Rural Non Farm Enterprises in Ethiopia: Challenges and Prospects 1

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1 Rural Non Farm Enterprises in Ethiopia: Challenges and Prospects 1 Briefing note prepared for the DFID funded study Understanding the constraints to continued rapid growth in Ethiopia: the role of agriculture. 2 The views expressed in this note are those of the author and are not necessarily representative of DFID. Bob Rijkers, Africa Region, World Bank Mans Söderbom, Department of Economics, University of Gothenburg Francis Teal, Department of Economics, University of Oxford Aim & Scope This note assesses the potential of rural non farm enterprises to foster growth in rural Ethiopia, paying special attention to the interaction between the rural non farm sector and agriculture. The findings presented in this note are based on analysis of the 2006/2007 Rural Investment Climate Survey (RICS). The RICS comprised the RICS Agricultural Sample Survey, a matched householdenterprise survey representative of the four major regions of Ethiopia, i.e. Tigray, Oromia, Southern Nations, Nationalities, and Peoples (SNNP) and Amhara regions, thus covering 90% of Ethiopia s population. The RICS also contained an in depth, matched household enterprise community survey of the Amhara region, the RICS AgSS. The statistics presented in this note are computed using the RICS AgSS unless indicated otherwise. Statistics computed using the RICS Amhara is indicated with an A. The note is organized as follows: the next section assesses the current contribution of rural non farm enterprises to income and employment in Ethiopia, while the third section analyses the determinants of participation in the non farm enterprise sector. Linkages between agriculture and the non farm enterprise sector are reviewed in the fourth section. The fifth section examines whether reducing market fragmentation, the key obstacle to improving the performance of nonfarm enterprises, can spur growth by comparing the performance of rural non farm enterprises with that of urban microenterprises, which are operating in better integrated markets. The note ends with a summary of the key policy takeaways. Contributions to Income and Employment The non farm enterprise sector makes considerable contributions to rural income and participation rates are rising. Approximately 25% of all households in rural Ethiopia own one or more non farm enterprises. Participation rates are highest in Tigray and lowest in Amhara. Despite high participation rates, very few (about 2%) of all households rely exclusively on non farm enterprise activity. Though it is difficult to measure enterprise profits and household income precisely, our estimates suggest that non farm enterprise profits on average account for approximately 38% of total household income for those households which run a non farm firm. Comparison of the three 1 This note draws heavily on Bob Rijkers doctoral dissertation. 2 Study coordinated by a team consisting of Stefan Dercon, Ruth Vargas Hill and Andrew Zeitlin.

2 most recent Welfare Monitoring Surveys suggests that participation in the sector is growing rapidly. However, existing firms appear stagnant and do not expand their workforce (see below). Non farm enterprises provide self employment opportunities, yet virtually no wage labour opportunities. Almost all non farm firms are small and own very little capital; the median capital stock is roughly 194 Birr (approximately 21 USD). The overwhelming majority of enterprises are one person enterprises and fewer than 1% of all enterprises employ more than 3 workers. In Amhara only 3% of all enterprises hire workers. A The most prominent non farm enterprise activities are trading and wholesale, closely followed by manufacturing and services. While the miniscule scale at which enterprises operate is striking, enterprises do not seem to operate at a sub optimal scale. Since the production technology of non farm firms exhibits constant returns to scale, there are no unexploited scale economies (at least not at the scale at which rural non farm enterprises operate). Furthermore, the returns to capital are highest at the lowest levels of the capital stock, which contradicts the idea that non convex production technologies and credit market imperfections generate poverty traps. If this would be the case, the returns to capital would be lowest at the lowest levels of the capital stock. Firms are stagnant. Even though the returns to capital are high at the margin, very few firms invest or expand their workforce; no more than 8% of all firms have increased the number of employees and only 30% have increased the total number of labour days used during the year since startup. A mere 19% of firms have re invested since they started. The lack of investment is due to the high risk environment that entrepreneurs face, the high cost of capital in rural areas, and precipitously diminishing returns to capital. The likelihood of investing falls as uncertainty proxied by the variability in agricultural performance induced by rainfall volatility increases. Investment is also negatively correlated with the household s ability to access emergency finance, suggesting that households with better insurance and/or access to credit are more likely to invest. Moreover, markets are small and localized. For example, more than 90% of entrepreneurs walk to the market and very few firms sell to customers outside their own community. As a result of prohibitively high transaction costs, most firms are local monopolists and even if they are not, they have substantial market power, further limiting their incentives to invest. Enterprise activity is worthwhile when other opportunities are lacking. The returns to running a nonfarm firm are very low; on average about 5.6 Birr per day, and even lower for enterprises managed by women. These marginal returns are much lower than the going wage rate for casual workers. In Amhara, the wage rate for casual agricultural labourers is approximately 7 Birr for women and 10 Birr for men. A Yet, wage labour opportunities are very scarce: combining primary and secondary employment 11% of the working age population in Amhara ever works for a wage. A In addition, enterprise activity is highly countercyclical with agriculture, which suggests that non farm enterprise activities are most appealing when the opportunity cost of labour is low. While virtually all enterprises are not very profitable, there is tremendous heterogeneity in enterprise performance both across and within locations, which is indicative of market fragmentation. Enterprises located in rural towns are almost twice as profitable as enterprises located in very remote rural areas. Enterprise sales are also strongly correlated with the agricultural performance of local and adjacent communities. The reason appears to be that demand for nonfarm products is much higher when agricultural performance is strong. Improved agricultural 2

