Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific No 2

ECONOMIC AND SOCIAL COMMISSION FOR ASIA AND THE PACIFIC

Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific No. 2

UNITED NATIONS New York, 2003

Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

ST/ESCAP/2322

UNITED NATIONS PUBLICATION Sales No. E.04.II.F.9 Copyright © United Nations 2003 All rights reserved Manufactured in Thailand ISBN: 92-1-120362-7 ISSN: 1729-9527

The Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific is published annually by the Economic and Social Commission for Asia and the Pacific. Any uncredited article or information in this Bulletin may be copied, summarized or translated into any language provided that acknowledgement of its use is made and a copy of the publication in which it appears is sent to the editor. However, permission must be received from the original author before use may be made of any article, picture, drawing, cartoon or other account for which credit is specifically given. The designations employed and the presentation of the material in this publication do not imply the expression of any opinion whatsoever on the part of the Secretariat of the United Nations concerning the legal status of any country, territory, city or area, or of its authorities, or concerning the delimitation of its frontiers or boundaries. On 1 July 1997, Hong Kong became Hong Kong, China. Mention of “Hong Kong” in the text refers to a date prior to 1 July 1997. The opinions, figures and estimates set forth in this publication are the responsibility of the individual authors, and should not necessarily be considered as reflecting the views or carrying the endorsement of the United Nations. Mention of firm names and commercial products does not imply the endorsement of the United Nations. Short articles and viewpoints on investment and enterprise development issues from readers are welcome. The editor reserves the right to edit and publish manuscripts in accordance with the editorial requirements of this publication. All correspondence should be addressed to: Chief Trade and Investment Division Economic and Social Commission for Asia and the Pacific (ESCAP) United Nations Building Rajadamnern Nok Avenue Bangkok 10200, Thailand

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CONTENTS

Page

Abbreviations ....................................................................................................................................... I.

SELECTED ISSUES ON PROMOTION AND ATTRACTION OF FOREIGN DIRECT INVESTMENT IN LEAST DEVELOPED COUNTRIES AND ECONOMIES IN TRANSITION ..........................................................................................

vi

1

– Marc Proksch Introduction ....................................................................................................................................

1

A.

Foreign direct investment: concepts and determinants ..........................................................

2

B.

Policy considerations for foreign direct investment attraction at the macro-level ..............................................................................................................................

5

Investment promotion and facilitation: issues and measures at the micro-level ...............................................................................................................................

9

Conclusions .............................................................................................................................

17

INSTITUTIONAL CAPACITY-BUILDING FOR SMALL AND MEDIUMSIZED ENTERPRISE PROMOTION AND DEVELOPMENT ...................................

19

C.

D.

II.

– Sailendra Narain A.

Status and contribution of SMEs in selected Asian countries and areas ...............................

19

B.

Challenges and prospects in capacity-building for SMEs ......................................................

23

C.

Institutions for SME promotion and development .................................................................

29

D.

Lessons learned and new framework for capacity-building of SMEs in developing countries ...............................................................................................................

35

Conclusions and recommendations .........................................................................................

40

E.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

CONTENTS

(continued)

Page

III.

SOCIAL ENTERPRISE: A FRONTIER FOR ALTERNATIVE ENTREPRENEURSHIP ..........................................................................................................

45

– Pak Po-Hi

iv

Introduction ....................................................................................................................................

45

A.

Social enterprise in context .....................................................................................................

45

B.

Social enterprise in snapshots .................................................................................................

46

C.

Sources of finance ...................................................................................................................

49

D.

Social enterprises versus other types of enterprises ...............................................................

50

E.

Conclusions: Why social enterprise? .....................................................................................

51

LIST OF TABLES

Page II.1.

Economic contribution of SMEs in selected economies ................................................................

20

II.2.

Share of SME exports in selected Asian countries ........................................................................

21

II.3.

Top 20 exporters, by technology category, 1985-2000 ...................................................................

22

II.4.

Impact of the 1997 financial crisis on East Asian firms ................................................................

24

LIST OF FIGURES II.1.

II.2.

Foreign direct investment flows as a percentage of gross fixed capital formation in developing Asia and the Pacific, among other areas, 1990-1999 ..............................................

26

Developing Asia and the Pacific: foreign direct investment inflows, top 20 economies, 1999-2000 .....................................................................................................................

27

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

ABBREVIATIONS

ADB

Asian Development Bank

AFTA

ASEAN Free Trade Area

AIA

ASEAN Investment Area

ASEAN

Association of Southeast Asian Nations (comprises Brunei Darussalam, Cambodia, Indonesia, the Lao People’s Democratic Republic, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Viet Nam).

B2B

business-to-business

B2C

business-to-consumer

BDS

business development services

BOI

Board of Investment

CIP

competitive industrial performance

DFI

development financial institutions

FDI

foreign direct investment

GDP

gross domestic product

HRD

human resources development

ILO

International Labour Organization

IMF

International Monetary Fund

IPA

investment promotion agency

IT

information technology

LDCs

least developed countries

M&A

mergers and acquisitions

MIDA

Malaysian Industrial Development Authority

MVA

manufacturing value added

NGOs

non-governmental organizations

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ABBREVIATIONS

(continued)

OECD

Organisation for Economic Co-operation and Development (comprises Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Republic of Korea, Spain, Sweden, Switzerland, Turkey, the United Kingdom of Great Britain and Northern Ireland and the United States of America)

R&D

research and development

RTAs

regional trading arrangements

SAARC

South Asian Association for Regional Cooperation (comprises Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka)

SMBA

Small and Medium Business Administration

SMEs

small and medium-sized enterprises

SSIs

small-scale industries

TNCs

transnational corporations

UNCTAD

United Nations Conference on Trade and Development

UNDP

United Nations Development Programme

UNIDO

United Nations Industrial Development Organization

WIPO

World Intellectual Property Organization

WTO

World Trade Organization

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I. SELECTED ISSUES ON PROMOTION AND ATTRACTION OF FOREIGN DIRECT INVESTMENT IN LEAST DEVELOPED COUNTRIES AND ECONOMIES IN TRANSITION Marc Proksch*

Introduction This paper deals with the promotion of foreign direct investment (FDI) in less and least developed economies and economies in transition. While many studies have been written on this subject, this brief paper stresses the need for creating and strengthening national competitive advantages as the central element of FDI-promotion and the main determinant for both inward and outward FDI. Once such advantages have been adequately developed, specific image-building and investment promotion strategies can be developed by competent institutions with the necessary legal and political support. While FDI can theoretically play a role in the building of national competitive advantages, country experiences have revealed that in the absence of such advantages, i.e., a clear product that a country can promote to attract FDI, FDI inflows to that country will be low and often motivated by factors other than profit, which is and remains the ultimate objective of all private sector businesses. The role of FDI in economic development has been debated at length and some consideration of the pros and cons is therefore necessary. However, in the context of less developed economies and economies in transition to a market economy in a world currently characterized by increasing integration of economies and increasing cross-border flows of capital, people, technology and other goods and services, foreign investment, if not a major pillar in a national development strategy, should at least be tolerated and exploited to the advantage of the economy as a whole. The argument will therefore not concentrate on whether FDI should be promoted

*

Economic Affairs Officer, Trade Policy Section, Trade and Investment Division, ESCAP.

or not. It is supposed that countries do welcome FDI as a fundamental contribution to the development process, though such a contribution should be evaluated in a wider context of policy reform and economic restructuring and development. Modalities for such promotion need further elaboration, however, as least developed countries (LDCs) and economies in transition have characteristics that distinguish them from other economies in the region and which may require adaptations in their policies and strategies to attract FDI. At the same time, these economies continue to differ considerably in terms of economic, political and cultural realities which would require a countryspecific approach as far as details of such policies and strategies are concerned. For obvious reasons, this would go beyond the scope of this paper. The main purpose is to outline those aspects and considerations which are relevant to any less developed economy in the promotion and attraction of FDI. This paper first discusses some definitions, concepts and determinants of FDI. While these determinants can be viewed both from the transnational corporation (TNC) which undertakes investment in the home country and the host country of TNC, the main concern is really with the host-country characteristics which can be identified on the basis of the current and potential development level of countries that wish to attract FDI. The linkage with overall economic development level serves to explain the nature, size and direction of FDI flows on the basis of which problems and obstacles can be identified and recommendations can be drafted. However, some knowledge of the considerations of investors in their investment decision is necessary to better understand the needs of foreign investors, and to accommodate these needs within the countries’ capabilities and policy priorities.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

Section B of the paper proceeds with a discussion of the fundamentals of attracting FDI. This involves the identification of a country’s competitive advantages. Without such advantages it would be unlikely that the country could effectively develop in a globalizing world or effectively attract FDI. It is a mistake to think that FDI can play a decisive role in shaping a country’s competitiveness. In contrast, it is the country’s competitiveness at the global level which defines what kind and level of FDI it can realistically expect to attract. Section C discusses in general terms the most important considerations for actively and effectively attracting, promoting and implementing FDI. While the discussion on competitiveness revolves around macro policies, the actual policies and strategies for attracting FDI discussed in this section are basically micro in nature and involve a discussion of the required legal and institutional framework, fundamentals of an investment promotion strategy and modalities for investment targeting. Some attention is also paid to the issues of monitoring and evaluation of FDI as well as postapproval (“after-care”) needs of foreign investors and issues related to investment implementation and facilitation. Section D ends with a summary of the major conclusions.

A. Foreign direct investment: concepts and determinants 1. Concepts and definitions The generally recognized definition of FDI used by UNCTAD in its World Investment Report series and based on OECD and IMF definitions is an investment involving a long-term relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate).1 FDI constitutes a

1

2

UNCTAD, World Investment Report, various issues (Geneva).

long-term engagement of foreigners who make investment in fixed assets with the purpose of establishing a production capacity to produce goods or provide services for sale at a profit. FDI implies that the foreign investor exerts a significant degree of influence on the management of the enterprise resident in the host economy. It is important to understand FDI for what it is, i.e., private foreign capital flows with management participation, and the modalities through which it takes place. Often, FDI is confused for a foreign investment which mainly involves portfolio investment in a foreign country but which does not involve management rights and the construction or purchase of immovable assets constituting production capacity. FDI therefore needs to be distinguished from such short-term “hot capital” which played a major role in triggering the Asian financial crisis in 1997. While foreign portfolio investment can be easily withdrawn, FDI is longterm in nature involving a commitment which cannot be easily terminated. While FDI typically consists of capital flows (which contribute to a host country’s generally scarce capital resources), it often contributes to the transfer of technology, skills, expertise and access to export markets in a convenient package and, as such, FDI is in great demand by most developing countries. Various types for FDI can be distinguished. 1. Greenfield investment: New equity capital investments and flows from abroad. This type of investment is usually the most desirable since it creates jobs in the host country; 2. Reinvested earnings: While not constituting a fresh capital inflow from abroad, this form of investment adds to the host country’s capital stock and assets and productive capacity (and possibly technology); 3. Intra-company loans: Capital flows from parent company (abroad) to subsidiary (in the investment locality) but must eventually be repaid with interest constituting larger capital outflows. This type of investment helps the foreign investor in financing his/her business and thereby enabling him/her to continue making a contribution to the national economy;

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

4. Mergers and acquisitions: This is the least desirable mode of FDI unless FDI was crucial to the success of the privatization of a loss-making public enterprise and provided fresh foreign capital, or in the case where the merger of a domestic company with a foreign company takes place on equal terms. Where a domestic firm fails, risking mass unemployment, acquisition by a foreign firm may be deemed desirable but from a development perspective this form of FDI is likely to make a limited contribution in the long run. Mergers by parent companies of leading global TNCs are outside the control of the host country where affiliates of both TNCs were operating before the merger and may lead to suppression of competition in the host country. 5. Non-equity forms of FDI: Subcontracting, licensing, franchising arrangements which do not necessarily involve capital flows from abroad but contribute to the development of the host country’s business sector. Different forms and modes of FDI are based on different considerations of investors and hence different determinants. While not providing a comprehensive overview, subsection 2 briefly discusses the main determinants of FDI, with particular focus on the specific characteristics of localities and countries which are considered by an investor as potential investment destinations.

2. Determinants of foreign direct investment What induces an investor, usually a company, in a particular country to invest in production in one or more other countries? Although this question has received wide attention in academic literature and other kinds of publications, a discussion once again in the context of this study cannot be avoided as: (a) determinants fluctuate constantly with ever-changing global economic conditions and economic and industrial structures in individual countries; (b) understanding determinants of FDI serves to thoroughly understand the size, nature and direction of investment flows, which is necessary to formulate meaningful recommendations; (c) determinants are often taken for granted, though they may differ among countries and even among TNCs; (d) new research findings shed new

light on and reveal new dimensions of motivations and factors leading to the internationalization of production; and (e) the increasing importance of particular modes for FDI are based on the realities of a rapidly integrating and globalizing world. Therefore, a renewed overview and categorization of FDI determinants will facilitate the formulation and implementation of investment promotion policies. Factors and conditions that are important determinants of inward FDI can be divided into two categories: (a) firm and industry-specific determinants; and (b) host-country specific determinants.2 Investor or firm-specific factors are those factors that induce the firm to invest abroad or at least offer an advantage or support for the internationalization of production, including firmspecific or owner-specific factors such as managerial skills, product differentiation, technological lead and know-how; large size and market power, marketing and organizational expertise, R&D capacity, among others.3 Typically, firms which have international exposure through export experience often engage in FDI to service the local markets better, although this does not apply to all products. Some products, after all, can only be provided through exports (e.g., Boeing aeroplanes) while others can be provided only through FDI (e.g., McDonald’s hamburgers). For the purpose of this paper, it is hostcountry-specific characteristics which are most important in the investment location decision for a foreign investor in a globalizing world. Not only countries, but locations within countries are selected for investment on the basis of various criteria. A company wishing to engage in FDI will examine alternative locations which result in a

2

While strictly speaking there is a third category of homecountry characteristics, knowledge of determinants falling in this category is not essential for economies in transition wishing to attract FDI though it would help in formulating policies to assist outward FDI. Those characteristics can also be translated in terms of a country’s status and level of national competitive advantage.

3

See Stephen H. Hymer, The International Operations of National Firms: A Study of Direct Investment (Cambridge, Mass., MIT Press, 1976) for a detailed discussion on firm-specific determinants.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

positive return on investment. What location will be chosen depends on the character of the would-be subsidiary. Either the subsidiary is set up to satisfy local market demand or is established to export back to the home country or to other markets. Both types will put different emphasis on the criteria a location (country) has to meet in order to receive FDI. The attractiveness of a country/locality as an investment destination depends on the general development level of the country/locality. In other words, while Governments of developing countries put much emphasis on FDI as a contributor to national economic development, a minimum level of development is required to attract FDI, unless the country has a large domestic market size or natural resources which can be easily exploited. However, for more upstream manufacturing activities and more sophisticated service industries, TNCs look for countries which offer the best facilities for the least cost. Using Porter’s analytical model of determining national competitive advantages, the following determinants for both inward (from the host country’s perspective) and outward (from the home country’s perspective) FDI can be distinguished:4 (a) Factor conditions: The term denotes the position of a country in factors of production necessary to compete in a given industry. Factors of production are composed of not only capital and labour but also human resources, physical and natural resources, climate and location. Countries with a relatively large pool of advanced factors, such as modern infrastructure and skilled labour force that are used by firms in an effective and efficient way in particular industries, gain competitive advantage in those industries, with high potential for FDI. However, firms from countries with selective factor disadvantages may feel compelled to invest abroad to tap resources in other countries where these factors are relatively abundant. At the same time, the country’s possession of both traditional and advanced factors forms a compelling reason for foreign investors to invest in that country. Not only is the availability of certain factors

4

4

Michael E. Porter, The Competitive Advantage of Nations (New York, Free Press, 1998).

important, but their costs are also. Thus, while FDI was traditionally motivated by low costs and hence cheap labour availability, increasingly the quality and skills of labour also matter in most industries. As a result, a proper mix of low cost and high skills is an important determinant for FDI in the labour-intensive industries. In a globalized world, not only the availability of roads and airports and telephone lines matter, access to a high-speed Internet connection and the overall ICT capabilities of a country figure prominently in the selection of localities by TNCs. (b) Demand conditions: With regard to the nature and size of domestic demand for the industry’s product or service, both the quantity and the quality of domestic demand are important. Not only does the size of home demand affect competitive advantage, but also the composition of demand. Countries gain competitive advantage in industries or industry segments where the home demand gives local firms a clearer or earlier picture of buyer needs than foreign rivals can obtain, and pressures local firms to innovate faster and achieve more sophisticated competitive advantages compared with foreign rivals. A large and growing pool of sophisticated and demanding buyers in a country greatly contributes to gaining competitive advantage in a particular industry and therefore by selected companies in that industry, which are often the more experienced TNCs. Of importance in this context also is the way in which a country’s domestic demand internationalizes and pulls its products and services abroad. If buyers are mobile and include TNCs, or if a country’s specialized universities attract foreign students, for example, the country’s products will be in demand abroad and FDI from the country is likely to follow. At the same time, of course, a country with large and sophisticated demand is very likely to attract FDI which is domestic market-oriented. Countries such as China and India are cases in point where rising levels of income offer enormous potential for TNCs. (c) Related and supporting industries: The presence or absence in the country of supplier industries and related industries that are internationally competitive determines the competitive advantage of local firms in a particular industry and the extent to which these firms will invest abroad.

