The Internationalization of SMEs in Regional and Global Value Chains

Current State of SMEs in Southeast Asia

Before exploring what policies can facilitate the internationalization of SMEs in Southeast Asia, it is useful to first examine the sector's characteristics to get a sense of the present and potential capabilities, as well as the constraints that are present. This, however, is a tricky task given the following factors: 1) a lack of timely and comprehensive information about SMEs due to a structural weakness in statistical service in many developing countries, 2) the wide differences in economic structures and levels of development in the region, and 3) differences in countries' definitions of SMEs.

Roles and Characteristics

With its massive size, the SME sector forms the backbone of Southeast Asia's economy. It accounts for a majority (more than 90%) of the number of all private-sector firms (Asasen, Asasen, and Chuangcham 2003) and employs a considerable proportion of the domestic workforce in each country (40–90%). Thus, it is not surprising that Southeast Asia's SMEs play a significant economic role, albeit to varying extents (see Table 2). They make a substantial contribution to employment (about 40–90%) and exports (more than 25%), and play different dynamic roles that drive economic growth and industrial development (Wengel and Rodriguez 2006). For example, SMEs in Singapore provide a flexible skilled production base that attracts MNEs; while in Viet Nam SMEs and rural enterprises were instrumental in the transition process from a planned to market economy.

Southeast Asia's SMEs pervade virtually all socio-economic activities and services across urban and rural-urban areas. But there is much variation in their sectoral composition. While SMEs have an overwhelming presence in the Malaysian service sector, they are strongly represented in agriculture in Indonesia, food, beverage, and tobacco in Cambodia, and wholesale and retail trade in the Philippines (Table 2).

Given the trends of rising globalization and economic integration in the Asian region, there is significant potential for the SME sector to increase its contribution to the region's development through greater participation in global value chains (GVCs). There are, however, some characteristics that are generally shared among SMEs in Southeast Asia that limit their ability to do so.

Entrepreneurism

There is a shortage of a sustainable entrepreneurial drive in the sector. This can be attributed to a weak culture of innovation, and in the high growth Asian economies an over-reliance on technologies brought in by MNCs. Entrepreneurship capabilities are crucial for SMEs to maximize their inherent comparative advantages gained from operating on a small scale, such as the flexibility to adapt to changing market demands.

Level of Expertise

The SME sector's development is also constrained by a lack of skill and expertise in organization and management, which are important for enterprises' efficiency, flexibility, and competitiveness (Asasen, Asasen, and Chuangcham 2003). The need for competent, contemporary management is compounded by the fact that drastic economic and technological developments have created new, modern ways of production and service delivery.

Related to this issue is information communication technology (ICT) capability. Although there have been no comprehensive studies done on the extent of adoption of ICT in the SME sector in Southeast Asia, preliminary data suggest that a huge number of SMEs in Southeast Asia have yet to establish an online presence and networking facilities (Asasen, Asasen, and Chuangcham 2003). This can be partly attributed to a lack of awareness and know-how and limited access to ICT infrastructure, hardware, and software.

Networking

There has been minimal clustering and network forming among SMEs, activities that, as many scholars agree, can help small firms overcome some of the barriers they commonly face, such as difficult access to information, markets, and inputs (Giuliani, Pietrobelli, and Raboletti 2005). This may be due to an inward-looking mentality that is typical among the family enterprises that account for a large proportion of the sector. To illustrate, more than 90% of SMEs in Cambodia are single proprietorship businesses, owned by an individual or family (Baily 2007). In Malaysia, micro-establishments represent 79.4% of SMEs (Normah 2006). Linkages also require fundamental shifts in business strategies that SMEs may not be able to achieve because of a lack of resources and knowledge.

Access to Finance

SMEs in most Southeast Asian economies have been having difficulty gaining access to finance for a long time. This can be attributed to imperfections in the financial markets and a lack of critical primary and secondary markets such as those for SME equity and bond financing. The formal banking sector remains the dominant source of credit for local businesses in the region. Worsening the problem, the current economic crisis has increased risk aversion and decreased liquidity. In response, governments have made substantial efforts to allocate formal-sector resources to support SMEs through measures such as subsidies and safeguarding banks. However, success has been spotty. Thus, SMEs are still struggling to secure long-term bank loans, working capital and bridge financing.

4.1 The Process of SME Integration into Global Value Chains

This section examines the three main frameworks that researchers have used to understand how firms internationalize and the consequent implications on government policy for SMEs. This will help shed light on the relevant motivating factors for these trends. Although the frameworks define internationalization as the process in which firms increase their involvements in overseas operations, the focus here is on SMEs and their participation in GVCs.