3 performance might also induce price effects, but our tentative evidence suggests that these are modest. In addition, enterprises engaging in trading or wholesale activities are the most profitable perhaps reflecting the existence of arbitrage opportunities while those engaging in manufacturing activities are the least productive. Finally, enterprise productivity is about 50% higher when the manager is a man,a even after controlling for activity choice, capital intensity and other differences between enterprises managed by men and women. Better educated managers operate more productive enterprises, yet the association between education and the manager s education is negligible at the lowest levels of education. Market fragmentation seems to be the most important constraint hampering the performance of non farm enterprises. This is borne out by the impressions of firm managers, who consider a lack of demand, transport and inadequate access to credit their most important problems. Market fragmentation limits demand and helps explain the heterogeneity in the returns to capital and labour, as well as why firms do not invest and expand. In short, the rural non farm sector is not a catalyst of growth, but rather provides income earnings opportunities to those lacking alternative options. While non farm enterprises make an important contribution to rural income and employment, running a non farm enterprise is predominantly a means to complement income rather than a pathway out of poverty. Who Participates? Enterprise activity is more prevalent in rural towns, especially important for women, and not an income risk mitigation strategy. Non farm enterprise activity is highest in rural towns and lowest in remote rural areas. Proximity to markets and roads is also a strong predictor of participation. The association between proximity and participation is strongly non linear since participation rates fall at a diminishing rate as the distance to the nearest road increases. Employment in non farm enterprises is particularly important for women, who seem to lack alternative income generating opportunities. Female headed households are more than twice as likely to run a non farm firm than male headed ones. Participation is furthermore positively correlated with the number of adult women in the household even after controlling for the gender of the household head. High female participation despite substantially lower returns attests to the underprivileged position of women in the Ethiopian labour market. Quite surprisingly, enterprise activity is not more common in areas with higher rainfall uncertainty and unresponsive to flood and drought shocks, suggesting that diversification into non farm enterprise activity is not used to mitigate income risk (either ex ante or ex post). The reason is probably that enterprise performance covaries with agricultural performance, thereby limiting the insurance function that non farm enterprises can fulfil: since markets are geographically concentrated diversification into non farm activity cannot provide insurance against covariate agricultural shocks. Linkages with agriculture Agricultural performance impacts the demand for non farm products and the incentives to invest in non farm enterprises. As alluded to above, non farm enterprise performance depends strongly on the performance of the non farm sector; increased agricultural income leads to a higher the demand for non farm products, presumably reinforced by Engel effects. More research is needed to substantiate the notion that improved agricultural performance would have price impacts. In 3