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

Conversely, an industry with many firms investing abroad will pull related and supporting enterprises abroad, in particular in services and supplier industries. The more linkages exist in an industry, the more FDI will emanate from the country with that industry, once a few firms in the industry or in related or supporting industries start investing abroad. At the same time, foreign investors require the services of well-developed supporting industries in the country where they intend to invest. As such, they are more likely to invest in countries where such services exist than in countries where they do not. Where they do not exist, supporting enterprises from the home country may follow the larger TNCs and invest in the host country. However, if those supporting industries are locally available, the host economy tends to benefit more. Relationships with domestic supporting industries often take place through subcontracting arrangements where the local enterprise benefits from its links with a TNC. Therefore, the establishment of backward linkages between TNCs and local (often small and medium-sized) enterprises is an important development tool. (d) Firm strategy, structure and rivalry: The fourth broad determinant of national competitive advantage in an industry is the context in which firms are created, organized and managed as well as the nature of domestic rivalry. While the first category of FDI determinants refers to firm-specific characteristics related to individual firms, this determinant of national competitive advantage refers to the unique corporate culture in a particular country on a country-wide basis, since goals, strategies and ways of organizing firms in industries vary widely among countries. Some cultures are more likely to attract FDI than others. More important, the pattern of rivalry at home also has a profound role to play in the process of innovation and the intimate prospects for international success. While higher intensities of competition in a given industry in a country would result in a higher chance that firms in these industries would engage in FDI and would extend their “battlefield” abroad, even at the global level, such industries would also attract FDI, in part because of the global character of competition that national rivalry would lead to, but also because highertechnology investment would be attracted by countries where a strong need for innovation had

led to the development of strong universities, R&D institutions and the like, and consequently to the availability of a pool of well-educated and highly trained personnel. It follows that the presence and high level of development of all four determinants would put a country in a position where it acts as both a favourite home and host country for FDI. For this reason, most FDI in the world takes place among developed countries and development means nothing more than a strong presence of the four determinants of national competitive advantage. The way Government influences each of the four determinants through a host of policies is important in explaining national competitive advantage and FDI patterns. Foreign investors look for countries with Governments which promote or do not hinder FDI and offer a stable political climate. In particular, foreign investors look for countries with conducive laws and regulations which are actually implemented and enforced in a non-discriminatory manner. Countries which have signed bilateral investment treaties with the home countries or are members of international dispute settlement arrangements are also favoured. Countries with open liberal trading regimes and membership in WTO would be considered as favoured investment destinations. In addition, cultural factors, including social norms and values and languages similar to those of the home country of the investor, also play an important role in the determination of competitive success and FDI, though such factors differ widely among countries and regions and are decreasing in importance in an increasingly globalized world.

B. Policy considerations for foreign direct investment attraction at the macro-level 1. General considerations In general, the lower the development level of a country’s economy, the more the country is in need of resources that FDI can provide. However, it is also evident that the lower the development level of a country’s economy, the less likely it is able to attract FDI. This apparent dilemma has

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

obvious policy implications for some developing countries, especially LDCs. FDI needs to be attracted to spur economic development, but economic development itself is a major determinant for FDI. Once economies gain development momentum, FDI can be more easily attracted, thereby further boosting economic development, which in turn will attract even larger inflows of FDI. The result is an accelerating pace of development in which FDI has a potentially important role to play. For less developed countries where such momentum has not yet been reached, FDI is not yet a viable policy tool to boost development, unless the country has exceptionally attractive characteristics favourable to inward FDI, such as a large natural resource base, strategic geographic location and characteristics (e.g., large coastline, natural harbours), cost-competitive labour force in the region, cultural links with TNC-home countries and the like. But even for those countries, FDI tends to concentrate on the exploitation of the particular characteristic with little feedback to the rest of the economy and limited contributions to national economic development. While it is widely recognized that the private sector is the main agent for national economic development, Governments will continue to play an important role in the development process. In particular, as long as countries are in the initial stages of development or transition to a market economy, Governments should take a lead in investment decisions as the business sector is not yet in a position to do so. However, as countries develop and market economies are growing, Governments should increasingly liberalize FDI and trade, and allow the private sector to make investment decisions by itself simply because it is better able to do so. This does not mean that government policy will become irrelevant. However, as countries develop, Governments should shift their role from initiator and leader towards facilitator in creating a favourable environment for business. With respect to the contribution of FDI to national economic development, Governments should ask the question whether FDI should be a main element of a national development strategy based on a strengths/weaknesses analysis of the country. If the answer is positive, such an analysis should also guide the Government in answering the

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question concerning which sector FDI should be attracted to. If there is scope and potential for FDI in the industrial sector, to which industrial subsectors should FDI be attracted? Another question is should the FDI be domestic market-oriented or export-oriented or both. If wrong decisions are made at this stage, then there will be either no FDI forthcoming or incoming FDI will be exploitative and not contributive in character. The best choices for countries in the initial stages of development are usually resource-based and labour-intensive, export-oriented FDI, even if the domestic market size is large. Only if the country moves towards a higher development level, domestic market-oriented FDI can be encouraged more to expand consumer choice and spur competition. As such, incentives and a legal framework should be created that are conducive to the kind of FDI that is to be attracted. In addition, Governments should endeavour to the maximum degree possible to meet the other needs of their chosen FDI-type. Another question Governments need to address is whether FDI by large-scale or small- and medium-scale TNCs should take place. While large-scale investments may mean more capital inflows, they also mean investments in projects with higher capitalintensity, which usually do not fit the country’s economic conditions. Given the fact that most investment from developing countries emanates from SMEs, which are more labour-intensive in character, it follows that often the best choice for Governments of less developed countries would be the promotion of FDI by SMEs. Governments typically favour joint ventures as the preferred mode of FDI, as local partners are expected to gain expertise from the investor and maintain management control to some extent, and as the investor may not be experienced enough to invest in another country completely on its own. Well-established TNCs usually prefer 100-per cent foreign ownership and may make actually a better contribution in terms of technology and skills. In many economies in transition, foreign investors have had negative experiences with joint ventures as the local partner is often faced with ideological constraints or simply lacks the experience of operating on the basis of market economic principles.

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

For large-scale investments, host countries should conduct or require comprehensive pre-feasibility and feasibility studies, if necessary with the help of specialized consultants or international organizations, containing a detailed economic cost-benefit analysis.5 Countries should realize, however, that their selection criteria for attracting FDI should be based on transparent and acceptable rules and in accordance with their international obligations, especially those within the framework of WTO. When countries move upward to more advanced levels of development, they need to adopt additional measures to attract more sophisticated forms of FDI with higher value-added content. Aggressive investments in factor upgrading, such as skill development, infrastructure development and financial sector development, among others, should continue to enable the country to attract investment from countries at higher development levels, including developed countries. For countries with large markets and rising incomes, demand conditions are now taken into account, and sophisticated demand is promoted. The emergence of supporting industries and increasing firm competition need to be actively encouraged. Countries in all stages of development, including the economies in transition, can take additional measures to attract FDI from higher developed countries. Apart from liberal national investment laws, administrative regulations and specific contractual agreements between the host country and the prospective investor, action needs to be supplemented by a variety of intergovernmental bilateral, regional and multilateral arrangements. Bilateral investment protection treaties have become major instruments in the relations between home and host countries. Developing countries conclude such treaties primarily to attract foreign investors.

5

Several international organizations such as UNIDO, the World Bank and OECD have formulated comprehensive sets of guidelines for project evaluation and feasibility study preparation. See, for instance, W. Behrens and P.M. Hawranek, Manual for the Preparation of Industrial Feasibility Studies (Vienna, UNIDO, 1991); and UNIDO, Guide to Practical Project Appraisal: Social Benefit-Cost Analysis in Developing Countries (Vienna, 1986).

2. Strengthening national competitiveness While FDI can make a potential contribution to national economic development, the development of national competitive advantages, as discussed previously, would provide the best momentum for the development of domestic private enterprises and the attraction of FDI. The development of national competitive advantages would also define the specific “product” a country could develop to attract FDI. Where such advantages are not apparent they can be created. It is therefore important for countries to undertake an in-depth analysis of their actual and potential competitiveness on the basis of which national development plans should be developed, outlining the strategic economic sectors for development and FDI involvement in the long term based on realistic assumptions and within a framework of attainable goals and time frames. To the extent that countries wish to ensure long-term inflows of FDI, Governments in these countries need to adopt policies to meet the needs of FDI for increasing levels of sophistication. The key policy in this context should be aimed at creating and sustaining national competitive advantage. Though the creation of national competitive advantage serves the general purpose of development and goes beyond attracting FDI alone, FDI in both its inward and outward manifestation plays such a key role in the development process, especially for countries at higher stages of development, that a brief outline of the government role in creating and sustaining national competitive advantage seems warranted. For the purpose of this paper, the main argument for the government’s role in this process is probably best explained by Porter, and will be briefly reviewed in this section.6 First, competitive advantage is created basically by firms through strategy. As such the private sector has the most important role to play in creating and sustaining competitive advantage. As countries develop or proceed with the transition to a market economy, Governments should limit interference with the investment process. Instead, the Government should focus its economic policy

6

Porter, op. cit., chapter 12.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

on the goal of “deploying a nation’s resources (labour and capital) with high and rising levels of productivity”, while policies towards the country’s industry should be aimed at “creating an environment in which firms can upgrade competitive advantages in established industries by introducing more sophisticated technology and methods and penetrating more advanced segments”. Governments cannot create competitive industries; firms must do so. Governments can shape or influence the context and institutional structure surrounding firms by shaping and strengthening the forces which define the four determinants of national competitive advantage and their interaction. In doing so, Governments should realize that competitive advantage in industry is relative. Standards for competitive advantage are set not within a country but by firms in other countries. However, creating and sustaining competitive advantage always entails the upgrading of industries through continuous innovation, at a faster pace than in competing industries in other countries. Second, it appears that a country’s competitive advantage in industries is often geographically concentrated within the country. As such, the role of local Government assumes as much, if not more, importance as the role of central Government, in the promotion and formation of industry clusters. Third, creating competitive advantage takes time, at least a decade or so, and should not be rushed. Fourth, countries gain advantage because of differences, not similarities; in Porter’s words, “each nation has a unique array of competitive industries, and no nation is, or can be, competitive in everything”. Where such competitiveness is not present, it can be created. Where product similarity exists with other countries or even within industries, brand name development is extremely important. For instance, most European countries compete in the automobile industry and produce cars. Their competitiveness lies not in the product but rather in the particular brand. Thus, Germany exports Mercedes Benz and BMW cars, France exports Peugeot and Renault, and the United Kingdom exports Rover and Rolls Royce. These cars serve particular niche markets and cater to specific sets of customers. However, even with regard to

8

products, competitiveness can and, in most cases, must be created. It is not evident that Switzerland should have a competitive advantage in financial services, watches or army knives. Competitive advantages in these industries were created; they did not exist by virtue of country characteristics. Fifth, government policy must provide an environment in which any industry can prosper if firms are innovative and achieve high productivity. Preferably, no prioritizing of industries should take place. Sixth, Governments should not succumb to pressures from business to create an environment of stability and guaranteed prosperity. Hence, the pressure for Governments to protect industry and demand special and differential treatment at forums such as WTO is self-defeating in the long run. Rather, facing the forces of competition on a global scale and investing heavily in upgrading the four determinants of national competitiveness, while pressing for liberalization of a country’s export markets (including agriculture) would benefit the country much more in the long run. Creating and sustaining national competitive advantage requires dynamism with continuous pressure applied for upgrading and sustaining investment. Trade protection would allow the country and the country’s businesses to avoid those pressures and hence fall behind industries in other countries, a situation which they ultimately will have to face in a globalizing world. A wide range of government policies affect national advantage in some industry or group of industries. Education policy, tax policy, healthcare policy, anti-trust policy, regulatory policy, environmental policy, fiscal and monetary policy and many others are all relevant. However, most Governments suffer to some degree from overlapping authority and inconsistent policies in different parts of government towards strengthening the competitiveness of a given industry. Only if a country/locality has developed minimum capabilities which make it a potentially attractive investment destination does competition for FDI worldwide require a complementary targeted investment promotion approach at the micro-level. Attention to detail in such an approach can make the difference in successful FDI attrac-

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

tion and can contribute to the country’s competitiveness. However, such a micro-approach by itself is never adequate if the macroeconomic conditions and fundamentals are not supportive; in such a case, it is likely to be even counterproductive.

C. Investment promotion and facilitation: issues and measures at the micro-level 1. General observations Countries wishing to attract FDI often launch ambitious promotion programmes, including a vast array of incentives without a proper evaluation process of what kind of FDI and how much FDI should or could be attracted. Especially less developed countries and countries with economies in transition should harbour realistic expectations with regard to the kind, quality and amount of FDI they could realistically expect to attract in the immediate future. As was pointed out previously, the level of a country’s economic development and its market economy are primary indicators for the level of FDI that a country can expect to attract. Thus, the more developed a country/ economy or the more advanced the transition towards a market economy is, the larger are the amounts of more sophisticated FDI that it will be able to attract. Often, FDI is targeted at helping the country diversify its economy away from dependence on one or a few commodities, such as oil and gas, cotton or minerals, or basic low valueadded industries such as textiles and clothing. However, rarely does FDI provide a really competitive edge in a given sector. The domestic private sector also has an essential role to play. The promotion and attraction of FDI requires a total commitment with a clear understanding of the potential impact of FDI on national economic development. Such an impact depends to a large extent on the country’s policy and legal framework. As SMEs make up the bulk of private enterprises in most economies, FDI attraction should focus on small-scale FDI from SMEs rather than from large TNCs, which often have much higher expectations, and on needs which developing countries are not always in a position to provide.

Exceptions involve cases where large-scale FDI is required, such as the exploitation of oil and gas, but as such sectors form natural attractions by themselves without much investment promotion required, the primary target group of such promotion efforts is logically the SME sector. Many such SMEs will want to reduce their risk exposure and will look for domestic partners to form joint ventures. However, the domestic private sector in various countries, especially those with economies in transition not used to working in a market economy environment, is often weak and in some cases still coping with a considerably large debt from the 1997 Asian financial crisis. As such, currently they would not be attractive joint venture partners for overseas SMEs. Hence, it is important to actively support and promote the development of private sector SMEs in the agricultural, industrial and service sectors. While countries are often keen on attracting high-technology investment from abroad, it should be realized that technology-intensive products require relatively huge amounts of investment, which typically fall outside the scope of SME capability and typically outside the capabilities of the host country as well. However, in the area of intermediate technologies such as some IT-related products (i.e., software or computer components), SMEs could play a useful role and are of potential importance to various countries depending on the country’s overall skill and education level and IT facilities. As discussed above, FDI can take place through various modes, including fresh equity (greenfield), inter-company loans, reinvestment and non-equity forms of investment. Ideally, the country should focus on greenfield investment, which would inject fresh equity capital into the economy and is more likely to lead to investment in diversified production capacity. Reinvestments should also be actively encouraged which may be an indicator of the investor’s satisfaction with the country’s investment climate. Other forms of FDI are not likely to contribute much to the country’s need for diversification and technology upgrading but should not be excluded as long as the net impact of FDI on national economic development is positive. Basically four types of FDI can be distinguished: (a) resource-seeking, (b) marketseeking, (c) efficiency-seeking and (d) strategic

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

asset-seeking.7 Some countries have a large FDI presence in the oil and gas sectors, which are their economic lifeline. FDI of the resource-seeking kind in these sectors is therefore not a typical target of current FDI attraction policies. What is often required is FDI which would add value to the resources through the development of pharmaceutical or petrochemical industries, for instance, and associated services. Market-seeking FDI is often constrained by the small market of developing countries, not only in terms of the size of the population, but also in terms of its purchasing power. Countries such as Kazakhstan or Mongolia have small populations relative to their land base, while other countries such as Bhutan, Cambodia or Kyrgyzstan are small both in terms of physical size and population. China with its huge population clearly is a magnet for market-seeking FDI. Small countries with small markets still offer some potential to small-scale investors in the retail sector. As such, foreign investment from SMEs to cater to domestic demand should not be necessarily neglected, although it is arguable whether or not such investment would contribute to meet countries’ often-stated goals for economic diversification and technology development. For countries with burgeoning populations where employment generation is a prime concern, obviously any FDI which contributes to employment and hence income generation should be welcomed. Often small countries do better in attracting market-seeking FDI within the context of regional cooperation, i.e., in the context of SAARC or ASEAN or other forms of regional trading arrangements (RTAs). Ideally, for FDI attraction, such RTAs should evolve into full customs unions. Efficiency-seeking FDI results from companies which seek to source the production of various inputs, even to the production of their final products, in different locations utilizing those locations’ different competitive advantages. As such, countries need to specialize within the context of regional cooperation in the production of specific products or services which can be used by other

7

10

Multilateral Investment Guarantee Agency (MIGA), Investment Promotion Toolkit Module 1 (see ).

countries in the further processing of a good, often by affiliates of the same TNC in different countries. Such specialization, in turn, would attract FDI or alternatively would lead to a stronger domestic private sector capable of producing those goods or delivering those services. Strategic asset-seeking FDI includes mergers and acquisitions, which would enable companies to establish a global presence. Although predominant in current global FDI trends, this form of investment is usually less desirable, unless it involves the rescue of a struggling domestic company or the privatization of a State-owned enterprise for which no capable domestic buyers can be found. Mergers are welcome where they lead to economies of scale and where the domestic enterprise is not totally overshadowed by the foreign partner. International mergers can lead to unfair business practices at home in a developing economy where previous foreign investors competing with each other are now joined in one single company in a position to “crowd out” the domestic private sector. As such, there is a reason for WTO to discuss global competition policy within the context of multilateral trade (and hence investment because most trade results from FDI) to the benefit of both developing countries and economies in transition. FDI can be attracted only to locations which have a clear competitive advantage. Locations in this regard should include areas within a given country. As was pointed out, to the extent that such advantages are not present, they can be created. Competitive advantages would enable countries/locations to develop a “unique selling proposition” which would figure prominently in their investment promotion strategies to convince investors that their location has advantages not easily found elsewhere.8

2. Institutional and legal framework (a) Institutional framework While it is understood that foreign investors seek out locations in countries with stable political environments, security and stable macroeconomic

8

Ibid.

