood. This may

be beneficial to smaii sawrnill companies d e s s large companies ultimately buy up most

of the forested private land.

The conthuing trend of pnvate land purchase by large forest companies could

hinder improvements in roundwood supply to small sawrnills to some extent. However, if

smali sawmills are able to work together to purchase private land, it is unlikely that this

trend could entirely offset the vast increase in land area that is to be ultimately pnvatized

through the land restitution process. (One cooperative option is explored in Chapter

Five.) Moreover, the expansion in overall harvest rates in private and public forests, as

50 well as improvements to the ailocation of public timber, could also counter this trend.

This gain in supply for small companies, in combination with the potentiai improvements

to the system of state forest sales, means that access to raw material by srnail sawmill

companies codd improve to the point that it wiIl cease to be a problem. If this occurs,

then the assessrnent of viability assumes that smail sawmillers are pnce takers and

purchase prices of raw materials reflect their economic value.

3.3. Labour

Assessrnent

Several reports on Estonia's forest industry suggest that one of the main reasons

that Estonian sawmills in general are able to succeed is that their wage rates and salaries

are relatively low compared to other European countries ("Review" 1996: 22). However,

wages are rising and the following sections examine reasons for, and the possible extent

of, this trend, as well as the implications that increasing wage rates may have.

Table 3.1 illustrates that wages and salaries in Finland are much higher than in

Estonia, and even with higher overall operating costs, make up approximateiy 11% of

total operating costs in Finland. Table 3.1 shows that in 1995 labour costs were only

about 4.5% of total operating costs for large sawmills in Estonia. Given that srnall

sawmills are much more labour intensive than large ones, and we therefore double this

51 portion of costs to 9%, then changes in labour unit costs may have significant influence

on the viabüity of small sawmills. An assessment of labour costs requires an

examination of changes in wage rates (fiom both a regional and national perspective) and

labour productivity (influenced by the efficiency of rnachinery as well as quaiity of

labour).

From a national perspective, an estimation of wage rate increases might be

relatively straightforward if it is assumed that wage rates will eventually rise until they

are comparable to those in Western Europe. However, it is quite unlikely that complete

convergence will occur, at least not for some t h e . Even within the EU, labour mobility is

limited. Fevre States that ". . .the fact that so few EU citizens migrate within Europe in

search of jobs undemines the EC's arguments about the relationship between migration

and economic development as well as the relationship between migration and social

exclusion" (Fevre 1998: 87). Estonia has, however, started fiom a position of very low

wages which are rising. Part of the reason for this rise is the gradual convergence of

output prices. This will continue to put upward pressure on wage rates, but the limited

mobility of labour, combined with Estonia's general economic conditions will counteract

this upward pressure to some extent.

One must also consider that the regions are already compe