4 addition, uncertainty regarding agricultural performance limits incentives to invest, at least in the short run. Moreover, income from agricultural activities is the most important force of startup capital for the overwhelming majority of entrepreneurs. Since, very few enterprises invest, startup capital is a strong determinant of future profitability. Non farm enterprise activity does not drastically reduce the supply of labour to agricultural activities. Non farm enterprise activity is much lower during the peak agricultural season, reflecting household labour allocation decisions to prioritize agriculture (as most labour input is unpaid). Conversely, the non farm enterprise sector does not seem to suffer a labour shortage; the low marginal productivity of labour in combination with the fact that very few enterprises hire workers suggests that supplying more labour to (existing) non farm enterprises might simply not be worthwhile at the margin. If anything, the non farm sector absorbs labour that cannot be gainfully employed elsewhere, rather than pulling people away from agricultural activities. The impact of the agricultural sector on wages for non farm enterprise employees seems small (and vice versa). Unfortunately, our ability to meaningfully compare the wages of wage labourers in agriculture and wage workers in non farm enterprises is severely hampered by very small sample sizes. Yet, the wages for the small minority of workers who are employed in non farm enterprises are typically lower than the returns to casual wage labourers engaging in agricultural activities. Such wage labourers are typically only hired in the peak agricultural season, when the demand for labour is high, which may explain why they earn more. By contrast, the returns to running a non farm firm do not seem to vary over the course of the year (since the production function satisfies constant returns to scale). Agricultural work might also be better paid because it is more physically demanding or because it is dominated by men, who tend to be better paid than women, even if they do the same job. The fact that little exchange of labour takes place in rural areas might also explain why wages for non farm employees are lower than those for farm workers The Benefits of Market Integration: A Rural Urban Comparison To examine whether promoting market integration would enhance productivity and stimulate firm growth we compare the performance of rural non farm manufacturing enterprises with manufacturing enterprises in rural towns and in major urban centers, where markets are better integrated. Though urban firms are much larger than rural firms on average, the focus is on comparing microenterprises since these constitute the most appropriate comparison group. Also, an exclusive focus on manufacturing enterprises minimizes differences due to sectoral affiliation, though urban enterprises produce a much broader range of products than rural ones. Urban enterprises produce much more output per worker than rural non farm enterprises, but use the same technology. Labour productivity in urban microenterprises is much higher than labour productivity in rural non farm enterprises. Urban enterprises are also more capital intensive, have a better educated workforce and are less reliant on household labour. In addition, they do not exhibit seasonality. The urban investment climate differs from the rural one; urban enterprises typically have much better access to credit; urban infrastructure is far superior to that in rural areas and competitive pressure is higher in urban centers. While these differences affect factor intensity and size, we could not reject the hypothesis that urban and rural firms use the same technology. 4

5 The returns to market integration are positive and diminishing. Total Factor Productivity of non farm enterprises located in rural towns is on a par with TFP of enterprises located in major urban centers, but much higher than that of rural enterprises in remote areas. Average TFP of enterprises located in remote rural areas is approximately 50 60% lower than the TFP of enterprises located in rural towns and urban centers. The higher labour productivity of urban enterprises relative to those in rural towns is thus largely driven by their higher capital intensity. The dynamic performance of urban microenterprises is superior to that of rural ones. While enterprises in rural towns are as productive as those in major urban centers, their average growth rate is 0% while that of enterprises in remote rural areas is 1%. By contrast, urban microenterprises grow 5% per year on average. Investment rates are also higher in urban areas. Promoting market integration through the formation of market towns is a particularly promising policy option but may not suffice to catalyse sustained growth. Since the returns to market integration seem to be highest at the lowest levels of market integration, promoting market towns might be a good way to enhance the productivity of the non farm sector. However, the disappointing dynamic performance of rural non farm enterprises suggests that rural towns themselves might need to be better integrated into the economy as a whole to foster sustained growth. More generally, the results from the rural urban comparison suggest that non agricultural growth is most likely to be led by urban enterprises, which exhibit much higher growth rates than rural firms. Policy Takeaways The rural non farm enterprise sector is unlikely to be the major engine of rural growth in the shortrun. Rural non farm enterprises do not grow, even though increased participation suggests the nonfarm enterprise sector is a progressively important source of income and employment, especially for women and those lacking other income earnings options. Non agricultural growth is most likely to be led by urban firms. Given the low rate of urbanization and the strong dependence of the Ethiopian population on agriculture, improving agricultural performance is essential to stimulate rural growth. Increased agricultural productivity would not only benefit the vast majority of rural households by boosting their incomes, but also benefit the non farm enterprise sector by raising the demand for non farm goods and encouraging factor accumulation. Market integration and improving the investment climate would improve the performance of the rural non farm enterprise sector and stimulate enterprise growth. The rural urban comparison suggests that market integration is an essential enabler for enterprise growth. Market integration can be enhanced through improvement of transport and information systems, increasing competition and removal of market failures in credit and insurance markets. The promotion of market towns seems a particularly promising means of fostering market integration, yet may not lead to sustainable growth unless it would accompanied by policies that would promote trade with other market towns and urban areas. Such trade would improve the performance of the non farm sector by allowing enterprises access to larger markets and cheaper inputs as well as by enhancing competitive pressure. Where possible, policymakers should capitalize on the complementarities between agriculture and the non farm enterprise sector. It is likely that policy reforms that benefit non farm enterprises also 5

6 benefit the agricultural sector and vice versa. Better access to credit, upgraded transport facilities and improved insurance, for example, would benefit farmers and entrepreneurs alike. Moreover, enhanced agricultural performance is likely to stimulate the performance of non farm enterprises, while improved off farm performance might stimulate agricultural growth, by acting as a pull factor. Disclaimer: The findings, interpretations, and conclusions expressed in this note are entirely our own. They should not be associated with the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. All errors are our own. 6