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

fundamentals, eventually it is the quality of micropolicies, including investment targeting efforts, which can be decisive in attracting a particular foreign investor. For this purpose it is important that an investment promotion agency (IPA) be established for the purposes of: (a) Undertaking image-building campaigns; (b) Targeting specific foreign investment; (c) Providing comprehensive and accurate information; (d) Identifying investment opportunities; (e) Assisting investors in finding joint venture partners; (f) Ensuring effective coordination with other agencies concerned and the private sector, and acting as one-stop shop for visas/licences/ permits; (g) Screening and processing investment applications in a speedy manner including the processing of requests for incentives; (h) Following up with investors during the investment process and facilitating investment; (i) Influencing the Government in the development of policies which improve the overall business and investment climate; (j) Monitoring investment and maintaining a comprehensive data and statistical base on investors and investment amounts and sectors. In order to implement these functions and duties, IPA should have sufficient authority, skills and financial resources. Lack of any of these requirements will undermine IPA’s performance, particularly in comparison with other IPAs in countries competing for FDI. IPAs should also have representatives in overseas embassies to actively promote investment. Most important, IPAs should have representatives from the private sector as private sector representatives have first-hand knowledge about private sector investment. In addition, IPAs should set up networks of partner agencies to facilitate their activities, such as IPAs in other countries (particularly ASEAN within the framework of the ASEAN Investment Area),

national and overseas chambers of commerce, international law agencies, and advertising agencies. Often, various agencies and ministries are involved in the investment process from attraction to implementation. The overall delineation of responsibilities and authorities of these agencies is often not clear, which undermines the efficiency of the investment promotion process and routinely leads to undue bureaucracy and delays in investment approvals. It is recommended that a single investment promotion agency be set up as a semi-government authority with private sector participation for the purpose of fulfilling the duties specified above. It is not practical for a ministry to act as an IPA since: (a) It does not have the required authority over other ministries and government agencies; (b) It has no credibility in the private sector; (c) As a ministry it is not able to attract skilled private sector people; (d) As a public-sector entity it is subject to cumbersome public-sector rules and regulations which may interfere with the business-minded, marketing-oriented function of investment promotion. It is important that this agency have the required authority to act as a “one-stop shop” and report directly to the Prime Minister or Head of Government. The establishment of such an agency should proceed by law and its board should consist of both public and private sector representatives. It should attract competent staff and therefore offer attractive but reasonable salaries. Thailand’s Board of Investment, the Malaysian Industrial Development Authority and Singapore’s Economic Development Board are often cited as model IPAs. Their structure and services are readily available on the Internet through their excellent web sites.

(b) Legal and regulatory framework Apart from the institutional framework, the legal framework in most developing countries and economies in transition remains underdeveloped. Because a strong legal framework, consisting of all relevant and required commercial laws such as

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

business, contract, financial, bankruptcy and investment laws, is a major determinant for all investors, Governments should pay priority attention to the swift formulation, adoption and enactment of these laws followed by the swift adoption of implementation regulations by decree. In addition, laws and regulations are required in virtually all sectors of relevance to foreign investors, including land, customs, foreign exchange, repatriation of profits and the hiring of expatriate and local labour. In this context, the following considerations could be taken into account: (a) Laws and regulations should be sufficiently liberal to ensure the efficiency of the private sector and private sector (including foreign) investment and the functioning of the market economy while sufficiently strict to ensure stability of the economy and orderly conduct of economic and business transactions. Thus, while economies, including trade and investment, should be liberalized and deregulated as much as possible to avoid undue “red tape” and government interference, they should be properly regulated and supervised so as to provide a stable and predictable framework in which economic agents can generate wealth. The 1997 Asian financial crisis is a prime example where financial deregulation and liberalization had proceeded to unsustainable levels without due consideration of prudential supervision and regulatory issues; (b) Laws and regulations should be clear, transparent, predictable and consistent and their formulation and implementation duly coordinated by the government agencies concerned, at both the national and local (i.e., provincial and municipal) levels; (c) The enactment of a separate foreign investment law may give the message that foreign investors will be discriminated against (compared with domestic investors). In order to ensure national treatment and non-discrimination, a single investment law applicable to both foreign and domestic investors should be adopted; (d) Recourse to proper dispute settlement mechanisms is an important consideration for foreign investors. In this context, countries should be a member of the International Centre for the Settlement of Investment Disputes and widely advertise such membership in an investment-promotion campaign;

12

(e) Countries should be careful with financial incentives. Incentives may attract undesirable investment and may not make much of a difference in the investment decision while imposing a burden on the government budget. The incentive regime should remain simple and limited only to deserving and needy investors, which actually make a contribution to the country’s economic development. It should be realized that incentives do not figure prominently as an investment determinant but may be important for the SME sector which otherwise operates in an environment where the risk is too high to warrant the investment. In addition, some export-oriented incentives may violate countries’ commitment as a WTO member of the WTO Agreement, which prohibits export subsidies; (f) The formulation and implementation of laws and regulations should proceed in a consistent and transparent manner in consultation with the private sector and even foreign investors during the formulation process. Foreign investment laws and regulations should be communicated in a timely manner in the languages of the main investors, particularly in English; (g) Laws and regulations should be duly implemented and enforced. This aspect of the legal environment cannot be emphasized often enough. Countries with comprehensive laws and regulations which remain unimplemented and not enforced, lack credibility and are often perceived as corrupt, offering a less-than-desirable investment climate; (h) As foreigners are often prevented from owning land in most developing countries, in particular, economies in transition, this restriction may be reviewed. It should be noted that countries where foreign investors can own land are more successful in attracting FDI and the countries do not suffer from adverse effects of foreign ownership. In this context, land ownership would offer a distinct host-country competitive advantage; (i) Laws related to foreign investors should avoid performance requirements in terms of local content, foreign exchange utilization, hiring of local labour and technology transfer. Successful businesses in a host country will automatically render benefits. Imposing such performance

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

requirements may undermine the efficient operation of a foreign business while being in conflict with international commitments under WTO and various bilateral investment treaties of the host country in question.

3. Investment promotion strategy An investment promotion strategy aims to attract foreign investors from targeted geographic locations and from targeted sectors to pre-identified locations in the host country. IPA would ideally be in charge of the development of an investment promotion strategy. In developing strategy, the following considerations need to be taken into account: 1. Investment where? While some countries intend to set up or have set up industrial estates and export processing zones, it may be argued in the case of small countries that the whole country could be one integrated export processing zone. While such zones have proved to be useful in attracting FDI, especially export-oriented FDI, they run the risk of isolating FDI from the rest of the economy, effectively preventing the establishment of important backward linkages and spillover effects from the operations of a TNC. While particular areas within a given country will be more inclined towards specific types of FDI and therefore require specialized development, competition among various subnational localities (e.g., cities, provinces) should be promoted only to the extent that it does not interfere with the country’s integrated and consolidated efforts to attract FDI and provide a stable, transparent and easily accessible legal and incentive regime. For example, the proliferation of various incentive regimes in a given country by locality should be avoided unless they are nationally administered. Investment promotion within the context of an RTA should also be carefully considered. In this context, the experiences of ASEAN with the ASEAN Free Trade Area and the ASEAN Investment Area are worth studying. 2. Investment from whom? While developing economies usually target the developed countries, such as Japan, the United States and those in the European Union, often they are not able to provide the investment environment

required by investors from these countries. Depending on the level of development, they may be better off attracting FDI from more advanced developing economies in the region. For instance, investors from Thailand in Cambodia and the Lao People’s Democratic Republic and from Singapore and Taiwan Province of China in China and IndoChina are among the leading foreign investors. 3. Investment in which sectors? The answer depends on the outcome of the competitive analysis study: in principle, in those sectors which add value to existing primary industries (e.g., oil and gas, and timber), including downstream and upstream industries, as well as related services. Whether export-oriented or domestic marketoriented FDI should be targeted depends on the country in question. Ideally, both types should be targeted, although export-oriented FDI tends to have higher spillover effects on national economic development if its import content is not too high. 4. Location audits need to be undertaken to compare a country’s or a locality’s strengths and weaknesses for selected sectors compared with other locations (both within the country and abroad). Such audits need to list the most important requirements of foreign investors in their respective industry and benchmark them in terms of strengths and weaknesses for easy comparison. Where investor requirements are not known, exhaustive research should precede a location audit by simply approaching TNCs and asking them. 5. How should investment promotion be conducted? The methods for investment promotion depend on the sector/company to be attracted and can range from PowerPoint presentations to roadshows and investment forums, and advertising campaigns. There is often an urgent need to improve and update or even establish a web site for investment promotion in the country. This can only be done by IPAs.9 Investment promotion should proceed in a systematic way, targeting individual companies. It should be based on location

9

Best practices in web site development for investment promotion in the region are offered by Thailand’s BOI and Malaysia’s MIDA. The web site of the World Association of Investment Promotion Agencies also provides useful information on the activities of various IPAs around the world.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

audits and the identification of specific industries and sectors which would potentially contribute to the country’s development objectives and which would be consistent with the country’s competitive advantages. Once a relationship with a foreign company is established it is essential that such a relationship remain confidential and that information provided by the investor not be used for public purposes unless the investor has given consent. Even if the investment does not materialize, information should not be provided to its competitors as such an act would undermine IPAs’ credibility with other investors, including the competitors. Investment targeting involves comprehensive research undertaken by competent IPA staff. It is therefore important that IPAs have well-trained and skilled staff to perform this kind of exercise.10 6. Investment promotion by whom? Ideally, by IPAs under the principle of single agency leadership in partnership with important stakeholders, including the private sector. Overseas diplomatic representative offices such as embassies also play an important role in this regard, in particular with regard to image-building. For countries which do not figure prominently as an investment destination, that is, those that have small markets and/or are landlocked but actually have promising potential, there is a need for a comprehensive image-building campaign. Such campaigns should be held in targeted locations and ideally would be undertaken by IPAs. Often, negative and wrong perceptions exist among investors in a particular country/location. In the wake of the global “war on terrorism” and recent events in South-East Asia, Islamic countries could become victims of prejudice and misperceptions. It is essential that such countries through their IPAs and embassies be very proactive in ensuring that potential investors have a realistic but accurate perception of the country concerned.

4. Monitoring and evaluation IPA is responsible for the careful tracking of investment in the country. As such it needs access

10 UNCTAD is a major source of information regarding in-

vestment targeting as well as for global investment trends through its World Investment Reports.

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to a reliable and accurate investment database. Such a database should include at least the following elements: 1. Name and address of investor, name of chief executive officer and other senior management officers; 2.

Nationality and sector of the invest-

3.

Type of FDI by:

ment;

a. investment (i.e., greenfield, reinvestment, mergers and acquisitions); b. ownership (joint ventures, 100-per cent foreign-owned); 4. Status of the investors: subsidiary or parent company (if subsidiary, comprehensive data on the parent company should be collected); 5. Amount of investment approved (by month, cumulated by year); 6. Amount of investment actually implemented (by month, by year); 7. Total investment flows in a year (by sector, host country); 8. Total investment stock (by sector, country, by year). Such data need to be collected upon the registration of the investment project and periodically on the basis of a legal requirement for foreign companies (as well as domestic companies) for periodic reports. If no such legal requirement exists, it should be created. The World Investment Reports of UNCTAD provide some information regarding the definition of some concepts, which will assist in data collection. The existence of a comprehensive database on FDI is essential in order to formulate realistic and consistent policies in this area. The collection and dissemination of such data should be harmonized as much as possible with other neighbouring countries within the context of regional cooperation or co-membership in RTA.

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

5. Investment approval and implementation (a) Investment approval (licensing stage) If the investment promotion campaign is properly developed, targeting realistic TNCs with realistic expectations, offering real products and facilities on the basis of a locality’s “unique selling proposition”, it is very likely that FDI will be generated. In the beginning FDI inflows may be low but as investor experiences in the country increase and are positive overall, enabling the foreign investor to make a profit, the investor will spread the news, which may lead to additional investment. In this context it is important that, once the investor has been attracted, that IPA follow up on the success of the investment and ensure smooth and efficient implementation of the investment project and subsequent operations. The perceptions and experiences of the foreign investor with a particular country start at the moment that first contact is made with IPA. Initial mistakes, poor English and unconvincing poorly prepared presentations by IPA do not make for a good start and may lead to ultimate failure to attract the investment. However, if IPA is successful, investors will visit the country/locality to make a final decision to invest. IPA should be closely involved in and comprehensively prepare the site visits by the representatives of the foreign investment company. When a positive investment decision is made, the job of IPA is far from over. IPA needs to ensure that the investment approval process is smooth, swift and efficient on the basis of transparent and predictable criteria. In many countries, the investment approval process is unduly long and cumbersome with too many licences and permits required from too many agencies/ ministries separately, delaying the implementation of the investment too long. In this regard, officials often do not realize the time-value of money where delays translate into financial losses for the investor. They often do not realize also the need for investors to report to their shareholders back home who demand progress and return on their investments and do not accept delays easily. In fact, ideally investment projects should be automatically approved with no licensing required as long as the investment is in conformity with the law. Where licences are required, ideally IPA should be able to

act as a one-stop agency in processing the investment licences as well as other required licences and permits for land, labour (i.e., work permits) and trade (import licences). It is therefore important that IPA have the required authority to coordinate effectively among ministries and other entities for the purpose of swift investment approval, typically within a matter of a few days. Negative experiences with the investment approval, i.e., excessive delays and “red tape”, will put off the investor and negatively affect the foreign investors’ perception of the country. Where economic and social cost-benefit analyses are required, the approval process obviously takes considerably longer. However, such analyses only apply to very large-scale projects which have either been undertaken by the Government before targeting the investor for the required investment or are undertaken by the Government upon the submission of an investment proposal by the investor or consortium of investors prior to the approval process.

(b) Investment implementation and facilitation (post-approval support) IPAs often make the mistake of not following up with the investor after the approval is granted and the implementation of the investment project can begin (e.g., construction of plant and other production facilities). Often, the investment is located somewhere in the country other than the capital where IPA is normally located, for instance, in another city or province. More often than not, local government officials are involved in the details of the implementation of the project and often their approval must be sought for local permits and licences and other preparations for the investment (e.g., site clearance, hiring of local labour). The interaction with and cooperation of these officials is therefore essential for the success of the project. Investors often make the mistake of not consulting with these officials before obtaining the licence and little coordination takes place between the locality and the centre (central Government). There are cases where local administrations are not aware of new laws and regulations adopted by parliament or a similar national legislative body because of poor communications and coordination. It also happens that local administrations have considerable discretion in passing local regulations and procedures, which

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

can considerably hamper the efficient implementation of an investment project even though the attraction and approval of the investment by IPA was successful and efficient. The above situation is particularly noticeable in former centrally planned economies where local administrations and party cells continued to wield considerable power with central Governments having little influence on local decision-making. Often, local officials are not as familiar and knowledgeable about market economic principles and the rationale of investment decisions as the central Government and are prone to corruption. In quite a few countries with economies in transition, and commonly in less developed countries across the board, the abnormal number of “inspections” by local officials of the investment site both during construction and after production has started is a major nuisance for investors and can only be dealt with through regular unofficial “payments” for which investors can actually be penalized by law in their home countries. It can be argued, of course, that the existence and level of such unofficial payments are more often than not a result of usually extremely low salaries of government officials, especially at the local level, which are not sufficient to meet basic needs. However, while this is clearly an important issue, the living standards of officials in cities and provinces is not a concern for investors and certainly not of their shareholders or parent companies back home. For them, when experiences at the local level with local officials become exceedingly negative and start to interfere with the potential or actual profitability of the project, investors may pull out of the investment and inform other potential investors that investing in that particular country or locality in the country is “bad news” and should be avoided. Never mind how effective and successful IPA is or how attractive the location is otherwise, if the cooperation and the understanding of local officials are not forthcoming and investment implementation suffers, the overall reputation of the country as an investment destination suffers. While such matters can be rectified, it will take considerable time and effort in “imagebuilding” to lure investors to return. In this context, the following recommendations can be made:

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(a) Investors should consult with local officials on their investment plans and establish the necessary contacts at the local level with those officials who are the actual decision makers and obtain their approval and cooperation before official approval by IPA or central Government is given for the investment. Often, IPA can help in mediating between the investor and local authorities and introduce the investor to them. It is also helpful for IPAs in large countries to have local representative offices, at least at the provincial level; (b) Central directives, laws and regulations need to be properly communicated in a timely manner to local authorities with clear guidelines with regard to their interpretation and implementation so as to ensure national consistency. In drafting legislation, local authorities should be consulted and involved in the decision-making process. Clear coordination mechanisms should be set up between the local and the central Government about investment approvals, procedures and trends so that the central Government/IPA could develop a clear picture of the investment situation and overall climate in the country. Obviously, where there are special investment zones or export processing zones, the boards of these zones should be closely involved in the coordination process and their authority and accountability (whether to local officials or directly to the central Government) should be clear and consistent throughout the country. Frequent consultations between local and central Government should take place to keep each other informed of each other’s constraints and intentions to take coordinated action when problems are looming, investor complaints are received or actual problems need to be resolved. Obviously, the involvement of local authorities in the investment decision-making process and the level of coordination with the centre depend on the role and power such authorities have. However, even in those countries where local authorities as yet play a relatively small role, this role is expected to grow in the future as investment and the need for dispersion of investment away from the main urban areas grow; (c) Where local authorities have considerable influence and legislative authority, it happens that investment promotion strategies and

I. Selected Issues on Promotion and Attraction of Foreign Direct Investment in Least Developed Countries and Economies in Transition

campaigns and even web sites are launched at the local level without much involvement and knowledge, if any at all, of the central Government. This may lead to inconsistent efforts for the country as a whole in attracting investment. In these cases also, coordination and proper communication between the localities and the centres need to be maintained while undue competition among localities within a country to attract investment, with each issuing its own incentives and procedures, needs to be avoided in order to avoid confusion for the investor and ensure national legal consistency; (d) Consultation mechanisms should also exist between foreign investors and the Government both at the national and local levels (i.e., the “private sector forum” concept used in various countries in Indo-China) with the close involvement of IPA as mediator, depending on the status of IPA. Investor concerns should be heard and acted upon, not merely in words but in deeds within the framework of what is considered reasonable and within the overall framework of the country’s national and local policies and legal framework. (e) IPAs should follow up with investors during the implementation of the investment project, address problems encountered, mediate with local officials, bring matters to the attention of the central government bodies concerned. Once an investor is attracted, IPA should develop a relationship with the investor for the duration of the investment project to ensure that the investor is satisfied and ready to reinvest or expand investment and convince other investors to invest in the country because of its excellent investment facilitation environment.