GVCs are evolving tiered structures. The main role is played by a lead firm that manufactures the final product. This firm is supported by a small number of preferred first tier suppliers, which are also supported by other suppliers, and so on, forming a tiered structure (Figure 7 [ PDF 14KB | 1 page ]). It is generally easier to enter a network as a lower-tier supplier. But this position tends to be unstable as other suppliers can easily replace the original supplier by offering better comparative advantages such as lower costs (Abonyi 2005). Therefore the challenge for SMEs is not only to try to enter GVCs, but to move up the tiers by increasing the value content of their activities.

Admittedly, the frameworks presented below are theoretical and distinct. However, all of them have found some empirical evidence in past studies (see, for example, Lloyd-Reason et al. 2005; Etemad and Wright 2003), suggesting that harmonizing the different approaches instead of viewing them as contradictory can help guide analyses of SME internationalization. Indeed, the theories seem to be interrelated. They all state that knowledge of foreign markets is a fundamental driver of overseas expansion, although they attribute the acquisition of it to different sources.

4.2 The Stage Approach

According to the stage model, internationalization can be seen as an incremental process where different stages follow each other in a logical order (Luostarinen 1994). The assumption is that a firm's knowledge about foreign markets and commitment to expanding overseas will consequently affect its business decisions and activities. As a firm's international involvement increases, so does its overseas knowledge and commitment, thus starting an expansionary cycle. The process has been described as “a gradual acquisition, integration and use of knowledge about foreign markets and operations and a successively increasing commitment to foreign markets” (Johanson and Vahine 1977: 36).

Governments can therefore play a critical “triggering” role by enacting policies to boost SMEs' knowledge of overseas markets and their commitment to expanding abroad. This can be done by providing information services and raising awareness about the benefits of internationalization, for instance. Once enterprises have branched out beyond national boundaries, the process is likely to gain momentum on its own. It then becomes more important for the government to play the role of facilitator, for instance by helping reduce entry barriers and lowering the cost of international expansion.

With rapid technological advancement and globalization, there has emerged evidence that the internationalization process is accelerating—a phenomenon the stage approach is inadequate in explaining. Though small, there have even been an increasing number of ventures that are global at start-up (Oviatt and McDougall 1997). This phenomenon is better explained by the following two models.

4.3 The Network Approach

Proponents of the network approach view internationalization as a natural development resulting from the process of establishing, improving, maintaining, and dissolving relationships with individuals and firms (Johansson and Mattson 1988). A firm's network of both local and overseas relationships is seen as a crucial form of capital as it can create trust, raise access to information, and increase the firm's ability to mobilize resources. As firms internationalize, the number and strength of relationships in their network increases, bringing more benefits and helping them integrate further into GVCs.

In line with this theory, studies have found that SMEs rely heavily on their networks for many activities when internationalizing, particularly in obtaining market knowledge and looking for opportunities (Mohibul and Fernandez 2008). Thus, a firm that wants to internationalize must first understand the market in which it operates—the environmental conditions and business relationships (Madsen and Servais 1997)—before finding ways to strengthen and utilize its network.

Facilitating the formation of relationships and linkages within local firms and between local and foreign firms should therefore be an essential component of policies helping SMEs internationalize. The government can, for example, assist SMEs in identifying foreign business partners.

4.4 International Entrepreneurship Theory

International entrepreneurship theory (IET) states that the basis for a firm's internationalization is international entrepreneurship, which is defined as the discovery, enactment, evaluation, and exploitation of opportunities across national borders to create future goods and services (Oviatt and McDougall 2005). Discovery refers to finding opportunities. Enactment entails seizing opportunities and acquiring a competitive advantage, and evaluation is used to assess the actions taken.

This framework is especially relevant in the current age of technology, where SMEs can make use of cheap and easy ways of getting information and communicating with other countries to help them expand their activities abroad. The approach is also useful in understanding international new ventures, which from inception strive to build competitive advantage from the use of their resources and the sale of outputs in various countries (Oviatt and McDougall 1994) and therefore defy the traditional stage theories of internationalization.

Research on IET suggests that the entrepreneurial qualities of SME leaders are key to a firm's internationalization, particularly in the early phases (Etemad and Wright 2003). However, as the business expands further, it gains more knowledge and expertise, and so the characteristics of the enterprise begin to exert more influence. Government policies aimed at helping SMEs internationalize should thus include the promotion of entrepreneurism, as well as encouraging and helping SMEs explore the usages and opportunities of technology.

4.5 Fostering Local Firms and Entrepreneurs

How to foster local firms and local entrepreneurs in the competitive environment is a big concern for developing countries. In the past, direct or indirect protection for local firms was taken for granted as part of the infant industry protection argument. But now in the globalization era, local firms must compete with gigantic MNEs in the open market from the beginning. Determining what sort of industrial policies or SME policies would be justifiable is one of the most controversial topics among development economists.

