SME-FDI linkages

Written by fe Bureau | Updated: Oct 28 2011, 08:16am hrs
Can foreign direct investment (FDI) be used to promote small industries In theory the potential is huge and depends on the linkages between small domestic firms and foreign direct investors, whether transnational corporations or other smaller firms, points out a recent Unctad study.

Titled How to Create and Benefit from FDI-SME Linkages, the study discusses best policy practices for attracting and benefitting from FDI in line with national development strategies. It draws lessons from the Malaysian and Singapore experiences, and notes that the linkages can take different forms, including backward, forward or horizontal. Backward linkages happen when foreign firms buy goods or services from domestic firms, and forward linkages when foreign firms sell goods or services to domestic firms. Horizontal linkages on the other hand happen during interactions between foreign and domestic firms engaged in competing or complementary activities.

The linkages benefit both parties. Foreign firms gain from reduced transaction costs, greater flexibility in operations and local adaptations, while help foster greater corporate responsibility. The small firms gain from increased local market opportunities, improved management skills, new technologies and improved access to inputs and markets. The host economy also gains by substituting imports with local products and from the spillover effects in the economy generated by stronger firms.

However, the benefits that stronger small enterprises provide the local economy is not automatic and a lot would depend on the macro environment. In fact, the spillovers from the linkages depend on many other factors, especially the technological and managerial capabilities of the local firms and also by the presence or absence of foreign suppliers in the domestic economy.

Another factor that has a crucial role in the spillover effects is government policy. While foreign investors may have some interest in promoting local linkages the actual impact is influenced by government policies that address market failures at various levels of linkage formation.

In fact, Unctad had identified two crucial areas in developing FDI-SME linkages as early as 2006. One major factor is the country's capacity to attract FDI. The second factor is the domestic firms' ability to build linkages and assimilate the knowledge and technology the linkages provide. An environment that provides adequate personnel with management and technical skills is very conducive to build stronger linkages. The availability and quality of the basic infrastructure also plays a crucial role.

The study, which culls the best practices for benefitting from foreign investments, assesses both public and private sector factors, including the way they interrelate. For a host country, the major public sector factors are the efforts to attract FDI, government objectives, policies and programmes. The primary private sector actors are the foreign affiliates themselves and their network with transnationals (TNCs) and domestic SMEs. Other constituents like business associations, universities, research centres and mixed private-public partnerships also play a crucial role in facilitating linkages.

By analysing the interactive effects of both government and private sector players in Malaysia and Singapore, the study provides useful insights on how different policy and programme options yield the best results. The study, thus, helps identify strategic policy choices for government and business that generate the most effective outcomes to benefit domestic SMEs, TNCs and the host country economy.

Though the promotion of strong linkages between foreign affiliates and domestic SMEs is a positive step and is also a politically attractive goal for both foreign investors and host governments, implementing such a programme is far from easy as the outcome of such policies is rather uncertain while the cost of assisting so many firms of diverse quality and commitments is often very prohibitive.

In the case of Malaysia, which pursued several development strategies that attracted different types of FDI, the initial SME programmes were largely focused on socio-economic goals, which sometimes restricted FDI operations as well as SME sector growth. However, later Malaysian policies shifted to SME programmes specifically designed to support FDI-SME linkages. In Singapore, early reliance on FDI was accompanied by programmes to assist certain SMEs to develop international capabilities. The large FDI presence in Singapore provided ample opportunities to forge beneficial linkages with SMEs, first through supplier relationships and then later though more international outreach.

However the Unctad study cautions that the case experiences of these two countries can only provide insights and are not a recipe that other countries can blindly follow. Individual country strategies will have to depend on realistic self-assessments of the countrys economic conditions and the FDI climate that will help tune the chosen goals.

The primary role of national governments will be to invest in basic infrastructure and human capital to improve conditions for both local entrepreneurs and foreign investors. Programmes that help overcome start-up obstacles, spur increased technical capacity, and support international market outreach can also help. FDI-SME linkages will also be boosted by initial training and mentoring, expanding, upgrading SME supplier capabilities, providing foreign market endorsements and channels for international sales.

The effectiveness of such interventions would be very much dependent on the governments' capacity to effectively design and execute promotion programmes. Sometimes it would also be appropriate to provide financial and other support for SMEs as also some targeted incentives for FDI to remove the initial barriers to FDI-SME linkages. However, SME growth can also be boosted by reducing the transaction costs of small business. Larger governments, which boost FDI-SME linkages, will encourage entrepreneurial innovation, provide opportunities for commercial operations and exploit the untapped reserves in the SME sector.