D. Conclusions Most developing countries actively promote FDI because it is generally recognized that FDI can make a significant contribution to economic development through the transfer of capital, technology and skills although such transfers are not automatic. However, as developing countries adopt a host of policies and strategies, including expensive incentives, to lure FDI, the success rate offers a mixed picture and is sometimes outright

disappointing. The reason is that FDI, emanating from business entities or individuals motivated by profit-making, is not going to those areas where it is doubtful that profit can be generated despite favourable incentives and other attractions. Investors evaluate potential investment areas/host countries on a comparative basis using objective criteria, which are important to the particular business of the investors but which routinely include considerations such as political and economic stability, adequate infrastructure, stable and solid legal framework and bureaucratic procedures. In the end, it is the overall development level and level of a country’s competitive advantages that will be the most important determinant of an investor’s investment location decision. The development of national competitiveness, especially in a globalized world, is therefore essential for effective FDI attraction and for overall economic development. The determinants of national competitiveness comprise the quantity and quality of production factors; strength and quality of home demand; quality and existence of supporting and related industries; and the level of rivalry, nature of firm strategy and values existing in a given industry in a particular country. The level to which these determinants and their mutual interaction has been developed define the level of competitive success of a country: the higher such development, the more likely the country would be able to successfully attract investment. As many developing countries have developed similar competitive advantages, it is important to stress differences and uniqueness rather than complementarity and hence a focus on micropolicies, which could prove decisive in the success rate of attracting FDI, has been found necessary. In this context, the strength and competence of IPA with proper and sufficient authority could be identified as a strong competitive advantage of a country. Such an IPA was responsible for the development of a comprehensive and realistic investment promotion strategy, developing a “product” to be promoted to foreign investors, including the “unique selling proposition”, and in the ultimate investment-targeting and attraction exercise. In so doing, IPA should highlight the competitive advantages of the location/country rather than offer generous incentives which could

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

otherwise not be backed up with favourable investment conditions. In the end this proved to be more important for a long-term engagement of a profit-oriented investment in a host locality. It may be emphasized that successful investment promotion and attraction will not lead to successful investment per se, but it is essential for IPA/host government to follow up with investors to ensure that the implementation of investment projects proceeds smoothly with the full cooperation and engagement of the local officials concerned and that a proper coordination mechanism exists for intergovernmental coordination and government-investors consultations.

18

In the final analysis, FDI will flow where business opportunities are the greatest and obstacles to business the smallest. Investors are quick to spot attractive locations in this regard without much official promotion. While active investment promotion has proved to make a difference in various Asian countries, a comprehensive and consistent market-friendly development strategy adopted and implemented by a proactive Government which facilitates rather than obstructs business and is private sector-oriented, promotes regional cooperation and embraces the global economy, is the best guarantee that investors will find the country/ locality increasingly attractive for their investments. Where they succeed, others will follow.

II. INSTITUTIONAL CAPACITY-BUILDING FOR SMALL AND MEDIUM-SIZED ENTERPRISE PROMOTION AND DEVELOPMENT Sailendra Narain*

SMEs have proved to be a vital element of growth in the global economy. Their contribution to the economic development of both developed and developing countries has been well recognized. In order to maintain sustained growth, the developing economies in particular have to take into account the latent force of the SME sector and harness it properly in their favour. However, in order to maintain a competitive edge in the fastemerging new economic order, and overcome various challenges in the domestic and international markets, SMEs would need to be provided with suitable institutional capacity-building programmes. Against this backdrop, this study: (a) outlines the contributions made by the SME sector in Asia with particular reference to 15 major economies in the region, namely, Bangladesh; China; Hong Kong, China; India; Indonesia; Japan; Malaysia; Nepal; Pakistan; the Philippines; the Republic of Korea; Singapore; Sri Lanka; Thailand; and Viet Nam; (b) examines both external and internal challenges, threats and opportunities; (c) assesses the programmes and role of Governments and support institutions in the promotion and development of SMEs; and (d) makes recommendations for various capacity-building measures for SMEs in developing countries. Despite the importance of the SME sector in the world economy, the paucity of authentic, uniform and up-to-date data and information asymmetry are major problems. This study has the same limitation. Therefore, care will have to be exercised while viewing the SME sector in a cross-country situation.

A. Status and contribution of SMEs in selected Asian countries and areas 1. Introduction Throughout Asia today, there is a new recognition of the role played by SMEs in the broader process of economic development. SMEs are increasingly viewed by government policy makers and international donors alike as a critical sector for generating economic growth. Given this increasingly important role, a proper understanding of the SME sector, its value and its needs has likewise gained urgency for policy planning and programme implementation. SMEs in Asia can be generally characterized as the engines of growth, the backbone of national economies, the highest employment-generating sector, a potential tool of poverty alleviation by creating self-employment avenues, and significant contributor to a country’s industrial production, exports, national income and GDP. SMEs have certain common positive characteristics, some of which are highlighted below: (a) They are initiatives and skills;

born

out

of

individual

(b) Offer great operational flexibility; (c) Enable low cost of production; (d) Have a high propensity to adopt technology; (e) Have a high capacity to innovate and export;

*

Consultant, Investment and Enterprise Development Section, Trade and Investment Division, ESCAP, and Chairman, Centre for SME Growth and Development Finance, Mumbai, India.

(f) Have high employment orientation; (g) Utilize locally available human and material resources;

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

(h) Reduce regional imbalances.

results. In countries where no definition exists, the enterprises are in a disadvantageous position.

2. Definition 3. Economic contribution Despite the common features globally, countries do not use the same definition for classifying their SME sector. Also, a universal definition does not appear feasible or desirable. The definitions in use depend on the purposes these are required to serve according to the policies of the respective countries/Governments. The three parameters that are generally applied by the Governments to define SMEs are:

In developing Asia, SMEs have made significant contributions over the years measured in terms of their share in: (a) number of enterprises; (b) employment; (c) production and value added; (d) GDP; (e) enterprises set up by women entrepreneurs; and (f) regional dispersal of industry, among others. The contribution of SMEs is vital in as much as they, by and large: (a) Make up 80-90 per cent of all enter-

(a) Capital investment in plant and machinprises;

ery; (b) Number of workers employed; (c) Volume of production or turnover of business. A quantitative definition in each national context is, however, advantageous, as it makes it easier to target macro-level policies for a specific group of enterprises. The countries with such definitions have recorded a higher growth rate in the SME sector. This indicates that the more precise the definition, the more effective the transaction of policies intended to benefit the sector with actual

(b) Provide over 60 per cent of the private sector jobs; (c) Generate 50-80 per cent of total employment; (d) Contribute about 50 per cent of sales or value added; (e) Share about 30 per cent of direct total exports. Table II.1 presents details of the economic contribution of SMEs in 15 selected economies.

Table II.1. Economic contribution of SMEs in selected economies Region/country or area

Percentage of SMEs

Employment (percentage)

Bangladesh China Hong Kong, China India Indonesia Japan Malaysia

87 99 98 95 97 99 –

80 73 60 80 94 72 18

Nepal Pakistan Philippines Republic of Korea

79 60 99 99.7

98 80 45 71

97 90 89 – 80

58 70 65 56 80

Singapore Sri Lanka Thailand Viet Nam LDCs in the region Source:

20

GDP/value added/output (percentage) 15 60 — 40 — 52 15 17.6 — 15 28 47.5 49 41 55 47 42 40-70

(GDP) (industrial output) (industrial output) (manufacturing output) (total output) and (value added) (GDP) (value added) (gross output) and (value added) (manufacturing output) (value added) (value added) (value added)

UNCTAD, Improving the Competitiveness of SMEs through Enhancing Productive Capacity, TD/B/Com.3/51/Add.1 (Geneva, 31 January 2003), table 2, p. 3 and country profiles of Nepal and Viet Nam.

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

The share of SME enterprises in the 15 selected economies to total number of industrial enterprises ranged from 79 to 99.7 per cent. Asia is dominated by SMEs, which are either proprietary or partnership concerns; these account for over 90 per cent of the total enterprises in the SME sector. Very few units (less than 2 per cent) are in the corporate sector. This ownership pattern has significantly influenced the pace and flow of institutional support and particularly access to institutional finance and credit. The share of SMEs in total employment ranged from 45 to 98 per cent (except in Malaysia, where the share was lower). Generally, in all Asian countries, the SME sector has been the second largest employer after agriculture. From the economic and social prospectives, increasing the production per worker-year is very important. In the global market, labour productivity is a key determinant of prices for SMEs. Higher output per employee leads to lower unit labour costs, which is an important condition for a competitive pricing policy. Asian SMEs having an abundance of cheap labour could gain a clear competitive edge in international markets, if this aspect is given due attention. A research study in February 2003 by ING entitled “Labour productivity in European SMEs” was based on a survey in the Netherlands and Germany. It found a clear relationship between the development of labour productivity and the cyclic conditions in the region.1 It also demonstrated that the structural environment imposes significant restrictions on the scope of companies in making decisions. It observed, “the more rigid the labour market and the greater the protection against dismissal in a particular region, the poorer the absorption of the labour supply by the company”. Almost all Asian countries suffer from this syndrome. Labour is available but productivity is low compared with many of the developed economies. The answer lies in a comprehensive policy for HRD for labour, technical training, increased funding for R&D expenditure (Europe is planning to raise R&D expenditure from 1.9 per cent of GDP in 2000 to 3 per cent of GDP in 2010),

1

See F.A. von Dewall, ed., “Labour productivity in European SMEs” in SME Special 2003 (Amsterdam, ING Economic Department, February 2003) pp. 4-5.

which is expected to raise labour productivity to higher levels in Asia as well; the competition targets will be within reach by 2010.

4. Exports Very often, the single most important indicator of competitiveness and growth is the contribution made by SMEs to the total exports of a country. This applies not only to the higher exports but also to the more diversified exports. It also includes “an expanding base of domestic enterprises able to compete globally; thus competitiveness is sustained and is generally accompanied by rising incomes”.2 The ability of SMEs to contribute to exports varies widely in Asia, between 10 and 60 per cent (see table II.2). This varying ability to export is in itself an indication of how competitive SMEs can be or not be in the global economy and the fact that specific support measures might be needed to improve their performance.

Table II.2. Share of SME exports in selected Asian countries Country

China India Indonesia Malaysia Republic of Korea Singapore Thailand Viet Nam Source:

Percentage share of SMEs to total exports 40-60 38 11 15 40 16 10 20

UNCTAD, Improving the Competitiveness of SMEs through Enhancing Productive Capacity, TD/B/Com.3/51/Add.1 (Geneva, 2003), table 3.

The top 20 exporters, by technology category, such as resource-based manufactures, nonresource-based manufactures, high-technology manufactures, medium-technology manufactures,

2

UNCTAD, World Investment Report 2002 (Geneva, 2002), p. 117.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

low-technology manufactures, during the period 1985-2000 are listed in table II.3. Nine of the top 20 exporters are in Asia, which indicates the potential of this part of the world.

Table II.3. Top 20 exporters, by technology category, 1985-2000 1. China 2. United States of America 3. Republic of Korea 4. Mexico 5. Malaysia 6. Ireland 7. Thailand 8. Taiwan Province of China 9. Singapore 10. Spain

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

Philippines Hungary Viet Nam India Israel Poland Turkey Czech Republic Chile Portugal

Source: UNCTAD, Improving the Competitiveness of SMEs through Enhancing Productive Capacity, TD/B/Com.3/51/Add.1 (Geneva, 2003), table 5.

5. Asian SME development outlook The Asian Development Bank in its Asian Development Outlook 2002 forecast that in contrast to the deteriorating outlook for 2001, the encouraging economic news of early 2002 was forming the basis for stronger medium-term growth forecasts in the Asian and Pacific region.3 The recovery is reflected in the percentage increase in GDP growth in developing Asia, from 3.7 per cent in 2001 to 4.8 per cent in 2002; it was expected to reach 5.8 per cent in 2003. A key element of this rapid rebound from the shallow recession was the behaviour of consumption. Other factors that could explain this resilience are: (a) low inflation; (b) the lowering of interest rates; and (c) sustained productivity growth and general optimism about long-run economic prospects, and increased flexibility in product and financial markets. Apart from manufacturing, the service sector holds promise for the Asian SME sector.

3

22

Asian Development Bank, Asian Development Outlook 2002 (Manila, 2002).

This is a growing industry in the SME segment generally in the world and specifically in developing Asia. Because of its potential to provide foreign exchange earnings, fiscal revenues, service sector jobs and backward linkages to industry, tourism could be an important element of many developing Asian countries’ development strategies. According to the World Travel and Tourism Council, the total contribution of tourism in developing Asia in 2001 was 9.2 per cent of GDP and 6.9 per cent of total employment; the relative percentages are 10.1 of global GDP and 7.9 per cent of total employment. This sector is one of the “sunrise industries” in the SME segment in Asia; it has vast potential to improve employment and job opportunities. The percentage share of employment offered by the tourism industry to total employment in the selected economies in 2001 is as follows: China (7.2); Hong Kong, China (7.2); Republic of Korea (8.4); Indonesia (6.7); Malaysia (9.4); Philippines (10.3); Singapore (9.7); Thailand (10.1); Viet Nam (5.3); Bangladesh (4.7); India (5.6); Nepal (7.1); Pakistan (5.0); and Sri Lanka (6.4). Given an aggressive implementation of development strategy, tourism may provide substantial employment opportunities with backward linkages to various SMEs in the industrial sector. In addition to tourism, biotechnology and the pharmaceutical industry have great scope for employment in the Asian SME sector. Cross-country examination of the facts and information in respect of the 15 selected economies reveals that in developing Asia:

•

The SME sector is the backbone of the economic structure;

•

SMEs have latent force and great potential for generating employment, industrial production, exports, reducing poverty and enhancing the rate of economic growth;

•

SMEs in Asia, by and large, suffer from information asymmetry, a lack of dynamic policies, poor infrastructure, insufficient support services and difficulty in accessing institutional finance;

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

•

SMEs can become competitive in the new economic order only when Governments, financial systems and support institutions together with industry associations take up capacity-building programmes relevant to the changing needs of SMEs.

B. Challenges and prospects in capacity-building for SMEs SMEs are generally perceived as highly vulnerable to both external and internal economic challenges. Following this premise, it is further believed that SMEs, as compared with the large industrial sector, are more prone to threats of market fluctuation, particularly in the developing economies devoid of adequate support services and capacity-building measures. This makes them uncompetitive in the international market when the new economic order is fast emerging, giving rise to new systems of international trade and stiff competition. However, in developing Asia this premise cannot be uniformly generalized. SMEs in selected Asian countries have shown adequate resilience in surviving the 1997 Asian crisis and later the competition arising out of economic liberalization and globalization of the market. In these cases, the globalization process has been advantageous to the SME sector, making it self-sustainable, self-reliant and competitive. There are also countries where SMEs have been adversely affected and would need capacity-building policy and support measures from the Government and the institutional network to face the challenges and identify opportunities in order to harness them to their advantage.

1. External challenges (a) Globalization and liberalization Most developing countries in Asia are vigorously pursuing economic liberalization policies and opening up markets in order to integrate themselves with the global market. Globalization offers advantages in terms of maximization of economic efficiencies, increases in output and growth, and disadvantages when the Governments concerned display a lack of strong political will and competence to make suitable adjustments necessary for the globalization process. The

globalization process has been pushed in many countries to an unsustainable level making, among others, the SME sector unviable and fraught with risks of severe competition in open markets. SMEs have been exposed to international and external challenges without advance preparations and suitable capacity-building. Many entrepreneurs are increasingly recognizing the opportunities offered by internationalization. Access to global markets has become a strategic instrument in their competitiveness and their further development. Access to global markets for small businesses can offer a host of business opportunities such as new and larger niche markets, the possibility of exploiting scale and technological advantages, upgrading of technological capability, ways to spread risk, lowering and sharing of costs, including R&D costs, and in many cases, provision of improved access to finance. Gaining access to global markets can help SMEs to realize their potential for prospective high growth and is often an essential strategic move for SMEs with large investments in intellectual property.

(b) Aspects of SME dynamism in East Asia The Republic of Korea: SMEs in the Republic of Korea have undergone a dramatic transformation. The share of employment originating in SMEs (in manufacturing) rose from 46 per cent (in 1975) to 69 per cent (in 1997) while that of value added rose from 32 per cent to 47 per cent. This is all the more striking if one considers that SME shares in employment and value added had declined throughout the 1960s. Given that the Republic of Korea’s economy has expanded tremendously in the past quarter century (with occasional downturns as in the period 1998-1999), these data suggest that SMEs have been important generators of income and employment in the Republic of Korea despite the general perception that the Republic of Korea’s economy is heavily dominated by large conglomerates. Indeed, Korean SMEs have also become well established, as have Japanese SMEs, in two activities often associated with dynamism: exporting and overseas investment. Korean SMEs have accounted for about 35 per cent or so on average of total exports from the Republic of Korea during the previous 20 years and have moved more rapidly into overseas investing than even larger Korean firms.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

China: This country presents an interesting case of market reforms and their impact. Since the late 1970s, China has gradually liberalized its economy and has allowed individuals to set up rural and urban enterprises in a wide range of economic activities. The evidence to date shows that SMEs in China have gained substantially from liberalization. While employment data show a relatively constant share for SMEs, value added data suggest an increase in share of total output from 57 per cent in 1980 to around 66 per cent in 1996. Indonesia: The regional financial crisis of 1997-1998 gave Indonesia a severe shock from which it has not yet fully recovered. Nevertheless, it is generally believed that SMEs in Indonesia benefited significantly from the turn to labourintensive exports in the late 1980s; SMEs were not more severely affected by the 1997-1998 downturn than larger firms. A significant amount of exportable output was also undoubtedly provided by the SME sector to larger firms under subcontracting arrangements. Thailand: Unlike the other cases, in Thailand, the overall share of SMEs in total employment fell from 60 to 52 per cent although it later picked up to 65 per cent in 2000. As in East Asian countries, the share of the smallest firms (with fewer than 10 workers) declined from 12 to 6 per cent. The Asian and Pacific developing region has frequently been termed one of the most dynamic parts of the global economy. On balance,

evidence of a gentle recovery in both the global and regional economies is becoming discernible. The majority of the ESCAP economies were expected to exceed their 2001 GDP growth rates in 2002. A benign inflationary environment and comfortable external positions indicate that most economies in the region have considerable leeway in compensating for the loss of external demand through domestic stimulus measures. Thus, the Asia-Pacific region seems to be quite resilient and is able to cope with economic problems in a speedier manner. In general, it managed to trigger a process of economic growth led by industry (particularly manufacturing) among a selected few developing countries owing to a combination of factors and a conducive environment during the last three decades despite the recovery from the 1997 financial crisis.