SMEs play pivotal roles in the functioning of international production networks and economic agglomeration. There are certainly ways to foster local firms or SMEs by utilizing globalizing forces.

There is evidence that local firms are participating in production and distribution networks, particularly in machinery industries. An empirical study of Thailand, based on an industrial survey, obtained interesting research findings. First, between MNEs and SMEs there have been positive spillovers and linkage effects in the machinery industry, but not in other industries so far. Second, the impact of trade liberalization differs from industry to industry. Trade liberalization has increased productivity in the machinery industry and labor-intensive industries. Third local firms in machinery industry in particular have received the largest benefits from trade liberalization.

Another example of the link between MNEs and local firms can be found in Penang, Malaysia. In Penang, many indigenous enterprises have developed through linkages with foreign electronics companies. Indigenous enterprises are participating in producing not only parts and components but also industrial equipment. Foreign assemblers operating in Thailand are also gradually outsourcing to indigenous suppliers. Most of the indigenous enterprises that have linked with MNEs are SMEs. Some of them have succeeded in the global market place, serving customers in Asia and Pacific region and worldwide.

Economic integration has provided business opportunities not just in production and distribution networks, but also in capturing enlarged markets. For example, a Malaysian electrical appliance firm is expanding OEM production outsourced from MNEs and in the process of increasing production of OEM, the firm is able to expand to integrated ASEAN market. It is notable in agricultural products, including food and beverage, that ASEAN enterprises have shown a big presence. A Philippine food and beverage industry firm has expanded its business to overseas in Australia, PRC, Indonesia, and Viet Nam. A leading Thai agro-based company expanded its business into Cambodia, PRC, India, Indonesia, Malaysia, Myanmar, Singapore, Viet Nam, and other countries.

Such indigenous enterprises have succeeded in establishing linkages with MNEs and thus have expanded their businesses in the integrated global market.

Prior to the Asian financial crisis in 1997, rapid and dynamic economic growth in East Asia was facilitated through market-driven forces. Various regional economic cooperation initiatives and schemes were introduced, including an agreement on the ASEAN Free Trade Area (AFTA) in 1992 that came into full operation by the end of 2003. However, in the past the impact of ASEAN-initiated regional cooperation was negligible because ASEAN economies were basically competing in the same product range and their main export markets were to non-ASEAN countries. Recently, however, there is clear evidence to indicate that the impact of AFTA has encouraged production networking in Thailand, Viet Nam, and other ASEAN economies on some intermediate and consumer goods. Some economists claimed that de facto economic integration has proceeded in East Asia, even in the absence of effective implementation of AFTA and other regional bilateral trade and investment agreements. The nature and characteristics of de facto economic integration are important for policy discussion to understand how far integration has been realized and what sort of integration has been achieved so far. Understanding such fundamental issues would be helpful for policymakers to design regional and bilateral free trade agreements (FTAs) in order to facilitate and accelerate the development of regional production networks. The development of vertical production networks has certainly been supported by trade liberalization efforts. On the other hand, the trade regime in East Asia is still far from a single production base and a single market. Substantial barriers in service trade still remain in East Asia. The development of vertical production networks, as well as remaining trade barriers, affects the nature of the on-going process of de jure economic integration in East Asia.

It is vitally important to understand the extent of the influence of the GVC and de jure regional trade agreements (RTAs) on regional production networking. Global business corporations have extended their production, material, and resource sourcing and markets beyond their domestic economies. Because of the pressure of integration, competition, and Just-in-Time (JIT) production system, which is based on timely delivery of spare parts and component to minimize the inventory costs, East Asia is now fully connected into a GVC system in which it produces the world production output. The importance of production networking, clustering (agglomeration), and fragmentation must be factored in de facto regional FTAs. There are some studies related to the importance of this issue. A future study should examine specific trade and investment areas and sectors.

4.6 The Impact of Sub-regional and Bilateral FTAs on Production Networking

Economic integration in terms of production networking or value chains has not benefited much from formal RTAs. The basic weaknesses of the ASEAN Free Trade Area AFTA, ASEAN Economic Community (AEC), ASEAN Investment Area (AlA), and ASEAN Framework Agreement on Services (AFAS) are that there are too many exceptions on key sectors of ASEAN economies. Furthermore, the standardization and harmonization of rules and regulations has been inadequate. Transportation, infrastructure, and institutions to implement those trade and investment agreements are also absent or inadequate.

Production network and regional economic integration are accelerating in Southeast and Northeast Asia within the framework of GVCs and expanding production networks in East Asia. These trends are being driven by competition, the rise of the PRC and India, the political stability of the region relative to other regions, and the availability of productive labor forces and resources, all buttressed by individual countries' macroeconomic regimes and liberal trade and investment regimes that promote economic development.