(c) SMEs and absorption of shocks The financial crisis in East Asia provides an opportunity to examine the link between industrial structure and economic resilience. The relative impact of the crisis by size of firm can be judged in part by the effects on capacity utilization and employment. Table II.4 summarizes some results from a survey sponsored by the World Bank in five crisis-afflicted East Asian countries towards the end of 1998. It shows that in all five of them large firms tended to have higher rates of capacityutilization after the crisis than smaller firms, but the share of SMEs with fewer workers, by and large, matched the share of large industries.

Table II.4. Impact of the 1997 financial crisis on East Asian firms Country

Size of firm

Capacity-utilization level after crisis

Share of firms with fewer workers after crisis

Indonesia

Small Large

51 63

54 45

Malaysia

Small Large

64 73

29 40

Philippines

Small Large

76 79

50 50

Republic of Korea

Small Large

71 77

61 80

Thailand

Small Large

57 67

56 45

Source: World Bank, Asian Corporate Recovery, 2000. Note: For the purposes of this survey, SMEs are defined as firms with fewer than 150 workers.

24

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

Berry, Rodriguez and Sandee, as part of a World Bank-sponsored project, investigated the impact of the crisis on small firms in Indonesia at a more disaggregated level.4 A survey of 800 small-scale enterprises conducted in 1998 revealed that up to 72 per cent had experienced some economic loss from the crisis. Other sources reported that small-scale garment producers had been badly affected by the decline in the flow of imported cloth and other raw materials on which their output depended. Other small-scale industries dependent on imported inputs or strong domestic demand, such as small clove-cigarette producers, also were hurt by the crisis.

(d)

Foreign direct investment flows in Asia and SMEs

FDI continues to expand rapidly, enlarging the role of international production in the world economy. FDI grew by 18 per cent in 2000, faster than other economic aggregates such as world production capital formation and trade, reaching a record level of US$ 1.3 trillion. FDI flows were, however, expected to decline in 2001.5 In developing Asia, FDI inflows reached a record level of US$ 143 billion in 2000. The greatest increase took place in East Asia; Hong Kong, China, in particular, experienced an unprecedented FDI boom, with inflows amounting to US$ 64 billion, making it the top FDI recipient in Asia as well as in developing economies. This upsurge in inflows has several explanations. First, it reflects a recovery from the economic turmoil of the recent past. Second, TNCs planning to invest in China were “parking” funds in Hong Kong, China, in anticipation of China’s entry into WTO. Third, the increase reflects major cross-border mergers and acquisitions in telecommunications, which alone accounted for nearly one third of the territo-

ry’s total FDI inflows. Fourth, there is an element of increased “round tripping” of capital flows into and out of Hong Kong, China. FDI flows as a percentage of fixed capital formation in developing Asia and the Pacific are given in figure II.1. FDI flows to China, at US$ 41 billion, remained fairly stable. In the course of its negotiations for membership in WTO, China amended some of its FDI policies. TNCs play an increasingly important role in the Chinese economy: for example, tax contributions by foreign affiliates accounted for 18 per cent (US$ 27 billion) of the country’s total corporate tax revenues in 2000. Inflows to South-East Asia (ASEAN-10) remained below the pre-crisis level. The subregion’s share in total FDI flows to developing Asia continued to shrink, and stood in 2000 at 10 per cent, as compared with over 30 per cent in the mid-1990s. This was largely a result of rising inflows into other countries in the region and significant divestments in Indonesia since the onset of the financial crisis. South Asia witnessed a drop in FDI inflows by 1 per cent over the previous year. India, the largest recipient in the subcontinent, received US$ 2 billion. Notwithstanding these mixed trends, the longer-term investment prospects for developing Asia remain bright. In addition to the quality of the underlying determinants for FDI, greater economic integration is likely to boost FDI in the region (see figure II.2). It needs to be watched because the benefits that SMEs derive from the FDI inflows should normally be substantial in terms of TNC-SME linkage programmes. Outward FDI from developing Asia doubled in 2000, to US$ 85 billion. Hong Kong, China was the most important source (US$ 63 billion); more than half its outward FDI went to China. Outward FDI from China and India also picked up.

(e) Future WTO agenda and SMEs 4

5

For details see Farruh Iqbal and Shujiro Urata, “Small firm dynamism in East Asia – An introductory overview”, Small Business Economics, vol. 18, No. 1-3 (Dordrecht, the Netherlands, Kluwer Academic Publishers, February 2002) pp. 3-4. UNCTAD, World Investment Report 2001 (Geneva, 2001).

Policy makers of developing countries will have to take into account a number of imbalances and asymmetries which have become evident. The implementation of the provisions has proved that provisions in favour of developing countries have not been implemented. Asian countries should

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

Figure II.1. Foreign direct investment flows as a percentage of gross fixed capital formation in developing Asia and the Pacific, among other areas, 1990-1999a (Percentage) Azerbaijan Georgia Armenia Bahrain Vanuatu Kazakhstan Hong Kong, China Kyrgyzstan Cambodia Singapore Papua New Guinea Lao People’s Democratic Republic Malaysia Fiji Jordan Maldives Thailand China Tonga Mongolia

60.3 51.4 46.0 37.9 37.1 36.8 41.4 36.6 35.1

Asia and the Pacific Asia West Asia Central Asia South, East and South-East Asia The Pacific Least developed countries in Asia and the Pacific Least developed countries in Asia Least developed countries in the Pacific Oil-exporting countries in Asia and Pacific All developing countries minus China

Latin America and the Caribbean Africa Developing countries and economies Developed Asia Developed Pacific Developed countries Central and Eastern Europe World -5

0

5

10 FDI outflows

15

20

25

30

FDI inflows

Source: UNCTAD, FDI/TNC database and World Investment Report 2001, 2001, p. 27. a

26

Ranked on the basis of the magnitude of 1997-1999 FDI inflows as a percentage of gross fixed capital formation.

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

Figure II.2. Developing Asia and the Pacific: foreign direct investment inflows, top 20 economies, 1999-2000a (Billions of U.S. dollars) 64 25 41 40 10 11

Hong Kong, China China Republic of Korea Singapore Malaysia Taiwan Province of China Thailand India Viet Nam Philippines Kazakhstan Saudi Arabia Turkey Azerbaijan Bahrain Pakistan Qatar Jordan Myanmar Sri Lanka -2

0

2 2000

4

6

8

10

1999

Source: UNCTAD, FDI/TNC database and World Investment Report 2001, Geneva, p. 28. a

Ranked on the basis of the magnitude of 2000 FDI inflows.

adopt a proactive approach aimed at establishing a “positive agenda” which would take account of all their interests.6 Thus, the future agenda should be:

6

ESCAP, UNCTAD and Asian Development Bank, “The future WTO agenda and developing countries”, Studies in Trade and Investment, No. 41 (New York, United Nations, 2000).

(a) Developing countries should intensify their efforts in pushing for greater market access in developed economies; (b) Developing countries should insist that serious consideration be rendered in the implementation of existing WTO provisions on special and differential treatment;

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

(c) Developing countries must make sure that future negotiations of new issues give due consideration to their developmental policies and objectives.

(f) Intellectual property for SMEs In today’s knowledge-driven economy, intellectual property is a key consideration and widely affects the SME sector in Asia (particularly India and China currently). SMEs are the main driving force of innovation and commercialization of their R&D efforts. Generally, the sector is left unprotected and the potential marketable initiatives are lost to large competitors. They are hardly aware of the intricacies of patents, trademarks, industrial design, copyright and related rights, trade secrets and undisclosed information. In this context it is essential that SMEs be made aware of intellectual property rights and duties. The package of assistance that is needed should: (a) Promote greater use of the intellectual property system by SMEs; (b) Strengthen the capacity of national Governments to develop strategies, policies and programmes to meet the intellectual property needs of SMEs; (c) Improve the capacity of relevant public, private and civil society institutions such as business and industry associations to provide intellectual property-related services to SMEs; (d) Provide comprehensive web-based information and basic advice on intellectual property issues to SME-support organizations worldwide. The World Intellectual Property Organization (WIPO) is identifying existing programmes and activities designed to enhance SME competitiveness through distance-learning programmes, publications, self-help kits, training workshops and direct support to business associations.7

7

28

See WIPO, “Making a mark”, Intellectual Property for Business Series No. 1 (Geneva, 2003).

2. Internal challenges (a) Government policies and enabling environment Entrepreneurs are products of their environment and it is the responsibility of policy makers to foster an environment conducive to the growth of the entrepreneurial spirit. The entrepreneurial environment is directly affected by:

• • •

Regulatory and tax burdens; Labour-market legislation; Competition policy and legal conditions.

Each economy should be encouraged to speed up efforts towards the removal of barriers to entrepreneurial behaviour and not to introduce regulations that are likely to penalize business failure.

(b) Policies towards SMEs Governments across the Asia-Pacific region have increasingly adopted specific policy measures to promote SMEs in order to create jobs. Such interventions have been at various levels. Macrolevel measures are concerned with formulating a supportive and enabling policy environment, while facilitating access to and participation in delivery systems. Intermediate- and micro-level interventions are more concerned with providing training, credit, and so on, to entrepreneurs. Many developing economies in the region have, however, failed to address adequately macro-level policies, although they have been carrying out micro- and intermediate-level interventions. For instance, coherent SME policies have been lacking in Indonesia, Nepal and the Philippines, although various programmes have been introduced to promote SMEs. Government efforts in the Philippines have focused in the past on promoting livelihood activities by facilitating training and microcredit, which caused microenterprises to increase in number without any prospect of improving incomes and productivity by establishing linkages with larger enterprises. In Indonesia, small enterprise promotion has in the past been linked to the government-sponsored development of cooperatives to facilitate access to microcredit in rural

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

areas. As a matter of policy, both Indonesia and the Philippines have set aside a percentage of loan funds of commercial banks for SMEs and have reported substantial lending. SMEs, particularly microenterprises in the informal sector, are considered to be the last resort for job creation in many Pacific island countries and other Asian countries. By contrast, advanced industrialized economies such as Japan have promoted SMEs to achieve competitiveness and productivity. The Japanese Government has regularly prepared “white papers” on SMEs in Japan, outlining its plans for creating an environment conducive to reforming SME management. Government policy includes promoting deregulation, supporting the start-up of new businesses, reviewing corporate laws and the relevant rules, and strengthening the financial/capital market to facilitate new business. There have been a number of policy initiatives in support of SMEs in the Republic of Korea since 1995, following the Special Measures Law for Regionally Balanced Economic Development and for Fostering Local SMEs (1994). With the Ministry of Trade, Industry and Energy as the apex body of the SME organizational support structure, various institutes have been working to create a favourable environment for entrepreneurship development and to provide assistance in finance, technology development and manpower training. In February 1996, the Small and Medium Business Administration (SMBA) was established to substantially strengthen support to SMEs. The SME Structure Improvement Programme, started in 1993, now comes under SMBA and it is responsible for planning and coordinating technology programmes, with 5,000-6,000 SMEs assisted annually. In India, a package of policy programmes for small-scale industries (SSIs) was announced in August 1990; it deals with a number of aspects of SSI development. However, the system of reservation of more than 800 specified industrial sectors for SSIs instituted in the 1960s to protect SSIs from undue competition has proved to be futile. This policy remains unchanged today, although certain items have been removed from the reservation list. There is increasing debate about its effectiveness. Some feel that the case for reserva-

tion is fundamentally flawed. The policy has crippled the growth of several industries and restricted exports, and has done little to promote SSIs. Among the economies in transition, China has had remarkable success with its village and township enterprise development programme, under which many economic activities falling within the public sector at the local level were transferred to viable SMEs. The Vietnamese experience with the Bank for the Poor (established in 1995 as a part of its follow-up to the World Summit for Social Development) was not very successful. Although the Bank became operational in 1996, the prospects for a vibrant enterprise sector remain distant and there continues to be much concern about the bureaucratic government machinery responsible for promoting industrial development in Viet Nam. A major point which emerges from the above review is that, in most countries of the region, there is inadequate recognition of the dynamic potential of SMEs. While they are viewed as necessary for job creation in the short run, the fact that their development can play an important role in the growth process is insufficiently appreciated. As a result, a “coherent policy framework” is lacking in many cases, although programmes for micro-level assistance to SMEs exist in all countries. Skill development programmes scarcely address their specific problems and very little effort has been made to promote their linkages with large enterprises. Unless these problems are addressed, SMEs will remain providers of low-quality jobs rather than becoming dynamic agents of economic growth.

C. Institutions for SME promotion and development With SME promotion and development being high on the national agenda, almost all Asian countries have put in place institutional networks for capacity-building and supporting the SME sector. The network can be broadly categorized as under: (a) Government and government-owned institutions;

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

(b) Public institutions; (c) Private institutions; (d) Industry associations and non-governmental institutions. These sets of institutions are mutually exclusive and are expected to serve the cause of the sector in their designated areas. According to the types of activities, they can be segmented into following categories dealing with: (a) Technology, R&D, innovation, quality/ environment management; (b) Human resources development, training and management; (c) Finance and innovative finance;

hence restricting loan assistance. Technology development is therefore a continued casualty, which is otherwise a critical determinant of developing countries’ ability to compete in the integrated global market. Government agencies and R&D institutions have to play a major role in bringing about technological change and modernizing the SME sector on a regular basis. Upgrading technology is an ongoing process and needs continuous change. Modernization needs to keep pace with development, or an industry would become marginalized and eventually it might even perish. UNIDO has prescribed four parameters to measure and monitor technological development. It has developed a framework for benchmarking national and sectoral abilities to produce competitively and to provide the structural inputs for sustained industrial growth. The four competitive industrial performance (CIP) components are:

(d) Women entrepreneurs’ development; (e) Others, such as export promotion, market development, governance and advocacy. Before assessing the efficacy of existing institutional networks, the major needs of SMEs, the status of existing programmes and the “gaps” requiring institutional interventions are discussed in the following paragraphs.

1. Technology, R&D, environment and ICT application Technology is one of the critical components in the project operation and success of any venture in the SME sector. SMEs generally suffer from the “technology obsolescence syndrome” (except for the recent upswing in the knowledgebased industries set up by first-generation entrepreneurs). This problem is more acute in developing economies owing to factors such as ignorance of the criticality of being technologically obsolete in the global markets (thus becoming marginalized and less competitive), lack of information about technological advancements, modernization without being cost-effective, support institutions lacking of the latest information on technology and risk-averse financial institutions not convinced of the profitability of technological upgrades and

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(a) Manufacturing value added (MVA) per capita; (b) Manufactured exports per capita; (c) The share of medium- and high-tech activities in MVA measuring the technological structure of MVA; (d) The share of medium- and high-tech products in manufactured exports, measuring the technological structure of manufactured exports. The focus on export performance seems justified since it is now realized that the growth of any developing economy largely depends on outward-oriented trade. Export promotion policies gradually encourage technological advancements, as the products have to be competitive in the global markets in order to survive. Therefore, if SMEs in Asia have to maintain competitiveness, they must be well equipped to gradually climb the “technology ladder”. The technology ladder is defined by the UNIDO-CIP index of export and manufacturing performance, with added recognition of mediumand high-tech activities. These features are generally lacking in developing economies in Asia for want of resources and institutional capabilities to capitalize upon such opportunities. On the basis

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

of CIP index results, UNIDO has observed, however, that “industrial performance and its drivers are diverging rather than converging, with success confined to a few developing countries”.8 It concludes by stating that “to achieve long term sustainable industrial development, countries and firms need a concerted strategy for industrial restructuring and up-grading for moving from simple to more advanced technologies.” UNIDO (2002) noted that East Asia was the best industrial performer in most respects, with a more technologically advanced export structure and rapidly improving drivers of industrial performance. According to the CIP definition of the technological ladder, the highest achieving developing countries are in South-East Asia (the Philippines, Thailand, Malaysia, Singapore, the Republic of Korea), while 9 of the 10 lowest achieving countries are in sub-Saharan Africa (e.g., Uganda, Zambia, Ghana, United Republic of Tanzania, Senegal). In order to remain technologically competitive, the Government and the institutions providing technical and innovative services to the sector will have to keep in mind the following drivers of technical performance:9 (a) Skill – a fundamental determinant of a country’s ability to compete and its attractiveness to FDI; (b) Technological effort – intensity of R&D indicates general ability to master and use new technologies; (c) Technology transfer – FDI is an important means of technology transfer; (d) Infrastructure – a fundamental determinant of any country’s industrial capabilities and its attractiveness to FDI.

(a) Business incubation In developing countries, business incubators are a quite recent phenomenon. There are no comprehensive surveys regarding the current status of business incubation in developing and transition economies. About 500 incubators existed in 1997. Today their number is considerably higher, taking into account the average 20 per cent annual growth rate estimated in 1997, and, above all, the impressive investments promoted in specific countries. The Republic of Korea alone is reported to have more than 300 incubators. In 2001 around 130 incubators existed in China, compared with 110 in 1999. Malaysia and India also invested considerably in incubators, especially technology-oriented incubators. Japan is very active in supporting incubators, both nationally and in developing countries, including, among others, Sri Lanka and Indonesia. Some of these incubators are also targeted at specific target groups, as in the case of marginalized women in developing countries. The Chinese incubation model differs considerably. It is generally linked to academic institutions and funded by a plurality of governmental and non-governmental resources. In China, incubators tend to be larger in terms of size and incubating capacity.

(b) The infoDev incubator initiative In May 2002, infoDev announced the launch of a new flagship initiative supported by the Government of Japan that is aimed at fostering entrepreneurship in developing countries through the use of incubators. The initiative is aimed at improving the performance of existing incubators in developing countries, achieving higher “survival rates” of incubated companies, growth and sustainability.

(c) The Tianjin Women’s Business Incubator 8

UNIDO, Industrial Development Report 2002/2003 (Vienna, 2002) and UNCTAD, Background paper for Expert Meeting on Policies and Programmes for Technology Development and Mastery, 16-18 July 2003, Geneva, TD/B/ Com.3/EM18/2 (Geneva, 29 June 2003).

9

Adapted from UNIDO, Industrial Development Report 2002/2003, op. cit.

The Tianjin Women’s Business Incubator is an initiative aimed at promoting women’s participation in China’s small business sector and reducing urban unemployment and poverty. The incubator is part of the “Re-employment and Venture Creation for Laid-off Women Workers” programme. The initiative is supported by the

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United Nations Development Programme (UNDP), the Australian Government and the Chinese Government. The project targets women laid-off from their job and helps them to start their own business.

(d) TNC-SME linkages for technology transfer TNC-SME linkages have been regarded as one of the most successful channels for technology transfer and efficiency in the SME sector. Owing to market forces, TNCs have responded to the changing economic environment by concentrating on their core operations, complemented by strategies to outsource operations in which they do not have a competitive advantage. Consequently, many TNCs have built up “supplier networks” of competitive local SMEs. While this has opened up new opportunities for a number of SMEs, the vast majority of them, particularly in developing countries, remain de-linked from TNCs and consequently miss the potential opportunities for quality production, R&D support and access to assured markets.

(e) ICT Application in SMEs SMEs should embrace “e-commerce” as early as possible in order to meet the emerging challenges. If a company aims only to become an Internet user, it needs to find an appropriate solution and to introduce it immediately. If a company wishes to use the Internet to transform itself into a service provider, then it needs to decide on its market position and segmentation. In either case, the role and drive of top management is important.

2. Cluster and network development Experience in developed countries shows that networks in a cluster generally develop around common needs and opportunities. Through participation in service networks, firms share the costs of market intelligence, quality testing and certification, material purchasing, or other common facilities. Based on these services,

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Networks reconfigure enterprise value chains, leading to economics of scale;

•

Networks increase internal specialization, enabling SMEs to achieve competitiveness;

•

Networks generate management economies.

Small firms do well where they have learned to cooperate across enterprise boundaries sharing information, forming networks in order to function, in groups, as do the best of big firms.

3. Women-specific problems Research in Cambodia, Nepal and Vanuatu shows that women entrepreneurs face similar problems to those of men in establishing and developing their businesses. There are many obstacles related to the physical infrastructure and the macroeconomic environment of the country, having an impact on both female and male entrepreneurs. Women entrepreneurs are further burdened by other obstacles that are women-specific. The latter comprise women-intensive variants of the problems all entrepreneurs face or are exclusive to women. The research and the surveys conducted show that these problems are rooted in: (a) The legal framework, combined with a discriminatory application of the law, or in the social or legal incapacity of women to enforce their rights; (b) Sociocultural attitudes and biases; (c) A lack of policies to support women’s entrepreneurship development. In this situation, women entrepreneurs find that they have limited access to finance, whether for start-up or for business development; limited access to facilities that can help them to overcome or complement insufficient business skills, such as those related to management, marketing (including exports and technology) and limited access to training and other business-development services.

4. Management training In today’s knowledge-based economies, firm-level investments in training and skills upgrading are believed to be one of the keys to

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

growth. In the “new economy” era, fast-changing technologies and globalizing economies are putting increased pressure on firms to reorganize their structure and enhance adaptability and flexibility.10 This is true for large and small firms alike, whose performance is increasingly dependent on a managerial structure, which should ideally be decentralized, participative and adaptive. According to OECD, good management is vital for better performance: “…. the array of managerial and organizational instruments used by high-growth firms is striking. They are no longer the privileged attributes of large corporations. The key factor in a firm’s competitiveness is better organization of the innovation process and other functions, more than innovation itself”.11

5. Sources of financing for SMEs SMEs face a number of impediments to their growth and survival, including limited access to financing. Access to financing has been identified in many business surveys as one of the major obstacles. Limited market power, lack of management skills, high share of intangible assets, absence of adequate accounting track records and insufficient assets, all tend to increase the risk profile of SMEs. Consequently, traditional commercial banks and investors have been reluctant to provide financing services to SMEs. In contrast, larger enterprises are accorded better attention from banks and other financial institutions.

(b) Venture capital Venture capital (VC) is recognized as an important financial challenge for innovation and high-risk projects. However, the VC industry still remains at an infant stage in most countries and economies in transition. Most LDCs and economies in transition lack an exit mechanism such as an organized public equity market for a VC industry. Further, they do not have large pension funds that can be invested in venture capital funds. VC is almost non-existent in many regions owing to a lack of liquidity and exits. By contrast, the Republic of Korea, China and India have been more proactive in the VC area. Their success is related partly to their integration into the global industrial economy, well-developed human capital and forward-looking policies of their Governments.

(c) Debt finance The high-risk, high-return nature of innovative SMEs suggests that debt-financing may not be appropriate, especially at an early stage. In the case of debt-financing, the investor’s return is limited while it is fully exposed to downside risk. Moreover, lack of accounting records, inadequate financial statements or business plans make it difficult for the banks to assess properly the creditworthiness of SMEs. Further, high administrative/transaction costs of lending or investing small amounts do not make SME loan portfolios a profitable business.

(a) Seed capital

(d) Credit guarantee

In order to obtain institutional support, seed capital or the promoter’s contribution is a must. Generally, banks insist on 25-33 per cent of the total project cost as a contribution from the promoters. This requirement places SMEs, especially the smaller ones, in a tight position. Hence, they tend to depend on their own resources, and that of family and friends, but such sources are not always available.

Banks are generally averse to assisting SMEs, for want of collateral and third-party guarantees. Many Governments have implemented loan guarantee programmes to close the perceived debt-financing gap, especially for innovative SMEs. The overall thrust of these loan guarantee programmes is to absorb part or some of the risks. The success of such a programme hinges on its ability to minimize the number of defaults, while providing loans to borrowers that would otherwise not have been able to obtain them in the private financial market.12 There are essentially two

10 OECD, Small and Medium Enterprises Outlook 2000

(Paris, 2000). 11 OECD, High Growth SMEs and Employment (Paris,

2002), p. 50.

12 OECD, Fostering Entrepreneurship (Paris,1998).

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government policy parameters in loan guarantee schemes: the premium and the guarantee. The premium can act as a deterrent to such schemes, whereas the proportion of loan guarantee by the Government can encourage the use of loan guarantee schemes. Thus, the Government needs to carefully balance these parameters to ensure that deserving SMEs are financed while maintaining the financial sustainability of these programmes.

(e) Mutual guarantee Started in Italy, the mutual guarantee programme has shown its sustainability. Under the scheme, SMEs through their associations promote own/mutual guarantee funds and leverage them with public- or government-promoted guarantee funds for wider coverage. Success is more frequent in this system, as SMEs are mutually responsible in taking the risks. Indian States such as Rajasthan have taken a lead in this direction and are trying to sensitize the banking sector accordingly.

(f) Export credit guarantee Export-oriented SMEs are increasingly taking advantage of globalization by expanding their markets abroad and importing best practices from abroad. However, compared with larger firms, SMEs have a reduced capacity to meet the regulatory requirements of importing countries as well as deal with different business practices abroad. Moreover, weak discipline in terms of timely payment by importers is another potential impediment to SMEs engaging in export since they tend to be more vulnerable owing to liquidity constraints. Thus, uncertainty associated with foreign markets and the inability to take countervailing measures can discourage SMEs including innovative ones from becoming globalized.13 In addition, SMEs located in limited local markets must have a global outlook to improve their growth opportunities. The solution lies in a suitable export credit guarantee scheme, which is being operated by many countries based on the risk perceptions of the importing countries.

13 OECD, Science and Industry Outlook – Drivers of

Growth, Information Technology, Innovation and Entrepreneurship (Paris, 2001).

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6. Microfinance Over 900 million people in about 180 million households in Asia live in poverty. Most of the region’s poor (those who earn less than one dollar a day), live in rural areas, although urban poverty is also a growing problem in virtually all developing economies. Most rural poor people are engaged in agriculture or related activities as labourers or small-scale farmers. Many are also involved in a variety of microenterprises. In many countries, women, who comprise a significant proportion of the poor and suffer disproportionately from poverty, operate many microenterprises.

(a) Lessons learned ADB microfinance operations continue to provide valuable lessons such as the following: (a) Adoption of the financial system development approach is the key to achieving sustainable results and maximizing development impact. This approach emphasizes an enabling policy environment, financial infrastructure and the development of financial intermediaries that are committed to achieving financial viability and sustainability within a reasonable period and that can provide a variety of financial services, not just credit, to the poor; (b) Microfinance clients are more concerned about access to services that are compatible with their requirements than about the cost of the services; (c) Given the diversity of demand for financial services, a broad range of institutional types is required to expand the outreach; (d) Strong retail institutions committed to outreach and sustainability are essential for extending the permanent reach of financial services and they can have a significant impact on poverty reduction. Thus, building the capacity of institutions with a commitment to reach the poor is vital; (e) Financial institutions committed to provide microfinance services in most countries require considerable technical assistance for capacity-building. This is particularly true for institutions that target potential clients in resource-poor areas and the poorest of the poor;

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

(f) The demand for savings by poor households and microenterprises is as strong as or stronger than the demand for credit. Expansion of the outreach of savings services can have a potentially significant impact on both institutional sustainability and poverty reduction; (g) Because microfinance is primarily targeted at the poor who are disadvantaged, social mobilization is necessary in order to introduce them to a formal or semi-formal, market-oriented institutional environment. This is particularly true for poor women and the poorest of the poor. It is important, however, to distinguish between financial intermediation and social intermediation in designing support programmes. The lessons from ADB’s activities are similar to those from activities of other funding agencies. Incidentally, a study conducted by the Inter-American Development Bank found that, of the 600 companies in Japan, the Republic of Korea, Singapore and Taiwan Province of China, microenterprises formed the majority of those that had started their business on a very low scale, mostly with the non-institutional funds, with their own savings and by borrowing from family and friends. That study showed that even high-growth companies in developing Asia had graduated from the microcredit level.14

(b) Business development services The development of SMEs has long been regarded as crucial for the achievement of broader development objectives, including poverty alleviation, economic development and the promotion of more democratic and pluralist societies. Donor support for SME development interventions has increased substantially in recent decades and donor agencies have accumulated considerable experience in this field. However, there have been major shifts in the approaches adopted. Donors have supported SME development in a variety of ways. Since the early 1980s, support

for financial services has received particular attention, reflecting the widespread agreement that real progress has been made in the design and delivery of financial services for enterprises. Support for the provision of business development services to SMEs has also been popular with donors since the mid-1970s. ILO has been working extensively in this direction.

D. Lessons learned and new framework for capacity-building of SMEs in developing countries 1. Lessons learned SME development being high on the national agenda of various countries and a number of programmes have been put in place. Information on the success or failure of such policies and programmes is the best source for policy makers to use in devising and refining the policy framework for SME development. The main lessons learned out of the cross-country experiences in SMEs capacity-development programmes are described below.

(a) Competitiveness as a long-term strategy A well-defined long-term competitiveness strategy is a must to improve the structural position of any country in the global economy by upgrading current activities and incorporating new skills and capital-intensive activities. A “national vision” should therefore be based upon a consensus among the national stakeholders and an awareness of both the national goals and the steps that have to be taken to achieve them. This should begin with stocktaking of the strengths and weaknesses of existing policies, programmes and structures at all levels, and be based on the lessons learned. Countries should design policies and programmes that add value to their national economic growth. Taking advantage of the cross-country experiences would be a step in the right direction.

(b) Public-private sector dialogue 14 Inter-American Development Bank, Entrepreneurship in

Merging Economies: The Creation and Development of New Firms in Latin America and East Asia (Washington, DC, March 2002) pp. 51-52.

An effective policy framework for SMEs should begin with identifying real constraints and possible solutions. A useful way of identifying

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such constraints is through public-private sector interaction and dialogue, thus creating an enabling environment and fostering policy coherence. Governments need to recognize and accept the role and status of the private sector as joint partners in development and as spokespersons for private enterprises. Countries that have operated with this philosophy have gained substantially.

(c) Gaps Despite the declared objectives and support programmes operated by a host of institutions, SMEs continue to face avoidable problems. The major “gaps” in the institutional delivery system and satisfaction level of the SME sector may be measured in terms of policy, legal and operational gaps.

introduced a “one-window” clearance system, even today an entrepreneur has to approach a number of government departments for various approvals. In a few countries, as many as 38 types of approvals are necessary. Such a situation calls for a comprehensive single piece of legislation governing the SME sector which is simple and sector-friendly by eliminating the “inspector raj”. (iii) Overlapping institutions The large number of target-oriented government-owned institutions has led them to compete with each other without much success. In a limited arena, they chase the same set of entrepreneurs, possibly resulting in double counting. There is considerable evidence of avoidable “overlapping” of their functions, which helps neither the SME sector nor the institutions concerned.

(i) Static policy regime While support institutions currently play a role in promoting SMEs, in some way or another, assessed from the angle of their efficacy, there seems to be room for improvement. Most of the institutions, devoid of any strategy for change, have failed to keep pace with global developments and in the process have become irrelevant to the SME sector. An analysis of the operational system of the existing network in the 15 selected economies reveals that in many of them, SME policies and legal provisions are outdated and not at all relevant to the modern-day situation. Some countries have yet to reach the stage of having a suitable definition of SMEs. This has retarded the growth of the sector, especially when it is exposed to international markets. It has been established that countries having a proper definition have progressed well. Some countries such as India and Indonesia have adopted a legal definition associated with SSI. There is an urgent need to have a consistent definition on SMEs. (ii) Archaic legal system The legal system requires urgent change as it is commonly restrictive in almost all the countries. Legal reform is particularly needed to prevent discrimination against women entrepreneurs. Despite many Governments having

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The support programmes operated by the institutions are far from market reality, as they are not subjected to change periodically. This results in more of a disservice rather than a service to the sector. Up-to-date information is critical in the field of informatics and market intelligence and the institutions need to adopt it. (iv) Lack of supportive financial system Despite the declared policy of the Governments and central banks of each country in favour of the SME sector, the financial system suffers from conventional attitudes hostile to lending to the SME sector. SME borrowers have not been able to establish their credibility in the eyes of the lending institutions. Loan guarantee schemes have not been able to enthuse bankers to lend liberally to the sector. Bankers treat the sector as fraught with high risks and the sector considers bankers to be unnecessarily hostile. R&D, initial public offerings, innovation and incubation, among others, require innovative finance in the form of venture capital. Only a few countries have been operating seed-capital schemes – not to mention the venture capital – in adequate measures for assisting high-risk propositions. (v) Risk-averse innovative finance While a few forward-looking countries have come up with innovative finance mechanisms,

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

most of the selected economies have yet to introduce an effective venture capital network. Innovations and R&D have yet to develop forwardlooking government and institutional policy programmes. Expenditure on R&D is one positive index of a country’s technological development status. The national budgets of many countries have shown very meager or no allocations even though most of the innovations the world over emanate from the SME sector and new technology provides a competitive edge on a sustained basis. (vi) Associations’ non-entrepreneurial role The gaps in effective capacity-building programmes for SMEs are not entirely due to the ineffective role played by Governments and support institutions; various national and regional industry associations are equally responsible. They have still not shed their traditional attitude and lobbying functions, always pressing for grants and subsidies from the Government. They continue to serve as complaint-making platforms. Associations currently have to be more entrepreneurial, pursue the public-private partnership philosophy and be relevant to the sector by conducting activities in the fields of information dissemination, subcontracting, B2B and B2C, business matching, exhibitions and trade fairs, among others.

(d) Private sector support services Most of the first efforts to develop support systems have involved the setting up of a major central SME development agency that is government- or publicly-owned and staffed. The supply-side approach of such centralized institutions proved to be flawed and it is generally acknowledged that such institutions achieved far less than anticipated, for the expenditure involved and reached far fewer beneficiaries than envisaged. This lesson calls for suitable encouragement for private sector intervention. One of the key problems faced by private sector organizations in developing countries, which affects their ability to provide good-quality services, is a lack of resources. Activities such as training, providing consultancy and information as well as the routine operations of such organizations in fields such as lobbying require staff and this can

be expensive. Private sector organizations in developing countries are either voluntary or compulsory, but in any case membership fees have to be kept relatively low if they are not to deter enterprises from becoming members. Governments and private sector organizations, considered to have the potential to develop good-quality support services, should work out, with the support of donors, some schedule for upgrading and transferring the required SME services to private sector organizations and agree on how this can be financed. A German aid programme in the Philippines has been engaged in such a project since 1990. It started with cover from donor funds representing 50 per cent of the cost of operating services; it was reduced to 20 per cent after five years after which the local organization was expected to finance the operation alone. However, although local counterpart organizations (generally regional chambers of industries) were able to develop some matching funding, the amount was not enough to replace the German aid funds.

(e) Absence of support networks The difficulties in developing a suitable support “network” for SMEs in developing countries should not be underestimated. In most developing countries institutions are reluctant to cooperate with each other. A high and exaggerated degree of individualism permeates most institutions and their management. Further, there is intense competition for funding, especially from Governments and donors. Building cooperation between institutions in the public and private sectors, between R&D institutions and the business world and between large and small enterprises is difficult. At times it may be necessary for Governments, donors and regional authorities to deprive institutions that refuse to cooperate with other agencies.

2. The need (a) The need for specialized institutions The experience of specialized financial institutions for SMEs in developing countries has been mixed. Although they have contributed to increased access of SMEs to long-term funding, they also have experienced low profitability and

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unsustainability. Hence, development financial institutions are competing to convert themselves into “universal banks”. Factors contributing to the success of these institutions include diversification of their products, reliance on self-mobilized resources and a commercial orientation. Specialized financial institutions and public funding institutions in general can reduce the financial risks through loan guarantee and counter-guarantee programmes; participating in equity funds for SMEs, especially in those areas not covered by traditional funds (seed capital and start-ups); creating credit windows for those SME segments experiencing difficulty in accessing loans from the banking system (women entrepreneurs, start-ups, microlevel borrowers, ethnic minorities); offering incentives (commissions) to financial intermediaries managing the credit or seed capital/equity funds for special SME segments; and providing technical support to NGOs or other institutions which could implement SME programmes.

(b) The need for mutual guarantee schemes Loan guarantee schemes in developing countries have suffered from a number of weaknesses such as moral hazard, inadequate procedures and delays in paying claims, which have discouraged banks from taking part in them. To enhance the potential capacity of these funds, they could be supported by public sector counter-guarantees, which have an advantage compared with direct guarantees or subsidies. A number of such initiatives are available in different parts of the world.