Despite many distortions and inefficiencies in implementing ASEAN regional cooperation schemes, there are many cumulative positive effects on the rapidly emerging production networking and agglomeration of industry in East Asia. The clustering of the automobile and parts industry in Thailand, the clustering of the electronic industry in Malaysia, and the knowledge-based industry cluster in Singapore are cases in point. Indirectly, positive and business-friendly policies and institutional environments in Southeast Asian countries have contributed to the emergence of industrial clustering, agglomeration, and production. Further and enhanced efforts to accelerate and integrate existing agreements in goods, services, and investment are vitally important for ASEAN economies to meet the challenges and opportunities related to the rise of the PRC, India, and the accelerating trend of GVC development. In the case of Cambodia, Lao People's Democratic Republic (Lao PDR), Myanmar and Viet Nam (CLMV), these countries require development assistance in addition to ASEAN regional economic integration. Without adequate development assistance, trade and investment liberalization would not be sufficient for these countries, perhaps with the exception of Viet Nam, to benefit from the emerging production networking and industrial clustering in Southeast Asia.

Economic integration through regional and bilateral FTAs can enhance regional production networking if policymakers can minimize the distortions related to regional and bilateral FTAs in East Asia. Since 2000, bilateral FTAs and sub-region FTAs have proliferated throughout East Asia. These bilateral FTAs are based on reciprocal preferential tariff schemes. Both parties choose their own sensitive list. This implies that, for example, the ASEAN-PRC FTA (ACFTA) is counted as 10 separate bilateral FTAs between PRC and the 10 ASEAN countries. The degree of market access faced by an ASEAN exporter varies according to the ASEAN destination markets. This means that there are 45 bilateral preferential trade relationships within 10 ASEAN countries. In the same way, the ASEAN-Japan FTA, ASEAN-Korea FTA, and ASEAN-India FTA are each 10 separate bilateral FTAs. ASEAN-CER (Closer Economic Relation of Australia and New Zealand) constitutes 20 bilateral FTAs. In total, 105 ASEAN FTAs are enforced and/or under negotiation. Any ASEAN exporter faces different preferential treatments based on destinations. Baldwin (2006) has called the overlapping FTA problem the East Asian "noodle bowl syndrome". Potentially, 16 countries would produce 120 bilateral FTAs in the region.

Different FTA strategies by individual countries may create severe overlapping FTA problems. Because of the different FTA strategies taken by each country, there is much heterogeneity in exclusion lists, tariff rates, rules of origin (RoO), dispute settlement mechanisms, mutual recognition, competition policy, and other norms and regulation among existing multilateral FTAs in Asia. The overlapping FTAs can complicate tariff rates and RoO for the same products, according to the destination. It is commonly agree that the costs arising from the RoO are expected to increase substantially when there are overlapped FTAs and RTAs.

Other than a lack of FTA, there are other crucial impediments to East Asia's bilateralism. First of all, with the exception of a few countries, East Asia has failed to form high level FTAs in terms of trade liberalization. Typically, reduction in agricultural trade barriers is important for narrowing development gaps, however, agricultural products tend to be excluded from most Asian preferential tariff treatments.

Moreover, the bilateral FTAs in East Asia have addressed trade liberalization in goods, but liberalization in service trade has not progressed much.

As a result, economic integration in East Asia still remains "shallow". Benefits from integration are limited since there are many border-related barriers other than tariffs.

The policy environment for trade facilitation in East Asia varies considerably by country. For example, custom clearance time is quite different among countries. Custom procedures are still complicated and lack transparency in many East Asian countries. This means that the policy space to facilitate trade, or reduce trade costs, is very large. If trade facilitation measures such as simplification and harmonization of customs procedure, paperless trading, and mutual recognition are improved, they will reduce trade costs and expand production networks by a considerable extent.

The enhancement of logistic infrastructure system, including that of the institutional system, is an issue to be challenged by East Asian policymakers in order to realize deep integration, since it serves to facilitate trade and location of production. A study on cross-border trade facilitation for ASEAN countries by the Japan External Trade Organization (JETRO) (2006) finds that goods between Bangkok and Hanoi, for example, have been transported mainly by sea, which does not fit the JIT production operation prevailing in other parts of East Asia. The JETRO study suggests that if logistic infrastructure systems, such as road networks, transportation terminal facilities, and legal institutions, are developed and established, then the volume of trucking transportation would increase. In a different context, land transportation clusters and volume would increase between Singapore, Malaysia, and Thailand if the three countries would agree to standardize their long-haul trucking system to facilitate cross-border trade and the JIT production network among the three most developed ASEAN economies.

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