(c) The need for alternative sources of funds Traditional bank credit remains one of the major sources of finance for SMEs. There is a need to explore alternative sources of funds, which would contribute to reduce the dependence of SMEs on bank credits. Venture capital and leasing could be significant sources of long-term funds, which currently are underdeveloped. In spite of a number of initiatives from international and national development finance institutions, venture capital funds for SMEs in developing countries are limited. When such funds are available, they are concentrated in high-growth and -risk sectors such as high-tech industries of the economy. An appropriate legal and regulatory framework as well as a

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favourable tax regime and a business culture that promotes entrepreneurship could contribute to their growth. For their part, banks should be encouraged to offer to SMEs alternative products such as corporate credit cards, leasing, factoring, composite loans (both long-term and working capital) and seed capital, and to participate, together with large enterprises, in local investment funds for SMEs.

(d) The need to combine finance with business development services Banks tend to charge SMEs high interest rates and to adopt a rigorous and pre-emptive approach with respect to collateral because of the difficulty they face in identifying creditworthy and promising SMEs. The most efficient way to encourage lending to SMEs is to improve existing institutions’ ability to construct a profitable and efficient way to encourage lending to SMEs and improve existing institutions’ ability to construct profitable and efficient lending programmes for SMEs. This can be achieved by minimizing the risks through appropriate tools and methodologies to assess the creditworthiness of potential SME borrowers and to lower the overall costs of lending to SMEs. The present review has provided strong evidence that commercial banks will lend to SMEs if there is a way to decrease transaction costs and risks. Commercial banks in developed countries have pioneered many techniques for reducing the costs of dealing with SMEs. These include credit scoring, client segmentation, direct mail campaigns, mutual guarantee schemes, risk selfassessment and external business appraisals. How effective will these techniques be in developing countries? The evidence points to the necessity of combining financial with non-financial business services if creditworthy SMEs are to be identified and assisted in developing the necessary management, marketing and networking skills to expand their businesses successfully. Given the lack of sensitivity of bank loan officers to SME problems, commercial banks are probably not the most effective source of technical assistance. It would be better for financial institutions to partner with existing business service providers than to start a new, unfamiliar and possibly costly activity.

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

Business development services (BDS) providers can play an important role in this process because they are close to their clients and they have direct knowledge of the enterprises’ financial status and past performance. BDS providers are often better placed than financial institutions to identify potential clients, ascertain their creditworthiness, disseminate adequate financial and accounting techniques, pre-screen project proposals, monitor repayment, exert peer pressure, and maintain one-to-one contacts during the entire payback period. Thus, the complementarity between BDS providers and financial services helps to:

•

Minimize both the risk and transaction cost to creditors and investors;

•

Make access to credit and equity less costly and less cumbersome for SMEs.

There are a growing number of examples of partnerships between BDS providers and financial institutions. Partnerships have been explored between the private sector and the German Savings Banks, Nat West, Bank of Ireland, Deutsche Bank, ING Bank, Banco di Sardegna and Banca Nationale del Lavoro. In developing countries, a number of BDS programmes are operating such as Empretec; they link credit delivery to the business development requirements of SMEs. Empretec is designed to build the capacity of SMEs, transform them over time into creditworthy borrowers and make them more attractive to financial institutions and venture capital funds. Enterprise Africa, a BDS programme of UNDP modelled on Empretec, has developed a joint credit-delivery scheme. Financial institutions can contract to BDS providers the credit appraisal or assessment, creditscoring and credit-monitoring processes as is done in the case of Enterprise Africa. It is usually less costly for the BDS providers to do this than for financial institutions to do so because the BDS providers know the track record of the entrepreneur and have usually assisted him/her in drawing up a viable business plan. Thus, BDS providers can function as a credit “window” that improves access to finance. The link between financial and non-financial service providers not only reduces the risk and transaction costs of financial institu-

tions but also increases the sustainability of the BDS provider. India tried to develop such a system by setting up technical consultancy organizations, but the experiment did not prove to be successful.

(e) The need for capacity-building of public sector institutions A crucial requirement to bridge the gap between good policy formulation and good policy implementation is the existence of strong, efficient institutions. Public institutions are needed to support the private sector, but in a new role as promoters and regulators, not usually in providing direct services or finance to business. As this role is new for institutions in many Asian countries, they often need to be upgraded and to redefine their functions in the light of the changed role of the State and the effects of globalization. This needs to be accompanied by retraining staff, adopting modern tools and introducing new working practices. In this era of globalization there is a particularly acute need to upgrade public institutions that provide technical support to the private sector, especially in the areas of quality management and standardization. Compliance with international standards of measurement and assuring trading partners of the quality and safety of exported products is becoming a major factor in the export competitiveness of countries. However, critical capacities are lacking in many Asian countries. There is an urgent need to create an appropriate “mind-set” for the institutions and upgrade existing bodies through the provision of modern equipment and staff training. There is a similar need to design and implement programmes to establish or improve certification bodies. The absence of such services can have serious consequences for businesses, especially those oriented towards export markets.

(f)

The need for strengthening the capacity of private sector institutions

Just as public sector institutions need strengthening to reflect changes in their mandates, the role of private sector institutions is also evolving. To a large extent, this reflects the lessons learned in recent years that Governments

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

have not been good providers of services to the private sector. While the role of the Government in supporting the private sector is an important one, its role in providing services should be indirect. The public sector can stimulate the provision of services through private sector providers, private consulting firms, for instance, or private sector associations. The era of government-operated business-support services is ending. New approaches to providing the technical services that business requires are being developed and offer the possibility of providing Asian enterprises with the access to resources they need to compete in the global market. These “market-based solutions” usually involve finding ways to stimulate the provision of business services by profit-making firms, by having the services provided by a private sector institution, or by providing enterprises with mechanisms to address their own needs. A future challenge for these institutions will be to develop the new products and services required by private industry to increase its productivity and competitiveness, especially in areas such as access to new technology, meeting eco-labelling and qualitycontrol requirements. One of the most promising approaches to private sector development is the promotion of partnerships between large and small enterprises through brokering arrangements. Another more recent development in market-based approaches is the promotion of networking services where private firms voluntarily associate as a group to undertake their own projects. Finally, one of the lessons learned that is particularly difficult to implement is the need to initiate private sector programmes that address technical assistance needs on a comprehensive, integrated basis. Although the need for this approach has long been recognized, it has proven difficult to put into practice because of the large number of organizations involved in private sector development; these include different government units, private sector development institutions, nongovernmental organizations and multilateral organizations. New programmes/projects need to be not only complementary to what is being done by others, but also to make a serious attempt at identifying the full range of needs.

40

(g) The need for strengthening markets in developing countries Developing countries face many of the same problems that economies in transition do. Developing countries with recent high growth rates must make complex economic adjustments to prevent overheating, inflation and the adverse effects of sudden declines in capital flows. Less robust developing economies suffer from over-regulation, slow privatization and trade restrictions. They face difficult challenges in reforming fiscal and monetary policies, liberalizing trade, increasing domestic savings and developing private enterprise. Many of the developing countries that have experienced strong economic growth, including China, the Republic of Korea, Malaysia and Thailand, have to invest heavily in physical infrastructure and relieve productive capacity constraints. Some of these countries are also experiencing labour shortages and labour-market constraints. Developing countries with moderate growth rates in Latin America and South Asia must accelerate the pace of macroeconomic reform and trade liberalization, continue to privatize State-owned enterprises and reduce fiscal deficits while increasing savings.

E. Conclusions and recommendations In the preceding sections, an attempt has been made to provide a detailed picture of various aspects of the environment in which the SME sector in Asia operates. The beginning of the era of economic reform marked the dawn of a new global market. In particular, the end of quantitative restrictions has increased the competitive intensity of product categories in which small enterprises previously played a predominant role under the protection of the policy of reservation. The process of liberalization poses new challenges for the SME sector. Having been nurtured in a protective environment, the sector now faces many challenges in terms of increased competition, technology upgrade and quality standardization. Against this backdrop, there is a need for effective capacity-building programmes both for the SME sector and the institutions serving the sector. This will enable the sector to become more fiercely competitive, more technologically

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

advanced and capable of efficiently withstanding the vagaries of globalization. Further, in order to move on the path of growth, domestic policies and programmes for the sector will have to be effective and growth-oriented. The role of the Government, financial sector, industry associations and all other stakeholders of the sector will have to be that of facilitators rather than regulators. To achieve this objective, the following expedient issues which can contribute to enhancing the competitive advantage of the SME sector may have to be brought into sharper focus:

• • • •

Government policy measures;

(b) SMEs are increasingly diversifying their products into knowledge- and skills-based sectors such as electronics, informatics, precision components and parts; (c) SMEs overseas markets.

are

increasingly

exploring

There is therefore a need for a comprehensive and well-integrated package of measures and incentives, on both the supply side and demand side, to foster the growth of a vibrant SME sector and improve the competitiveness of SMEs in both domestic and international markets.

Fiscal issues; Capital/financial support; Capacity-building initiatives.

1. Conclusions Globalization and its manifestations have already had clear impacts on Asian SMEs, which have not altogether been positive. In recent years, while it is easier to point to market forces as the ultimate factor for development and growth, including the development of SMEs, there is a general consensus that rapid and not well-thoughtout means of liberalization of trade and investment, including too rapid and inappropriate sequencing of reform measures, have done more harm than good, especially for SMEs. While market forces will squeeze out inefficient SMEs and will, at least in theory, improve economic efficiency at the national level, the social consequences of overreliance on the market and uncontrolled liberalization measures should be the major consideration for government support in developing countries. It is necessary to allow some time and suitably equip SMEs and the support organizations to adapt to changing global and regional economic realities. In so doing, Governments need to realize that SMEs have already changed themselves to some extent along the following major lines: (a) There is a growing “professionalism” in some sectors of SME management and there is a felt need for the same in the sector. Gradually SMEs are opening up to change;

In developing such a comprehensive and well-integrated “hand-holding” support package, careful consideration should be given to aspects such as: (a) The ever-present temptation to create new organizational structures would have to be resisted, and existing institutions, suitably reorganized, reformed and strengthened, should be utilized to extend support services and input to SMEs; (b) Support measures should be extended only to deserving SMEs and not to those that are likely to waste resources. Perpetual support and subsidies should not be granted to inefficient SMEs; (c) Capacity-building policies should be development-oriented rather than protective or restrictive. Market-oriented policies that increase competitiveness, innovation and resilience should be emphasized so that SMEs can become selfreliant and an effective source of competition; (d) Incentive measures should be direct and use prices and markets as much as possible; (e) Government agencies should actively seek to involve NGOs in developing programmes and delivering support services to the SMEs. In low-income countries such as Bangladesh and Nepal, some NGOs have proved to be highly effective in delivering credit and providing other kinds of support to rural-based small industries.

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2. New policy direction Previously, government policies sought to nurse new enterprises but overlooked the needs of growing enterprises. In a context where an unprecedented expansion in the global market is taking place, the guiding principles of support institutions for SMEs should arguably be to reinforce the impulse towards accelerated expansion. The social benefits of the enormous public expenditure in nurturing new enterprises can be realized if strong and viable SMEs grow rapidly. In the past there was excessive emphasis on SMEs being in competition with large enterprises. The experience in many countries suggests that SMEs are as often complementary to the operation of large enterprises as they are in competition. A wide range of relationships exists among the small, medium and large segments of industry. Small firms can act as ancillaries, suppliers, subcontractors and the like. New capacity-building policies designed to support SMEs must encourage such interdependent relationships among them. Cluster development is considered as the centrepiece of the future strategy for promotion of the SME sector. Such clusters can lower transaction costs, help to realize informational economies and lower credit surveillance costs. In South and South-East Asian countries, agglomeration of SMEs has taken place spontaneously without support from the Government. The growth in such clusters in the previous two decades, driven by cheap labour and access to markets, is currently slowing down, mainly as a result of their primitive state of infrastructure and services. The sagging infrastructure, environmental erosion, endemic technological obsolescence and abuse of child labour in such clusters are obstacles to the development of SMEs. Clearly the prevailing emphasis on protection of SMEs and the attendant mechanisms are inappropriate in the current context. Instead, the growth of SMEs has to be assisted by promotional and capacity-building measures/means and this will require several changes. A variety of government agencies providing a gamut of promotional services to SMEs,

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ranging from consulting to quality control, have been rendered ineffective by their very introduction. These institutions can be revitalized if business-related services are divested from Government and are delivered by independent agencies. Governments can meet their obligations more effectively if they incur the cost of nurturing new enterprises. Government expenditures can yield great social benefits by facilitating entry, if such expenditures are confined to new, small entrepreneurs. Moreover, government aid should be largely restricted to activities at the time of SME formation. SMEs prefer and can afford services offered by the private sector. However, Governments can play a useful role by sharing the cost of common facilities such as training, technological upgrade, infrastructure development, effluent treatment and market promotion. The energy of the government agencies is exhausted by regulations, while the evolution of policy languishes. A comprehensive law for the SME sector would be preferable, but much remains to be done in this direction. Issues such as limited partnerships and receivables have yet to be addressed satisfactorily. In order to keep in step with the changing domestic and international environment, it is imperative that a new approach for promoting the sector be developed. The State must increasingly use its scarce resources to act as a facilitator rather than as a provider of services. Past policies have excessively concentrated on small industries rather than other activities such an industrial support services and the services sector at large. The core competence of the SME sector is its flexibility and capacity to customize. Unfortunately the policies have not yet addressed such problems adequately. The industrialization process of countries in the South and South-East Asian subregion still has a long way to go and there will be a continuing need to foster new entrepreneurs for the foreseeable future.

3. The need for deregulation SMEs in Asian countries have suffered as a result of Governments’ obsession with regulation. In this era of economic liberalization and privatiza-

II. Institutional Capacity-Building for Small and Medium-Sized Enterprise Promotion and Development

tion, the dismantling of control over industry and the withdrawal of direct government intervention in favour of market forces comprise the need of the hour. All statutes, regulations and procedures should be reviewed and modified wherever necessary to ensure that their application does not militate against the interests of the SME sector. Procedures should be made simpler, bureaucratic control effectively reduced, unnecessary interference eliminated and paperwork reduced to the minimum to enable entrepreneurs to concentrate on production and marketing. SMEs have to bear the increased transaction costs of local formalities right from their incorporation to the commissioning of production and even thereafter. There are many problems with the regulatory framework existing in most countries in the region; they are related to the complexity of laws, compliance constraints, and implementation problems. Today, most Governments have taken note of changes and there is no dearth of government policies and programmes duly supported by a host

of extension and financial institutions. There is a strong need for: (a) effective delivery mechanisms for providing assistance, (b) means for avoiding duplication and overlapping programmes of institutions, (c) ways to streamline the complex processes and procedures coupled with a large number of approvals and (d) more emphasis on BDS and capacity-building measures.

4. New agenda for institutional capacity-building through SME policy reforms The various sectoral policy reforms needed to promote effective capacity-building measures for the promotion and development of SMEs should touch upon: (a) Government-public policy; (b) Financial sector; (c) Public-private sector.

Government-public policy reforms

• • • • • • • • • • • • • • •

Creation of enabling environment Definition of SMEs by including the service sector Legal reforms, single legislation for SMEs and simplification of procedures Technology-R&D – environment management Infrastructure-cluster development Marketing-trade-exports-WTO HRD and training enterprise development Public-private sector partnerships Information technology policy One-window clearance and support mechanism Streamlining existing institutional network Effective delivery mechanism Incentive for corporatization Exit policy and capital market development Special funds for technology development

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

Financial sector reforms

•

Central banking policies – interest rates, collateral, securities guarantee fund/mutual funds, bill markets, factoring

• • • • • • •

Prudential norms for banking reforms, documentation Capital markets, venture funds Rehabilitation finance Sensitizing banks about SME lending Credit rating for SMEs Innovative finance to SMEs – e.g., venture capital Combining financial and non-financial services – BDS

Public-private sector reforms

• • • • • • • •

Private sector and industry associations’ entrepreneurial role Private sector’s proactive role – good governance and advocacy role Subcontracting, ancillary and vendor development Technical and marketing support Public-private partnership programmes TNC-SME linkages Networking with NGOs, associations and extension agencies Collaboration with donors, bilateral and multilateral development banks

Such comprehensive measures may be expected to yield the desired results. Great efforts would also have to be directed towards ensuring “institutional delivery mechanism”. Even if all these institutions are in place and their various programmes functioning, the gaps continue mainly because the institutions have failed to ensure proper delivery of their programmes to the SME sector. The benefits do not reach the target groups. Developing countries are well advised to plug such loopholes for better results.

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In sum, it is hoped that the well-coordinated capacity-building programme recommended above, for both the SME sector and support institutions, will go a long way in sustaining the promotion and development of SMEs in Asia and provide them with adequate competitiveness to compete in the global markets. In order to reap maximum benefits from the programme, the “mind-set” of SMEs and support institutions, however, must undergo a radical transformation and they should be more open to “change” to keep pace with the rapid globalization process.

III. SOCIAL ENTERPRISE: A FRONTIER FOR ALTERNATIVE ENTREPRENEURSHIP Pak Po-Hi*

Introduction Anyone concerned with addressing the various dysfunctions of existing mainstream entrepreneurial culture and practice should be long acquainted with the term social enterprise. In substance, social enterprise is nothing other than an advanced form of cooperative entrepreneurship or cooperative enterprise. Unfortunately, the present writer, who had attempted during the years following the 1997 Asian financial crisis, to convert public works projects into “cooperative green enterprises”,1 discovered the term on the Internet by sheer chance. The discovery was something of a shock because it appeared to embody everything that those of us in the development field in general and the anti-poverty field in particular aspire to achieve through policy initiatives, programmes and projects, yet it had not even once been mentioned, let alone discussed, in the various spheres of the writer’s orbit. Prodded to learn more about it, the writer spent considerable time surfing the Internet and eventually organized a week-long study tour that took 10 like-minded academics, representatives of selected businesses, funding agencies and self-help support agencies to London in September 2003. Although social enterprise is an important ongoing

*

President, Korea Institute for Social Information and Research, in collaboration with Mr. Joong-Wan Cho, Economic Affairs Officer, Investment and Enterprise Development Section, Trade and Investment Division, ESCAP.

1

The attempt was ultimately unsuccessful because the Government of the Republic of Korea, while allocating US$ 1.5 million for a string of demonstration projects, had not chosen to authorize the conversion of the projects into cooperative enterprises because it had neither the legislative nor the policy mandate to do so.

concern in many European countries, the United Kingdom of Great Britain and Northern Ireland was selected for language reasons and London was the locus because the time available to the tour members did not allow cross-country visits. Further, within the United Kingdom, London seemed to be a place where social enterprise has a strong and extensive grounding as well as infrastructure. The social enterprise agencies and bodies in London were chosen from listings on the Internet and the British Council kindly made the necessary arrangements and provided an experienced tour director and transport at cost. The following is a rough summary of the materials culled from eclectic web sites and the briefings by the agencies/bodies visited as well as personal impressions on their activities.

A. Social enterprise in context Social enterprise is an evolving and complex business strategy and practice that cannot be defined easily. At the risk of oversimplification, social enterprise can be regarded as an operational manifestation of social economics. Born in the midst of the social dislocation brought on by the industrial revolution, social economics has consistently represented a reaction to the economic “orthodoxy of material wealth, unfettered markets and individualistic competition and emphasis on abstraction” and striven towards a more realistic science of human welfare calling on the State to “take on the function of ‘protector of the poor’”.2 In its singular form, the term “social

2

Mark A. Lutz, “Social economics, justice and the common good”, International Journal of Social Economics, vol. 29, No. 1/2, 2002, pp. 27-28.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

enterprise” is often interchangeably used with “social economy”, which can signify the concept of social enterprise as well as the economic sector where social enterprises operate. It is also more or less synonymous with social entrepreneurship; therefore, the term can stand for a particular entrepreneurial strategy. At the practical level, social enterprises are akin to cooperative enterprises, as previously indicated. As such, their existence goes back a century or more in Europe, but the evolution of cooperative enterprises into “social enterprises” is fairly recent and appears to have coincided in continental Europe with the early post-cold war years when the integration of transitional economies into a free-market context became a major issue. This could be gauged, in part, from the proceedings of the First European Social Economy Conference in Central and Eastern Europe, held at Prague in 2002 under the theme “Praha Social Economy 2002 – Enlarging Social Economy” and, in part, from information available on the work of the European Commission, which includes strong and consistent support to cooperatives, mutual societies, associations and foundations.3 In the United Kingdom, the initial leading social enterprise actions centred around regenerating depressed urban areas, through means such as community-based cooperative enterprises to create self-sustaining services. These, in turn, created job opportunities for the beneficiaries of the very same services. Other social enterprise actions were aimed at improving housing, creating parks out of abandoned public lands, gaining authorization to renovate decrepit public structures into office spaces for rent to small cooperative businesses and publishing public service-oriented weeklies to be sold by impoverished youths, the disabled or the elderly to enable them to preserve their selfsufficiency or give them a start towards upward mobility, among others. Some of those social enterprises grew into highly competitive business concerns in the mainstream market even while

3

46

and .

closely adhering to the principles and standards of social enterprise. The success of the urban-centred social enterprise strategy has led to its extension into the rural sector. An administrative unit was established in the Office of the Deputy Prime Minister for that initiative; thus, social enterprise became a national policy approach in the United Kingdom. In the United States of America, social enterprise appears to have maintained a lower profile than in continental Europe and the United Kingdom. There, it is often associated with “notfor-profit” organizations that are venturing into “for-profit” modalities. Nevertheless, the idea of socially responsible and ethical business practices on one hand and that of cost-effective public goods and services on the other are as old as that country. The search for operational modalities that will give full substance to social enterprise ideas is still a live concern, as is evident, in part, from the fact that Harvard University offers courses on social entrepreneurship. The above description of social enterprise as a concept and practical business modality is by no means adequate. Since the focus of this paper is on its pragmatic aspects or how it is actually being carried out in the field, however, conceptual or theoretical discussions will be deferred to another opportunity. In delineating various features of social enterprise in practice, a good part of the presentation is based on the Social Enterprise London web site accessed during mid-2003.4

B. Social enterprise in snapshots Social enterprises are part of the growing social economy. The social economy is a thriving and growing collection of organizations that exist between the traditional private sector on one hand, and the public sector on the other. Sometimes referred to as the “third sector”, the social economy includes voluntary and community organizations, foundations and associations of many types.

4

.

III. Social Enterprise: A Frontier for Alternative Entrepreneurship

Social enterprises are businesses that trade in the market in order to fulfil social aims. They bring people and communities together for economic development and social gain. Social enterprises have three common characteristics: (a) Enterprise-oriented. They are directly involved in the production of goods and the provision of services to a market. They seek to be viable trading concerns, making a surplus from trading. (b) Social aims. They have explicit social aims such as job creation, training and the provision of local services. They have ethical values including a commitment to local capacity-building. They are accountable to their members and the wider community for their social, environmental and economic impact. (c) Social ownership. They are autonomous organizations with a governance and ownership structure based on participation by stakeholder groups (users or clients, local community groups etc.) or trustees. Profits are distributed as profit-sharing to stakeholders or used for the benefit of the community. Social enterprises stand out from the rest of the social economy as organizations that use trading activities to achieve their goals and financial self-sufficiency. They are businesses that combine the entrepreneurial skills of the private sector with a strong social mission that is characteristic of the social economy as a whole. Social enterprises have a governance structure based on participation by the workforce or other stakeholder groups. This participation varies according to the different models applied to needs under diverse circumstances. Social enterprises come in a variety of forms, which include:

•

Employee-owned businesses: creating jobs and rescuing jobs as part of economic development strategies;

•

Credit unions: finance;

providing access to

•

Cooperatives: associations of persons united to meet common economic and social needs through jointly-owned enterprises;

•

Development trusts: key actors in community-based regeneration;

•

Social firms: providing employment and training to people with disabilities and other disadvantaged groups;

•

Intermediate labour-market companies: providing training and work experience for the long-term unemployed;

•

Community businesses: social enterprises which have a strong geographical definition and focus on local markets and local services;

•

Charities’ trading arms: enabling charities to meet their objectives in innovative ways, such as fair trade companies.

Problems that can affect this sector of the economy are labels and definitions: trying to define a social enterprise can be like trying to define an elephant – very difficult but not very useful, because you certainly know one when you see one. Worse still can be the problem of labelling and defining the different types of social enterprises. However, one need not be put off by words, labels and definitions; they may be used if they help and ignored if they do not. It is important to remember that social enterprises can have an important role to play in the twenty-first century economy and can present good business opportunities.

1. Organizational features (a) Control mechanism Social enterprises are controlled through a variety of ownership structures, using a variety of models. In some social enterprises, there is a small core of individuals play a role similar to trustees. Such “trustees” fulfil the dual role of members and directors of a corporate board. The trustees receive no personal profit from the business.

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Such enterprises often provide income or employment for the disadvantaged or services to a community. By contrast, social enterprises such as credit unions or cooperatives have a large number of members who elect the board of directors. These are self-help organizations. A wide range of representative models is found between these two types, sometimes involving a variety of stakeholders being represented on the board.

(b) Income Social enterprises differ from the voluntary sector in seeking to become self-sufficient and not grant-dependent by developing businesses in a market place. While most are viable businesses receiving no grants or donations, some social enterprises, particularly those addressing social exclusion, receive start-up and capital grants. In disadvantaged communities, these grants finance capital purchases and start-up costs in the same way that equity finances mainstream businesses. These grants are usually tied to training programmes or the delivery of other social benefits.

(c) Social goals They are actively aware of their social and environmental impact. They actively manage their operations to minimize and offset negative consequences and optimize positive ones. Social enterprises have social goals; they are socially responsible and are socially-owned. They are community-led organizations, responsible to their members. They seek to empower communities and build social capital. As in credit unions, it is the depositors that own the business. Communities can use joint ventures to pursue their aims.

(d) Development focus Social enterprises need to balance social and economic aims. For example, successful, a credit union must not become a people’s bank”, serving only the poorest community.

their to be “poor in a

A common finding in the research on successful social enterprises is their strong underlying sense of common purpose. Social enterprises

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are mission-driven, often in reaction to social and economic problems: the closure of a factory, social exclusion, the decline or absence of an important service or lack of employment opportunities, for example.

(e) Market focus In the 1980s, many community businesses were closely linked to local government initiatives and training programmes. They required ongoing subsidies to operate. A Rowntree-funded research report, entitled Unleashing the Potential, stated: “There are successes, but the scope for economically viable small businesses on an estate where there is little spending power is limited. Those which are commercially viable tend to cover a much wider geographical area.” Communities now recognize the need to build sustainable businesses that outlive the Single Regeneration Budget or other grant programmes that financed their start-up. While some successful community businesses deliver local services, that is, community-owned retailing or credit unions, most seek wider market opportunities. The problem of economic development is seen not only as an absence of resources but also an absence of market relationships. As with other businesses, finding a viable market is the key to sustainable community businesses. In the 1980s, it was common for community cafés to be established on housing estates. In contrast, Annabelle’s, a social enterprise firm, operates a restaurant in a fashionable part of London; half its employees are people who have experienced mental health problems.

2. Social enterprises for business advisers Social enterprises have much in common with other businesses and need access to professional advice on many of the same issues. They also have important differences that business advisers need to consider, such as the following: Social enterprises are mission-driven. They often react to social and economic problems, such as the closure of a factory, social exclusion, the decline or absence of an important service or lack of employment opportunities. Some social

III. Social Enterprise: A Frontier for Alternative Entrepreneurship

enterprise leaders may have a wider perspective but community members sign up to support social enterprises out of a desire to meet a real need. Social enterprises seek to integrate social goals into their business. In the early stages, they need to clarify these goals and their understanding of how to integrate them within the business. Developing an understanding of the new wave of business enterprises that successfully integrate social and economic goals is critical. The social aims strengthen the business by building loyalty among customers, employees and other stakeholders. Social enterprises need to develop as organizations. Social enterprises are team enterprises, developed and run by groups of people. They require access to people trained in organizational development who understand working with and developing strong boards; can coach managers on team-building and participatory management; understand contemporary employee involvement techniques; and have experience in community consultation processes. Social enterprises draw on the best in modern management and take participation seriously. Their participatory nature can provide a competitive advantage by building loyalty and tapping the knowledge of consumers and employees. Social enterprises rally communities around a real need. They have the opportunity to become highperformance organizations that private firms would envy for their sense of common purpose.

C. Sources of finance In social enterprises with formal members, the equity may comprise:

•

Member shares: An investment by each member varies from £1 to £10,000 or more. In social enterprises with wide community membership, the individual member’s share is generally small, often less than £100. In employee-owned firms, particularly employee buy-outs to rescue a business, a member’s share may be large (£2,500-£10,000 or more).

•

Member investment: Voluntary investment by some members in the form of member loans or preference shares.

Other sources of finance may include:

•

Retained earnings including capital grants: Capital grants can be shown on the balance sheet and amortized at the same rate as the assets they financed. (This means that a capital grant need not be included in income in the year received.)

•

Bank loans: Banks will provide loan funds to social enterprises on the same basis as they lend to the private sector. Some banks also have special programmes and products to support social enterprises. Several banks provide special packages to credit unions, while others offer special products for employee-owned businesses. Some banks also have staff that specialize in supporting community enterprises or cooperatives.

•

Social investment funds: A number of specialist funds target social enterprises. These funds may require less security than banks and will have staff that are knowledgeable about the social enterprise sector. Community finance initiatives provide loan finance to social enterprises and microenterprises.

Social enterprises tend to cluster. They often group together in areas where there is a wellmanaged agency facilitating networking. Assisting a new social enterprise to network with existing successful social enterprises is an important part of the development process. Social enterprises have different financial and legal structures. Section C describes a variety of these structures. For all these and other reasons, advisers to social enterprises go through special training to acquire appropriate specialized expertise. More often than not, they themselves form social enterprises geared to providing professional services to other social enterprises.

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

•

Grants: Some social enterprises, particularly those addressing social exclusion, receive start-up and capital grants. In disadvantaged communities, such grants substitute for equity investment by financing capital purchases and start-up costs. These grants are usually tied to training programmes or the delivery of other social benefits.

but that the 10-20-per-cent difference often constitutes the make or break factor. The difference is found in the organizational culture. Social enterprises have participatory cultures with a strong sense of social mission and community. The commitment to a participatory culture can mean that it is easier for social enterprises to survive downturns than it is for conventional businesses.

•

Tax credits: In the United Kingdom, tax credits are used to promote employee ownership. The new All Employee Share Ownership Plan provides tax benefits to employees who invest in their company. In addition, companies which give shares to employees as bonuses can deduct the value of the shares from pre-tax income.

1. Marketing

1. Assets, liabilities and security The ownership of assets in social enterprises is similar to that of other businesses, with one exception: they may have assets donated or transferred to them by supportive organizations. The transfer documents may contain special covenants limiting the use of the assets or governing the disposal of the assets if the business fails. If the social enterprise is a trading subsidiary of a charity, it may covenant any profits to the charity. In this case, the social enterprise would not normally build reserves, as the profits are transferred to the charity. There is also a “group” structural problem, that is, it is effectively impossible to lend on a “group basis” to a charity and its trading subsidiaries. Often the charity owns the assets but cannot use them as a charge to secure a loan for its subsidiary.

Similarity: As is the case with other SMEs, social enterprises sell goods and services in the market place. For this purpose, they need to develop good marketing skills. Difference: Social enterprises, as community organizations, are often able to build community loyalty and maintain support in difficult times. In some key industries such as care, social enterprises may have an easier time building up trust. Such loyalty and trust does not substitute for providing good products at a good price.

2. Management Similarity: Social enterprises require all the management skills of the SME sector. As with many smaller businesses, the managers of social enterprises need to be skilled in more than one management function. Difference: In social enterprises, the participatory culture makes extra demands on managers, but it can bring about greater flexibility among the workforce. It is also more likely that the board of directors of a social enterprise will include nonexecutive directors. These may well be people with particular skills, local knowledge or contacts. If used properly, they can provide strengths not available to many small firms.

Social enterprises may be incorporated with limited liability as are other companies.

3. Finance

D. Social enterprises versus other types of enterprises

Similarity: The balance sheets of social enterprises look similar in many ways to those of most SMEs.

It has been suggested that social enterprises may be 80-90 per cent similar to other businesses,

Differences: The investment instruments of social enterprises are different. Profits may be

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III. Social Enterprise: A Frontier for Alternative Entrepreneurship

used for community benefit or distributed to stakeholders under profit-sharing schemes. Social enterprises may have difficulty gaining access to finance. However, in some cases they may access community finance initiatives. These special funds target social enterprises and disadvantaged neighbourhoods.

4. Organizational structure Similarity: The operational structure of social enterprises is similar to that of other firms in the same industry, particularly firms that emphasize teamwork. Differences: Social enterprises often place more emphasis on training and may employ extra training staff. This is particularly true for social enterprises working with the long-term unemployed or with people with special needs such as social firms. Successful social enterprises will generally make more use of teamwork and genuine participatory structures than mainstream SMEs.

5. Legal framework Similarity: Social enterprises are subject to all the same regulatory requirements as other SMEs (minimum wage, health and safety, etc.). Differences: Social enterprises, particularly credit unions and cooperatives, may be incorporated under different legislation. Social enterprises have members or trustees, not shareholders.

E. Conclusions: Why social enterprise? From the foregoing, it is obvious that the social enterprise strategy, as currently effective in the United Kingdom and elsewhere in Europe, has a crucial role to play in creating jobs for the jobless at one end of the spectrum and transforming the strongly profit-focused business and industrial management culture into a radically humane community dedicated to creating public goods and services as well as profit at the other end. Falling between these extremes would be the regeneration of depressed urban and rural communities (as well

as the prevention of such degeneration), promotion of fair trade in business and industrial practices, introduction of participatory democracy as the key to successful business management, the empowerment of people and communities in the process of their participation in business and industry. The search for an economic system capable of bringing prosperity and a sense of well-being to all has a long history. In the nineteenth and the twentieth centuries alone, numerous thinkers, including Adam Smith, Maynard Keynes, Vilfredo Pareto, Carl Marx and Friedrich Engels, grappled with these concepts and a number of revolutions were carried out in disparate parts of the world in the hope of actualizing such a system. The socialist revolution that had ushered in communism as the mainstream socio-economic and political order in many countries, which held sway in them until not so long ago, is perhaps the most notable example of the latter. The collapse of the socialist order gave way to the rise of “globalization”, another promise of an economic panacea that exerts power over current national and international affairs without necessarily seeming to fulfil its promise so far. If anything, the status of the world economy is shakier today than before globalization. The economies of those regions and countries that are ill-equipped or unprepared for competition in the global free market find themselves generally worse off than before globalization. Moreover, even the economies of the purveyors of globalization have been floundering of late after some initial “sunshine” years. The socio-economic and political malaise stemming from the current economic order and that carried over from previous orders have been debated ad infinitum by countless scholars, experts, policy makers, citizen groups, workers and industrialists. Nevertheless, real solutions to the malaise remain elusive. Countries find themselves hard put to balance their budgets, cope with rising unemployment, protect the environment, prevent businesses from going bankrupt, keep consumption at an optimum level and prevent the poverty gap from widening further, among many others. The United Nations has been an active participant in the debate and the actions related to the search for solutions. Good governance, human

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Investment Promotion and Enterprise Development Bulletin for Asia and the Pacific

development, environmental protection, gender equality, social integration, employment generation, poverty eradication, among others, all included under the banner of “sustainable development”, have formed its strategic policy and programme underpinnings for the previous decade or longer. A multitude of projects have been undertaken in the efforts to give substance to the notion of sustainable development. Such projects bore positive fruit in some areas. The achievements in health, education and gender equality have been

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considerable; in the areas of social integration and environmental protection, they have been tentative. As far as employment generation leading to poverty eradication is concerned, despite remarkable aggregate progress, the projects have not worked except in selective pockets. It is against this background that “social enterprises” offer realizable alternatives for sustainable development in the Asian and Pacific region as they have been doing in Europe and elsewhere.